Tax rate uncertainty, labor supply and saving in a nonexpected utility maximizing model

Abstract

The effects of uncertainty in rate of return tax rate, wage income tax rate and a comprehensive tax rate which affects both return to saving and wage income are analyzed in a nonexpected utility maximizing framework of Selden (1978). We consider a two period model where the agent works and saves. The effect of rate of return tax rate uncertainty on labor supply and saving critically depends on the magnitude of the elasticity of intertemporal substitution. A wage income tax rate uncertainty on the other hand unambiguously raises work effort while its effect on saving again depends on the magnitude of the intertemporal substitution elasticity. For empirically plausible magnitudes of the intertemporal substitution elasticity, saving responds positively to wage income tax rate risk. The effect of a comprehensive tax rate uncertainty on labor supply and saving, however, depends solely on the magnitude of the elasticity of intertemporal substitution.