Automatic Stabilization and Labor Supply
Mathias Dolls (ZEW Mannheim)
Clemens Fuest (ifo Institut)
Andreas Peichl (ZEW Mannheim)
Christian Wittneben (ZEW Mannheim)
Very preliminary draft. Please do not cite or distribute!
This version: August 10, 2016
This paper estimates the stabilizing effects of tax and transfers systems through a
marginal incentives channel. When income taxes are progressive, the tax rate that a
household faces will fall following an income decline in a recession, thereby increasing
work incentives and hence labor supply. This effect offsets part of the initial income
decline, stabilizing aggregate income and output. The magnitude of the effect depends
on the change in the marginal tax rate after a change in gross income, as well as the
elasticity of labor supply with respect to a change in the after-tax wage.
We estimate a structural discrete choice labor supply model and individual tax
rates for households in the EU28 using the microsimulation model EUROMOD and
EU-SILC household data. Our estimations show that up to ten percent of a fall in
household income is offset by an increase in labor supply. The EU average is roughly
two percent. The results reveal a large heterogeneity across countries, which is mainly
due to differences in the progressivity of the tax systems across Europe: the incentive
effect is large in countries with a highly progressive tax schedule, while it is zero for
countries with a flat tax, where the marginal tax rate is constant. Differences in labor
supply elasticities also play a significant role.
JEL classification: H31, H24, C25, H12
Keywords: Stabilization; Household Labor Supply; Elasticity; Income insurance;
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1 Introduction
Tax and transfer systems redistribute incomes across households. They also serve as Automatic
Stabilizers, providing insurance against income fluctuations over the business cycle. By Automatic
Stabilizers we mean those elements of the tax and transfer system that mitigate fluctuations in
output without discretionary government action (Dolls et al., 2012b).
This paper estimates the stabilizing effects of tax and transfers systems through a marginal
incentives channel. When income taxes are progressive, the tax rate that a household faces will
fall following an income decline in a recession, thereby increasing work incentives and hence
labor supply (Christiano, 1984). This effect offsets part of the initial income decline, stabilizing
aggregate income and output. The magnitude of the effect depends on the change in the marginal
tax rate after a change in gross income, as well as the elasticity of labor supply with respect to a
change in the after-tax wage.
In general, the stabilizing power of taxes and transfers can work through four channels (McKay
and Reis, 2016):
1. Disposable Income channel
2. Marginal Incentives channel
3. Redistribution Channel
4. Social Insurance Channel
The disposable income channel works through a mechanical effect of the tax system to absorb
fluctuations in gross income, which stabilized aggregate demand through the stabilizing effect
on disposable income (Pechman, 1973; Auerbach and Feenberg, 2000; Dolls et al., 2012b). In
the presence of nominal rigidities, this stabilization of aggregate demand will stabilize output.
The marginal incentives channel works through the change in the marginal tax rate when a
household is subject to an income shock. In a progressive tax system this will lead to an increase
in work incentives, which increases labor supply. The redistribution channel takes into account
that receivers of transfers may have higher propensities to spend out of their income, which
leads to the stabilization of aggregate demand. Through the social insurance channel, automatic
stabilizers influence precautionary savings, in particular, they might reduce savings to the point
that households encounter liquidity constraints after they face a shock.
Contribution This paper focuses on the marginal incentives channel. We estimate labor supply
elasticities for households in the EU27, as well as the responsiveness of the tax and transfer system.
In particular, we estimate the change of the marginal tax rate with respect to a percentage
change in the gross income. The marginal tax itself gives an indication of the tax system’s
automatic stabilization capacity according to the disposable incomes channel (Pechman, 1973;
Auerbach and Feenberg, 2000; Dolls et al., 2012b). When households face a sudden and temporary
income decline, they may temporarily be subject to a lower marginal tax rate. This triggers an
intertemporal substitution of labor. The magnitude of this effect is mainly driven by the change
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in the marginal tax rate that follows the income shock, and the elasticity of labor supply with
respect to the net wage.
Our first contribution is the estimation of labor supply elasticities in a consistent manner for a
large set of countries. We use a compelling methodology that allows to compare labor supply
elasticities consistently across countries. Secondly, we contribute to the literature that assesses
the incentive effects of the tax system by providing estimates of effective marginal tax rates and
the progressivity of the tax and transfer system (see Auerbach and Feenberg, 2000; Saez, 2002;
Immervoll et al., 2007; Wallenius, 2013). Thirdly, we contribute an estimate of the Automatic
Stabilization effect that operates through the marginal incentives channel.
Literature [TBC] McKay and Reis (2016); McKay and Reis (2016), Mattesini and Rossi (2012),
Oh and Reis (2012) Auerbach and Feenberg (2000); Auerbach (2009) Dolls et al. (2012b, 2011,
2012a) Kniesner and Ziliak (2002a,b) Blundell and MaCurdy (1999); MaCurdy et al. (1990);
Ziliak and Kniesner (1999); Bargain et al. (2014); Bargain and Peichl (2013)
2 Estimation
3 Datasets
4 Stabilization Framework
5 Results
6 Conclusion
2
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