Understanding Labor Supply and Taxation for Improved Financial Planning

1. CHAPTER 18 PERSONAL TAXATION AND BEHAVIOR

2. Labor Supply D |Slope| = w Income per week E1 G iii ii Income i Leisure Work 0 T F Hours of leisure per week time endowment

3. Effects of Taxation D |Slope| = w Income per week H E1 G iii ii |Slope| = (1-t)w Hours of work after tax E2 G’ i I 0 T F Hours of leisure per week Hours of work before tax

4. Effects of Taxation D Income per week H E1 G iii E3 Hours of work after tax ii K i J 0 T F Hours of leisure per week Hours of work before tax

5. Effects of Taxation D |Slope| = w Income per week |Slope| = (1-t2)w E1 N E4 (1-t1)$5,000 + (1-t2$5,000 (1-t1)$5,000 |Slope| = (1-t1)w |Slope| = (1-t2)w P 0 T F Hours of leisure per week Hours of work before tax

6. Empirical Findings • Eissa [2001] • Males • Females

7. Some Caveats • Demand-side considerations • Individual versus group effects • Other dimensions of labor supply • The compensation package • The expenditure side

8. Labor Supply and Tax Revenues Wage rate per hour SL j k a c w b d (1-t1)w e (1-t2)w f (1-tA)w i h (1-t3)w L3 LA L2 L1 Hours per week L0

9. Tax Rates versus tax revenue – Laffer Curve Tax revenue t1 t2 tA t3 Tax rate

10. Debate Over the Laffer Curve • The Laffer curve and the elasticity of labor supply • Where on the Laffer curve is the economy operating? • Empirical estimates of the elasticity of labor supply • Other ways tax rates can affect tax revenues • Determining the optimal tax rate

11. Saving N Future consumption c1 E1 c1* iii ii i I1 Endowment point Saving ІSlopeІ = 1 + r M c0* I0 Present consumption (c0)

12. Deductible Interest Payments and Taxable Interest Receipts N Future consumption c1 E1 c1* P c1t After-tax budget lineІSlopeІ = 1 + (1-t)r I1 A Savingaftertax Q M c0* c0t I0 Present consumption (c0) Saving before tax

13. Deductible Interest Payments and Taxable Interest Receipts N Future consumption c1 E1 c1* P c1t After-tax budget lineІSlopeІ = 1 + (1-t)r I1 A Savingaftertax Q M c0* c0t I0 Present consumption (c0) Saving before tax

14. Nondeductible Interest Payments and Taxable Interest Receipts N Future consumption c1 c1* P c1t After-tax budget lineІSlopeІ = 1 + (1-t)r I1 A Q M I0 Present consumption (c0)

15. Some Additional Considerations • Real net rate of return • Many assets • Private saving versus social saving • Validity of life-cycle model • Empirical evidence: the effect of taxation on saving

16. Tax-Preferred Savings Accounts • Types of tax-preferred savings accounts and how they work • Are contributions to these accounts new saving? • Administrative details and effect on saving

17. Taxes and the Capital Shortage • Taxes and investment • Taxes and excess burden • Closed versus open economy • Empirical evidence

18. Housing Decisions • Effects of the income tax on housing decisions • Rnet = R – I + ΔV • Implicit rent not taxed • Deductibility of mortgage interest and property tax payments • The decision to rent or buy

19. Proposals for Change • Critique of subsidy for owner-occupied housing • Are there significant positive externalities? • Impact on distribution of income • Political feasibility of taxing imputed rent • Reform proposals • Elimination of deduction for property tax and mortgage interest • Placing an upper-limit on deductions • An efficient solution

20. Portfolio Composition • Tobin’s model of portfolio composition • Impact of proportional tax with full loss offset • Impact on return • Impact on risk • Empirical evidence

21. A Note on Politics and Elasticities • Ambiguity about effect of taxation on behavior • Importance of elasticities • “Convenient” beliefs about elasticities

22. Taxes and Human Capital Accumulation • Human capital • Investing in human capital • B – C > 0 • (1 – t)B – (1 – t)C = (1 – t)(B – C) > 0 • Income versus substitution effects • Shortcomings of model • Returns uncertain • Explicit costs • Other taxes • Progressive taxes

23. Effect of Taxation on Saving • Problems using the regression approach • Specification issues • Measurement issues • Bernheim [2002]