Labor Income Tax Research Articles

Envelope Wages, Hidden Production and Labor Productivity

We evaluate the relative importance of aggregate labor productivity versus income taxes and social contributions for tax compliance in an economy with a large degree of informality. Empirical evidence points out that tax evasion in Europe happens through partially concealing wages and profits in formally registered enterprises. To this end, we build a model in which employer-employee pairs of heterogeneous productive capacities make joint decisions on the degree of tax evasion. The quantitative model is used to analyze the case of Bulgaria which has the largest informal economy in Europe and underwent a number of important tax reforms over the period 2000–2014, including the introduction of a flat income tax in 2008. The estimation strategy relies on matching the empirical series for the size of the informal economy and other aggregate outcomes for 2000–2014. Our counterfactual experiments show that the most important factor for the changing size of the informal economy is labor productivity, which accounts for more than 75% of the change. The variation in corporate income tax accounts for the rest. We find that the 2008 flat tax reform did not play any visible role in coping with informality.

Should Euro Area Countries Cut Taxes on Labour or Capital in Order to Boost Their Growth?

The large imbalances within euro area have led to renew interest in tax policies that could reduce labour costs and thus improve competitiveness and growth. In this paper, we consider whether it would be more growth-enhancing for euro area countries to, instead, use capital income tax cuts. To address this issue, we focus on the open-economy dimension and make the simplifying assumption of complete insurance markets. Using a DSGE model calibrated for France within the euro area, we show that the increase in output resulting from tax cuts on capital income would indeed be higher than the increase in output resulting from tax cuts on labour, both in the short and long run. Importantly, the strong response of output to capital income tax cuts appears to be partly explained by the particularly high level of capital income taxes in France. Moreover, such tax cuts would be less efficient if they were expected to be only temporary. Finally, we illustrate our main points through a recent fiscal package implemented in France, which combines labour and capital income tax cuts. After briefly assessing this package, we find that investment and real output would have been more strongly boosted in the medium run if this package had been focused to a larger extent on reductions in capital income taxes.

Redistribution with Labor Markets Frictions

How do labor market frictions affect optimal redistributive policies? Are current real world policies efficient? To answer these questions and assess their quantitative relevance we embed an otherwise standard Mirrlees’ (1971) economy in a directed search environment. Effort and employment probability wedges must have the same sign for an allocation to be efficient. Moreover, constrained efficient allocations are shown to be monotonic in both effort and the probability of finding a job, a property that is not implied by incentive compatibility. After showing that labor income tax schedules along with unemployment benefits do not suffice to implement constrained efficient allocations, we describe tax instruments that do. Our optimal policy formulae can be used to derive an allocation which improves upon any constrained inefficient, and cannot be improved upon by local reforms. We calibrate our model to match data for the US economy and quantify the gains from moving to an optimal policy, finding that it leads to a 2.17% increase in Government revenues.

Redistribution and insurance with simple tax instruments

We analyze optimal taxation of labor and capital income in a life cycle framework with idiosyncratic income risk and ex-ante heterogeneity. Tax instruments are simple in that they can only condition on current income. We provide a decomposition of labor income tax formulas into a redistribution and an insurance component. The latter is independent of the social welfare function and determined by the degree of income risk and risk aversion. The optimal linear capital tax is non-zero and trades off redistribution and insurance against savings distortions. Our quantitative results reveal that the insurance component contributes significantly to optimal labor income tax rates and provides a lower bound on optimal taxes. Optimal capital taxes are significant.

Macroeconomic impacts of fiscal policy shocks in the UK: A DSGE analysis

This paper develops and estimates a new-Keynesian dynamic stochastic general equilibrium (DSGE) model for the analysis of fiscal policy in the UK. We find that government consumption and investment yield the highest GDP multipliers in the short-run, whereas capital income tax and public investment have dominating effect on GDP in the long-run. When nominal interest rate is at the zero lower bound, consumption taxes and public consumption and investment are found to be the most effective fiscal instruments throughout the analysed horizon, and capital and labour income taxes are established to be the least effective. The paper also shows that the effectiveness of fiscal policy decreases in a small open-economy scenario and that nominal rigidities improve effectiveness of public spending and consumption taxes, whereas decrease that of income taxes.

Do Capital Income Taxes Hinder Growth?

One of the main arguments against raising capital income tax rates is that doing so discourages savings and investment and hinders economic growth. However, academic research on taxes and growth suggests that this argument has no real basis. And the primary alternatives to capital income taxation — labor income taxes and increased government borrowing — carry their own potentially adverse effects on growth.

A Tale of Tax Policies in Open Economies

Recent financial crises in Europe as well as the periodic battles in the U.S. over the debt ceiling point to the importance of fiscal discipline among developed countries. This paper develops an open economy model, calibrated to the U.S. and a subset of the EMU, to evaluate the impact of various permanent tax changes. The first set of experiments considers a targeted one percentage point reduction in the government deficit-to-GDP ratio through raising one of: the consumption tax, the labor income tax, or the capital income tax. In terms of welfare, the consumption tax is found to be the least costly of the tax increases. A second set of experiments looks at deficit-neutral tax changes: partially replacing the capital income tax with either a higher labor income tax or higher consumption tax; and partially replacing the labor income tax with an increased consumption tax. Reducing reliance on capital income taxation is welfare-enhancing, although it leads to short term losses. Reducing labor income taxation improves international competitiveness and is welfare-improving.

A TALE OF TAX POLICIES IN OPEN ECONOMIES

To evaluate fiscal policy reforms for Euro‐area countries, this article develops and calibrates a small open economy model. Debt reduction reforms require higher tax rates in the short term in exchange for lower rates in the long term as the debt‐servicing burden falls. Using the capital income tax to implement such a policy leads to welfare gains; the consumption tax, a very small welfare gain; and the labor income tax, a welfare loss. Holding fixed the long‐run debt–output ratio, offsetting a lower capital income tax with either a higher labor income or consumption tax generally yields welfare gains.

Locational efficiency in a federal system without land rent taxation

We show that in a federal state with mobile population labor and capital income taxes do not suffice to achieve efficiency in general, but that they do suffice if the federation consists of just two types of regions. In the general case we study the resulting second-best problem and find that in the second-best optimum the level of public good provision is efficient, but neither capital nor labor is allocated efficiently.

Optimal Public Debt Consolidation with Distributional Conflicts

In this paper, we adopt a Ramsey-optimal approach to the identification of debt reduction strategies, that is, the optimal policy mix for labor and capital income taxes, public expenditures and inflation designed to achieve an exogenous debt reduction path. Our model accounts for monopoly profits, limited asset market participation and asset holders' infrequent optimization of their portfolio composition between money holdings and other financial assets. The optimal policy envisages persistent reductions in public consumption and increases in taxes and inflation. Distributional conflicts arise between asset owners and the rest of the population. When asset holders interests are relatively less important in the planner's objective function, labor income taxes are drastically reduced whereas capital income taxes and inflation are increased. Just in this case the consolidation has short term expansionary effects.

The switch from patents to state-dependent prizes for technological innovation

The intertemporal-bounty system is proposed to replace patents by requesting innovators to place innovations in the public domain in exchange for bounty claims. This eliminates monopoly distortions. As tradeable assets, bounty claims can earn intertemporal bounties or state-dependent prizes, conditioned on time-varying market sales from bountiable goods multiplied by a time-invariantbounty rate. Creative destruction can make some bounty claims worthless, however. Government collects taxes to pay bounties. The switch from patents to intertemporal bounties is simulated using an R&D-based growth model calibrated to the U.S. economy. Funded by a tax on labor income, the regime switch can generate a consumption-equivalent welfare gain of 7%. This is considered the maximum opportunity cost to keep the U.S. patent system, as the labor income tax is non-distortionary in the model. Funded by the distortionary capital income tax, the regime switch can remain welfare-improving, provided the bounty rate is set appropriately.

Sectoral Infrastructure Investments in an Unbalanced Growing Economy: The Case of Potential Growth in India

We construct a two-sector (agriculture and modern) overlapping generations growth model calibrated to India to study the effects of sectoral tax rates, sectoral infrastructure investments, and labor market frictions on potential growth in India. Our model is motivated by the idea that because misallocation depends on distortions, policies that reduce distortions raise potential growth. We show that the positive effect of a variety of policy reforms on potential growth depends on the extent to which public and private capital are complements or substitutes. We also show that funding more infrastructure investments in both sectors by raising labor income taxes in the agriculture sector raises potential growth.

Quasi-hyperbolic discounting, paternalism and optimal mixed taxation

This paper develops a dynamic model with endogenous labor supply, savings and health capital, where the consumers differ in ability as well as suffer from a self-control problem generated by quasi-hyperbolic discounting. The purpose is to analyze how a paternalistic government, which implements a time-consistent mix of labor income taxation, capital income taxation and commodity taxation, ought to use this tax system for purposes of redistribution and correction when individual ability is private information. Among the results, we show how the (nonlinear) income taxes ought to be used as indirect instruments for influencing the commodity demand behavior at the individual level: the intuition is that linear commodity taxes are not flexible enough to achieve proper incentives for consumption of unhealthy goods.

Indexing the income tax code, monetary/fiscal interaction, and the great moderation

This paper considers the consequences of automatically indexing the US federal income tax code to inflation. Indexation, implemented during the 1981 federal tax overhaul, and active monetary policy constitute necessary conditions for a unique rational expectations equilibrium in standard New Keynesian models with a generalized, progressive labor income tax. Additionally, fixing the monetary regime shows that indexation reduces overall volatility in the model as well as the contribution of supply-side disturbances. Together, these results support a fiscal extension to the “good policy” hypothesis of the Great Moderation and encourage further indexation of the United States tax code.

Tax wedge in Croatia, Belgium, Estonia, Germany and Slovakia

The aim of this paper is to analyse the taxation of labour income in Croatia, Belgium,Estonia, Germany and Slovakia. Having presented an outline of tax system rules, the paper shows the decomposition of the net average tax wedge for different family types and different income levels based on the OECD methodology. The results show that all observed countries apply a progressive tax schedule, apart from Germany where taxation for higher gross wages is not progressive due to a cap on the SIC base. When it comes to a taxpayer earning an average gross wage, a Croatian single worker without children has the lowest tax burden, followed by Estonia, Slovakia, Germany and Belgium. However, as regards taxpayers earning 400% of AGW, Estonia has the smallest tax wedge, followed by Slovakia, Germany, Croatia and Belgium. Similar results are obtained by analyzing the tax wedge for couples with two children where one spouse is out of work.

Estimating the impact of income tax on personal savings in Serbia: The two channels approach

This paper provides an empirical evaluation of the effects of income taxation on personal savings in Serbia, by taking into account both transmitting channels: the direct impact of capital income tax on the rate-of-return and the indirect impact of labour income tax on disposable income. The estimated elasticity of bank deposits to the rate of return of 0.3 and the estimated elasticity of employment income to a labour tax wedge of −0.38 suggest that income tax function aimed at minimising the efficiency losses should not considerably differentiate the tax burden on labour and capital income. We show that in the case of the introduction of a revenue-neutral income tax, with a single marginal tax rate of 15% and considerably larger labour income exemption, households’ savings in Serbia would decline by 0.27%. This means that the negative impact of a rise in the capital income tax wedge on savings would prevail over the positive effects of a labour tax wedge cut. The results imply that the overall possibility to boost savings using tax policy is modest.

The Taxing Deed of Globalization

This paper examines the effects of globalization on the distribution of worker-specific labor taxes using a unique set of tax calculators. We find a differential effect of higher trade and factor mobility on relative tax burdens in 1980–1993 versus 1994–2007 in the OECD. Prior to 1994, greater openness meant that higher income earners were taxed progressively more. However, after 1994, we document a globalization-induced rise in the labor income tax burden of the middle class, while the top 1 percent of workers and employees faced a reduction in their tax burden of 0.59–1.45 percentage points. (JEL D31, F16, F61, H22, H24)

The effect of endogenous human capital accumulation on optimal taxation

This paper considers the impact of learning-by-doing on optimal tax policy in a general equilibrium heterogeneous agent life-cycle model. Analytically, it identifies two main channels by which learning-by-doing alters the optimal tax policy. First, learning-by-doing creates a motive for the government to use age-dependent labor income taxes. If the government cannot condition taxes on age, then a capital tax or progressive/regressive labor income tax can be used in order to mimic age-dependent taxes. Second, a progressive/regressive labor income tax is potentially more distortionary in a model with learning-by-doing since the distortion is propagated through the additional intertemporal link between current labor and future human capital. Quantitatively, I find that both of these channels are important for the optimal tax policy. Adding learning-by-doing leads to a notably flatter optimal labor income tax due to the second channel. Moreover, including learning-by-doing causes an increase in the optimal capital tax due to the first channel. I find that when solving for the optimal tax policy in the learning-by-doing model, the welfare consequences of not accounting for endogenous human capital accumulation are equivalent to around one percent of expected lifetime consumption, a majority of which are due to adopting too progressive of a tax policy.

Endogenous Market Structures and Optimal Taxation

This article provides optimal labour and dividend income taxation in a general equilibrium model with oligopolistic competition and endogenous firms' entry. In the long run, the optimal dividend income tax corrects for inefficient entry. The dividend income tax depends on the form of competition and the nature of the sunk entry costs. In particular, it is higher in market structures characterised by competition in quantities rather than those characterised by price competition. Oligopolistic competition leads to an endogenous countercyclical price markup. As a result, offsetting the distortions over the business cycle requires deviations from full tax smoothing

Optimal income taxation when asset taxation is limited

Several frictions restrict the government's ability to tax assets. First, it is very costly to monitor trades on international asset markets. Second, agents can resort to nonobservable low-return assets such as cash, gold or foreign currencies if taxes on observable assets become too high. This paper shows that limitations in asset taxation have important consequences for the taxation of labor income. We study a simple dynamic moral hazard model of social insurance with observable and nonobservable saving decisions. We find that optimal labor income taxes become less progressive when the ability to tax savings is limited.