Discreteness and the Welfare Cost of Labor Supply Tax Distortions*

Abstract

We compare the welfare costs of tax distortions of labor supply in one‐ and two‐member household discrete and continuous choice labor supply (leisure consumption) models calibrated to the same aggregate uncompensated labor supply elasticities. In the discrete models, taxes induce a large response from a subset of the population, whereas the majority of the population exhibits unchanged behavior. In contrast, the majority of the population reacts to tax changes in continuous models. Discrete choice matters as the welfare costs of similar taxes vary significantly when individuals face discrete labor supply choices from when they choose working hours continuously.