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Tax effect

In this article I pretend to compare two goods, leisure and consumption, in order to test the responses in the labor supply side to increases in marginal taxes variations. I made two assumptions in order to proceed with my analysis: first, that consumption and labor are perfect complements – my utility is just fulfilled if I have proportional quantities of both – this lead me to the second assumption that we are indifferent between consumption and leisure. It is easy to get the first assumption; if I want to consume more I have to work more (without any income change). The second is more tricky, because preferences vary across person, but  by common sense we know that every citizen enjoy leisure time as well as consumption.

I used the Slutsky equation to drive my conclusions. “The equation demonstrates that the change in the demand for a good, caused by a price change, is the result of two effects”: substitution and income effect.

I base my article in the paper of Nada Eissa, Taxation and Labor supply of married women: the Tax Reform Act of 1986 as a natural experiment. The author analyses the responsiveness of high income married women to a decrease in the marginal tax rate using two control groups (in which the tax rates had a lower variation) with lower income. He is interesting to test whether the labor supply increase due to the reduce of taxes or if it’s associated with shocks in the labor market. Eissa was able to prove using differences-in-differences and a regression framework that participation rates increased in the upper-income group.

Looking in a microeconomic point of view, we can easily arrive to similar conclusions. If taxes decrease the net wage increase, so I will receive more for the same hours worked. Testing with Slutsky equation, we have to measure the impact of each effect.

The straight of each effect will depend, whether the reform is permanent or temporary. Citizens can’t predict the future, so the weight of each effect depends in what they believe. The paper of Eissa mention, which already have been a pre-reform in 81. With this, we can assume that people believe that this reform could be temporary; therefore the substitution effect will be stronger than income effect.

In other words, married women with high income will enjoy the increase in the net wage, because they believe this is a “unique opportunity” and in the future periods marginal tax rates will increase again (what actually happened in 93). She shifts her demand towards labor. Working more, she can consume more but she enjoys less hours of leisure. The opportunity cost of leisure increased, so she substitute leisure for more hours of work and in this way to consume more in present and future times.

Maria Dentinho 615


Author: studentnovasbe

Master student in Nova Sbe

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