Taxes, Hours and Employment

1. Taxes, Hours and Employment Edward C. Prescott Reykjavik, Iceland, July 26, 2007 Cutting Taxes to Increase Prosperity

2. Two Economic Diseases • Low productivity • Low market hours Output per person is productivity times market hours per person

3. Examination Prescott, M.D.

4. Statistics for 2004 relative to U.S.

5. Diagnosis • E.U.-15 has a case of the low labor supply disease • E.U.-15 also has a mild case of the low productivity disease

6. Is Europe Getting Sicker? Decade ProductivityGrowths

7. Answer • Maybe there is a productivity growth problem, but probably not • No doubt that Europe has the low hours disease • But reforms are on the way, and Europe’s health will improve

8. European Productivity • The European Union is a good system • Has led to high productivity • For 40 years prior to World War II, European productivity 53% of U.S. level • Since 1990 about 90% of U.S. level

9. Hours per Week per Person 16-64

10. When Did the Sickness Develop? • Europe didn’t have the low hours disease in the early 1970s • Then 23.8 hours per person per week • Now European hours 18.3 • U.S. hours increased from 23.5 to 25.4 in this period because of 1986 Tax Reforms

11. What Caused the Sickness in Europe? • Western Europe increased marginal effective tax rate from 40% to 60% • U.S. kept its tax rate at 40% A 60% tax rate means on margin if someone works more and produces 100€ worth of output, get to keep 40€

12. U.K. Is Not That Sick • U.K. market hours only fell from 25 per working-age person per week in early 1970s to 23.3 today • But …

13. The British Are Not European

14. What about Iceland? • Tax system • Flat rate individual income tax rate, 36% • Consumption tax rate, 35% • Value-added tax rate between 14% and 24.5% • Part of property tax • Most of excise duties • Relatively modest payroll tax rate, 6%

15. Iceland: Predicted vs. Actual Labor Supply • Average hours worked per person 1996-2005 • Predicted: 24.3 • Actual: 26 • Inconsistencies in measurement • Foreign workers • Number of part-time workers • Size of underground economy bigger in U.S. and Europe

16. Is Scandinavia a Problem for the Theory? • Discrepancy for Scandinavia is not a measurement issue • With simple theory aggregate hours under predicted by 20-45 percent • But this theory abstracts from • Other factors that affect work incentives

17. Features of Scandinavian Welfare States • Subsidized day care conditional on working • Subsidized elderly care • Some government employment not employment • e.g., those in training programs

18. Findings • Public expenditures on home good important for explaining labor supply in market and at home • Accounting for public provision of day care and elderly care in Scandinavia closes half of gap in predicted market work • Sweden, after its long secular decline relative to other advanced industrial countries, beginning in 1995 has been reforming, has become more prosperous Ragan (2005), Stockholm School of Economics

19. What Is the Cure? Tax Rate Cuts

20. What about Side Effects of Tax Cut? • Won’t this reduce revenues that are needed to finance social programs? • The answer is …

21. Answer • No • Why: Revenue will not fall

22. Iceland: Corporate Tax Rate Down, Revenue Relative to GDP Up Corporate Tax Rate(right scale) % % Corporate Taxes as % of GDP (left scale) Source: Iceland Ministry of Finance

23. Cutting Taxes and Preserving the Welfare State • Shift to some mandatory saving for retirement and nonextraordinary medical expenditures • Avoid throwing away output • France 25% • Iceland 10%

24. Europe Will Cut Tax Rates and Will Boom • Europe has no choice except to reform • There will be healthy growth in Western Europe • with 20% increase in output in 5 years • and a catch-up to the United States • Process already started

25. Spain Is Leading the Way • Spain cut tax rates in 1998 and made other labor market reforms • Let’s see how Spain has been doing

26. Dramatic Improvement in Hours Source: OECD

27. Why Isn’t This Cure Widely Known? Some History • Macroeconomists found market hours respond strongly to incentives • Microeconomists argued otherwise

28. Who is Right Matters for Evaluating Tax Policies • Public finance people sided with macroeconomists • Martin Feldstein and Glen Hubbard (former chairmen of the Council of Economic Advisors) in mid-1980s • But were ignored

29. Congress Sided with Labor Economists • U.S. Congress ruled that its budget office must assume the effect of tax rates on hours is zero • Congress likes to tax and spend • Congress does not like to impose dead-weight losses • Dead-weight loss big if macroeconomists right, small if labor economists right

30. We Now Know So Much More • We know theory predicts economic fluctuations of the nature observed if and only if this labor response is high (Kydland-Prescott Nobel Prize paper)

31. A Puzzle • Microeconomists looking at individual behavior were finding one thing • Macroeconomists looking at aggregate behavior were finding something different • Why weren’t the two findings consistent?

32. Theory to the Rescue • Microeconomists assumed that people varied the length of the workweek and not the number of weeks worked over the lifetime • Europeans workers work 40 weeks a year while U.S. workers work 46 weeks a year • Europeans retire earlier than Americans

33. Model of Life Cycle Labor Supply • There are two margins of labor supply • Length of working life • Hours per employed person Rogerson and Wallenius (2007), Arizona State University

34. Hours  = .3  = .5 Age Taxes Reduce Both Margins • Length of working life important margin

35. Puzzle Resolved • Macroeconomists permit (and the new generation of labor economists permit) fraction of lifetime worked to vary • Micro and macro observations are now in conformity • Same response for all countries (including Japan, Australia, New Zealand, Japan, Chile, Greece and Ireland, as well as the G7 countries)

36. Welfare • Nonmarket time is valuable • Because of taxes, the value of time on margin is higher in the business sector than in the household sector Welfare gains of cutting tax rates are …

37. Iceland

38. Tax Rates Can Be Cut Below U.S. Levels • How: Shift from tax and transfers to retirement saving accounts • Over 25 countries have them • Singapore and U.S. have health savings accounts

39. U.S. Is Shifting • Big shift in U.S. to savings for retirement • Even federal government has shifted • State and local governments have begun to shift • Like Iceland, everyone will have their savings account

40. What about Transition Costs Of moving to a saving system? • There are none • Switching is a bookkeeping entry that makes some implicit government liabilities explicit • Honest accounting is good • Poverty rate would be reduced

41. Conclusions • Iceland doing well, but could be doing better • By moving in the direction of a saving system to finance nonextraordinary expenditures