Abstract
A higher labor tax rate increases the equilibrium real interest rate and reduces the equilibrium wage in a heterogeneous-agent model with endogenous savings and indivisible labor supply decisions. I show that these general equilibrium (GE) adjustments, in particular of the real interest rate, reinforce the negative employment impact of higher labor taxes. However, the representative-agent version of the model, which generates similar aggregate employment responses to labor tax changes, implies that GE feedback is neutral. The cross-country panel data reveal that the negative association between labor tax rates and the extensive margin labor supply is significantly and robustly weaker in small open economies where the interest rate is less tightly linked to domestic circumstances. This empirical evidence supports the transmission mechanism of labor tax changes for employment in the heterogeneous-agent model.
Highlights
The goal of this paper is to explore general equilibrium (GE) feedback regarding the employment effects of labor tax changes
Using a fairly large cross-country panel data set, I first document that the negative relationship between the labor tax rate and the extensive margin labor supply is considerably flatter among SOEs
I have found that GE feedback, in particular of interest rate adjustments, reinforces the negative employment impact of higher
Summary
The goal of this paper is to explore general equilibrium (GE) feedback regarding the employment effects of labor tax changes. The aggregate efficiency unit of labor falls relatively less than other macroeconomic aggregates, including aggregate capital stock, with respect to higher labor taxes This leads to lower equilibrium wages and higher equilibrium interest rates, both of which tend to reinforce the negative impact of labor taxes on employment. As the interest rate in small open economies (SOEs) is less tightly linked to domestic circumstances, a testable implication of the theory is whether the negative employment impact of higher labor taxes is weaker or not among SOEs, compared to nonSOEs. Using a fairly large cross-country panel data set, I first document that the negative relationship between the labor tax rate and the extensive margin labor supply is considerably flatter among SOEs. labor supply elasticities, estimated from panel regressions in the spirit of Prescott (2004) and Chetty et al (2012), show that the elasticity among SOEs is significantly lower than that among non-SOEs, which is in line with the transmission mechanism of labor tax changes on aggregate employment in the heterogeneous-agent model.
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