The Prospect of Higher Taxes and Weak Job Growth During the Recovery from The Great Recession: Macro versus Micro Frisch Elasticities

Abstract

Labor input growth during the recovery of the U.S. economy from the Great Recession of 2008–2009 has been considerably lower than expected. A number of scholars have attributed this disappointing outcome to the prospect of higher taxes, induced by the fiscal imbalances that will materialize in coming decades under current policies. The paper examines this fiscal sentiment hypothesis from the perspective of a neoclassical growth model, under the assumption that the typical household's preferences can be represented by a utility function that implies a constant intertemporal (Frisch) elasticity of substitution for aggregate hours of work, and for a hypothetical tax regime that incorporates the Congressional Budget Office' s assessment of the U.S. fiscal situation. The paper finds that the empirical relevance of the fiscal sentiment hypothesis depends on whether this Frisch elasticity of labor supply is closer to the relatively large values needed to account for the observed volatility of labor input at business cycle frequencies, than to the lower values estimated by microeconomic and quasi-experimental studies.