Labour Supply and the Incidence of Income Tax on Wages

In the simple framework of a static model for equilibrium wages and labour supplies, we show that the incidence of income tax on equilibrium wages can be measured independently from the individual labour supply elasticity. This extends recent work by Blundell, Duncan and Meghir (1998) and Eissa and Liebman (1996), who estimate labour supply elasticities, and Gruber (1997), who estimates tax incidence on earnings. Our measurements are based on a large multi-level longitudinal data set of Danish private sector establishments.We find strong evidence for partial shifting of the burden of income tax from worker to employer. Higher marginal tax rates are associated with increases in gross wages and earnings. A traditional estimate of the elasticity of labour supply with respect to the net wage, which assumes no shifting of the burden of income tax, is found to overstate incentive effects by a factor of two. * Financial support from the Danish Social Science Research Council, the UK Economic and Social Research Council and the Leverhulme Trust is gratefully acknowledged. The paper has benefited from the comments of Richard Blundell, Ebbe Graversen, Lars Muus and Ian Walker which lead to many insights and clarifications. Søren Leth-Sørensen created the original dataset and made this work possible. The usual disclaimer applies. 1 Motivation and Introduction The effects of tax policy reform depend upon how policy changes the prices that agents face in the market, and on how behaviour in the market responds to these changes in prices. Most empirical research focuses exclusively on the latter. The maintained assumption is that a tax is incident on those who are formally liable to pay it and that there is no shifting of the burden of taxation. As a part of the total tax wedge between production and consumption wages, labour taxes (on payroll and/or earnings) account for half of all OECD government revenue (OECD, 1998). These taxes influence both workers’ decisions about how much labour to supply to firms and firms’ decisions about how much labour to employ at the going wage rate. The labour supply and tax incidence literatures have separately failed to reach any consensus on the magnitude of the elasticity of labour supply with respect to net wage and that of the gross wage with respect to labour taxation. The responsiveness of gross wages and employment to labour taxes depends upon three related factors: first the nature of the tax wedge driven between the real consumption wage and the real product wage, i.e. how taxes are raised; second, the degree of labour market competition (reflected in the institutional structure of wage setting) and the degree of product market competition; and third, the perceived links between labour taxes and future benefits, for example pensions, sickness and unemployment transfers. The theoretical labour tax incidence literature has produced a variety of results according to different wage setting assumptions. Malcomson and Sartor (1987) show that in general the effect of average tax rates on gross wages is ambiguous. Jackman and Layard (1990) show that increased tax progressivity can have favourable employment effects in a variety of models of equilibrium unemployment: efficiency wages, union-firm bargaining and monopoly union settings. Lockwood & Manning (1993) show under certain assumptions, union-firm bargaining leads to higher gross wages with tax progressivity. However, Mortensen and Pissarides (1994) show that the opposite can be true in a model of employee-firm bargaining over wages and employment. Holmlund and Kolm (1995) show tax progressivity can moderate real wages and increase employment in a model of bargaining between unions and firms over wages and hours, provided unions care about net wages. 1 For recent surveys see Blundell and MaCurdy (1998) and Liebfritz, Thornton and Bibbee (1997) respectively. 2 Nickell and Layard (1998) for instance, suggest two cases in which the type of taxation may matter for incidence. Firstly, moving from tax on income (earned and unearned) to payroll taxes on earnings only reduces the tax rate on non-labour income, which may reduce labour supply. Secondly, in the presence of minimum wages, a switch from income to payroll tax reduces the demand for minimum wage earner services because the wage cannot adjust downwards.