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Working Paper Series - Taxation And Labor Supply Decisions: The Implications of Human Capital Accumulation



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Taxation And Labor Supply Decisions: The Implications of Human Capital Accumulation


Volume : 0

No : 0

ISSN : WPS0205

Publisher : Arab Planning Institute - Kuwait

Author (s) : Mustafa Babiker 

Published Date : 1/1/2002


Contents :
The conventional literatureon the effects of labor taxation has typically ignored the role of educationand human capital accumulation. The recent development in growth theory withthe reinterpretation of human capital as an engine of growth, however, has setthe path for a rich research on taxation and labor supply decisions. Thoughthis research is still in its early stages, it has contributed a lot to ourunderstanding of the distortionary effects of labor taxation. In particularthis research has shown that labor taxes do not only affect the current laborsupply decisions but also affect the future supply decisions and the growthrate of the economy. Unfortunately, the details of these effects appear to varyconsiderably and indeed it is a primary concern of this paper to explain and reconcilethese differences. The typical conflicting results in this newly bornliterature arise in relation to whether labor taxes are more or lessdistortionary than capital taxes, and to whether labor tax reform or capitaltax reform has the most effect on economic growth. The recent papers by Lucas(1990), Pecorino (1994), Devereux and Love (1994), Wang and Yip (1995), andIhori (1997) lie within this domain. Although all these authors have used moreor less the same conventional setup of two-sector endogenous growth models,their conclusions differ widely.
Lucas (1990) has found that a revenue-neutral replacement of capital tax bylabor tax has virtually no effect on the US growth rate. In contrast,Pecorino (1994) has found that such a replacement reduces the growth rate ofthe USeconomy. Devereux and Love (1994) have concluded that capital tax is the leastefficient way of raising revenue compared to either a wage tax or a consumptiontax. Yet, for Taiwan,Wang and Yip (1995) have shown that a shift from capital to labor incometaxation retards economic growth. Not the end of the confusion, Ihori (1997)has found that, when bequests are not operative, a tax on human capital doesnot reduce growth but a tax on physical capital does.
The frustrating frequency of such conflicting results raises many doubts on thebasic setup in these models and greatly undermines the usefulness of theendogenous growth framework for addressing important policy issues such as taxreform. Hence, understanding and sorting out the sources of these conflictingresults is exercise worth of pursuing. Stokey and Rebelo (1995) have addressedthese sources among the endogenous growth studies that have looked specificallyon the tax reform question in US. They found that the conflicting results onthe effect of tax reform on the USgrowth rate are solely explainable by the differences in model parameters thathave been used in these studies. In particular, they found that parameters suchas factor shares, depreciation rates, the elasticity of intertemporalsubstitution, and the elasticity of labor supply have critical leverage on theobtainable results in these models.Our objective in this paper, however, ismore pedagogical. Different from Stokey and Rebelo (1995), our concern is toinvestigate more generally the implication of model parameters and assumptionsin the generic endogenous growth setup for the conclusions to be drawn on thedistortionary effects of labor vs. capital taxation. Also different from Stokeyand Rebelo (1995) study, our focus is not limited to the steady state growthrates but, in addition, encompasses the growth effects during the transition tothe steady state. Finally, different from all the aforementioned studies, ouranalysis, in addition to the growth effects, also accommodates the welfareimpacts of taxes in these endogenous growth models. These latter twodifferences are particularly important and worth a brief comment at this stage.First, we find that the transitional impacts of different taxes on growth ratescan be quite different in these models even when the steady state impacts areexactly identical. Second, in many instances, we find that the welfare effectscan move in opposite direction to the growth effects when comparing thedifferent tax packages. This suggests that two tax schemes that have identicalsteady-state effects may have quite different welfare implications. With thismore general framework at hand, we are able to generate a range of possibleoutcomes on the distortionary effects of labor vs. capital taxation by onlyvarying the representation of labor supply and the substitutability of laborand capital in the technology producing the consumption good. This range ofoutcomes accommodates virtually all the seemingly conflicting results in theliterature reviewed at the beginning of this section.The rest of the paper isorganized as follows. Section 2 presents a standard two-sector model ofendogenous growth and conjectures the implications of labor and capitaltaxation in this setup. Section 3 develops a stylized dynamic generalequilibrium model that captures the main features of the theoretical framework.Section 4 presents our simulation results, and section 5 provides someconcluding remarks.

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