November 2007, Vol. VII, Issue VI

Labour Supply and Marginal Tax Rates:

A case study of Belgium, France, Italy, the Netherlands, the United Kingdom and the United States of America

By A.J. de Bruin

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Policy Summary

In most nations, the law-abiding, hard-working individual loses a substantial part of his income to a range of taxes connected to his work, consumption and personal life. Taxes on labour income are particularly noteworthy, since they discourage people from working as hard as they would under a less punitive fiscal regime. This diminished labour participation creates a deadweight loss and reduces national income.

The attached research paper by Bram de Bruin (Erasmus University, Rotterdam), originally prepared as a masters’ thesis and with assistance from the European Independent Institute (The Hague, The Netherlands) investigates the effect of labour income taxes on the supply of paid labour for several Western countries over the last two decades. De Bruin uses time-series econometrics to determine the macro-economic impact of the labour income tax, adapting the marginal tax rate data from a recent paper by Nobel laureate Edward Prescott (2004). Though limited availability of historical macro-economic data prevents the construction of good models for some countries, all countries that can be modelled using linear time-series methods clearly confirm the damaging effect of excessive income taxes on the supply of paid labour.

In addition to confirming the damaging effect of labour income taxes, the paper also gives specific estimates of its magnitude for several countries and at the same time sheds some light on the amount of time it takes for changes in taxation to affect the labour market. For the countries with the best data, namely France, Italy, the Netherlands and the United States, the statistical estimates imply labour supply elasticities of approximately 0.43, 0.2, 0.15 and 0.18 respectively. In non-economic language, this means that the amount of paid labour would increase between 1.5 percent and 4.3 percent in the selected countries if the tax pressure on labour income was reduced by 10 percent (i.e., a reduction in the marginal tax rate from 40 percent to 36 percent). Moreover, the structure of the models shows that the time required for such an effect to materialize in the respective labour markets would be between one and two years.

Another noteworthy hypothesis that is confirmed in the paper, one already implied by Prescott’s analysis of the supply of paid labour (2004), is that the amount of time people spend working is not significantly influenced by union membership or other institutional factors by themselves. In other words, only when they are strongly correlated with tax pressure do institutional factors significantly influence the supply of paid labour. Attempts to add non- fiscal explanatory variables (concerning union strength, technological and demographic development) are largely unsuccessful and, in the few cases that they are successful, tend to have a small and/or ambiguous impact on the supply of paid labour.

Last but not least, an additional confirmation of the negative relationship between labour income tax pressure and the activity on the labour market is provided by a statistical analysis of the pooled data made up of all countries included in the paper. A visual inspection of this data immediately suggests that the negative impact of labour income taxes on paid working hours not only holds within countries, but clearly also across countries. This hypothesis is then statistically confirmed by means of pooled regression, which demonstrates, when it comes to the influence of labour income taxes on aggregate economic performance, there is little difference between countries.

In general, the conclusions of this paper are consistent with the notion commonly known as the Laffer Curve, which holds that a decrease in marginal tax rates on productive activity in high-tax societies will stimulate economic activity, thereby generating at least some additional government revenues that compensate for the revenue loss due to the lower tax rate. The paper focusses on the marginal tax rate of labour, which is a major contributor to the overall tax level, and predicts that lowering this marginal rate will generally boost labour participation. This increase in labour participatio n will, other things being equal, expand economic output, leading to a Laffer-Curve effect as additional tax revenues flow back to government (though only in rare cases will the additional revenue from stronger economic performance fully offset the revenue losses caused by the lower tax rate).

As already noted by Prescott (2004), from the viewpoint of public policy this is good news, since it implies that the general welfare can be considerably enhanced by cutting both government spending and income tax rates. Such reforms are especially important as a tool to address the aging problem faced by most Western nations in the coming decades. Given the gravity and universal character of the questions investigated in this paper, its research deserves to be expanded on in the future, by for instance increasing the number of countries, refining its statistical methods and gathering more relevant macro-economic data.