Estimating Labor Supply at the Extensive and Intensive Margins

How wages and non labor income affect the decisions to work and hours of work are critical for understanding the work disincentive effects of taxes and transfers, and the attendant design of optimal income tax and transfer schemes. I use data from the Current Population Survey and variation induced by fundamental reforms to the U.S. tax and welfare systems in recent decades to estimate the labor-supply response at the extensive and intensive margins to changes in after-tax and transfer wage rates and nonlabor income. I find that wage changes have a large effect on the decision to work (the average elasticity of employment is 1.3), but a small effect on hours of work (average compensated wage elasticity of 0.16). The estimates are consistent with a recent theoretical model by Saez (2002) that suggests that the optimal transfer policy is one that involves a modest income guarantee for non-workers coupled with subsidies for low-income workers much like the current EITC program.