Life-Cycle Labor Supply with Human Capital: Econometric and Behavioral Implications

I examine the econometric and behavioral implications of including human capital in the life-cycle labor supply model. With human capital, the wage no longer equals the opportunity cost of time – which is, instead, the wage plus returns to work experience. This has a number of important implications, of which I highlight four: First, labor supply elasticities become functions of both preference and wage process parameters. Thus, one cannot estimate elasticities without also specifying and estimating the wage process. Second, once human capital is accounted for, the data appear consistent with much larger labor supply elasticities than most prior work suggests. Third, contrary to much conventional wisdom, permanent tax changes can have larger effects on current labor supply than temporary tax changes. Fourth, human capital amplifies the labor supply response to permanent tax changes in the long-run, because a permanent tax reduces the rate of human capital accumulation, slowing the growth of wages. Acknowledgements: This paper was presented as the keynote talk at the Journal of Applied Econometrics conference on earnings dynamics, Paris, April 2014. An earlier version was presented as the Cowles Lecture at the 2011 North American Summer Meetings of the Econometric Society. Seminar participants at the University of Minnesota, the Australian National University, the University of Melbourne, the University of Zurich, the World Congress of the Econometric Society (Shanghai), the 2010 Australian Conference of Economists, the University of California at Berkeley, the 2011 SETA Conference (Melbourne), the Federal Reserve Bank of New York, the Prescott Center at ASU, Oxford, UCL, LSE and the Becker-Friedman Institute provided useful comments. I thank Susumu Imai and Nada Wasi for performing many of the simulation exercises reported here. This research has been support by Australian Research Council grants FF0561843 and FL110100247, by the AFTS Secretariat of the Australian Treasury and the ARC Centre of Excellence in Population Aging Research (grant CE110001029) at UNSW. But the views expressed are entirely my own.