Piece-wise or differentiable budget constraint? Estimating labour supply function for Finnish females

Abstract

Various estimation approaches have been used in recent literature to study the effect of nonlinear income taxation on labour supply. Different techniques and data sets have produced a wide range of income and substitution elasticities. In this study, we utilize register data provided by the tax authorities. This gives us good possibilities to construct detailed budget constraints for each individual in our sample. We estimate labour supply function using the piece-wise linear budget constraint approach and the differentiable budget constraint approach suggested by MaCurdy et al. (1990). Our results support the view that if one is able to mimic the actual budget set closely and if the degree of progression is high then these two methods are likely to produce similar results. Some sensitivity analysis is also carried out using alternative assumptions concerning the budget sets.