Welfare Effects of Tax Reform and Labor Supply at the Intensive and Extensive Margins

Abstract

This paper argues that recent empirical evidence on labor supply behavior— showing stronger participation than hours-of-work responses— has important implications for the evaluation of tax reforms. We outline a simple welfare theoretic framework incorporating (discrete) participation responses, and show that in the presence of nonlinearities in the taxtransfer system, it is necessary to distinguish explicitly between intensive (hours worked) and extensive (participation) behavioral responses for welfare analysis. This is because welfare effects from participation depends on a different tax wedge than welfare effects from hours worked. To examine the quantitative importance of the theoretical results, we evaluate the welfare effects of a large tax reform in the United States, the Tax Reform Act of 1986, on female household heads. The simulations show that TRA86 created substantial welfare gains, concentrated largely along the extensive margin of labor supply. Our results indicate that policy simulations which do not account for (discrete) participation responses may make significant errors.