Card on Income and Substitution Effects

In Ec 10 we have been studying income and substitution effects. As a result, this passage from a recent interview in The Region with noted labor economist David Card caught my eye:

Region: As you may know, Ed Prescott has argued that different tax rates on labor in the United States and Europe explain why Europeans work fewer hours than Americans. Do you accept that explanation?

Card: I think that taxes could be part of the story. I would be surprised—given what I think is the credible range of estimates for the elasticity of labor supply—that tax differences are big enough to really explain the whole story.

It is conventional in one school of macroeconomics to assume that the elasticity of labor supply is quite high. And for some purposes that assumption may be correct. In thinking about responses to intertemporal or short-run shocks, for example, it is possible that the relevant elasticity is higher than labor economists have been able to estimate with conventional data and methods. A lot of work in the last 20 years has shown that the actual responsiveness of individuals to short-run fluctuations in wages may be bigger than the conventional estimates from the literature in the 1980s. Nevertheless, for the issue of taxes, we're really concerned about the long-run labor supply elasticity, which includes both the so-called substitution effect, representing the pure price effect of the higher wage, and the income effect. Those two go in opposite directions.

I believe that many labor economists in the United States—starting with H. Gregg Lewis, who was the intellectual father of modern labor economics—would agree with the view that in the long run the income effect dominates the substitution effect, so that over time, as societies become richer, people work a little bit less.

Region: They want more leisure.

Card: Yes, on average. That conclusion would be consistent with the long-run pattern of labor supply in the United States between 1890 and 1990. And in that case, one would normally assume that higher taxes [mean] lower wages and lead to a bit more work. That would have been my starting presumption, to tell you the truth: that the long-run labor supply elasticity is pretty small, and probably negative....

My own view would be that the plausible elasticity is not very big and that therefore the tax explanation won't go too far. But I don't want to get in a fight with Ed Prescott. After all, he's got a Nobel Prize and I don't [laughs].

I am not convinced that David is right. Here is the key question: When evaluating the effects of high taxes in Europe, compared to lower taxes in the United States, do we want to include both income and substitution effects, as David suggests, or just substitution effects?

The answer, I believe, depends on what happens to the tax revenue. If the tax revenue is wasted, then high tax rates are like low wages, and David is right. But suppose, more realistically, that the tax revenue is in effect rebated lump-sum to the taxpayers through a variety of entitlement programs (such as national health insurance). Then we are left with only a substitution effect. In this case, the effect of high taxes on the quantity of labor supplied is larger.

So I am more inclined to agree with Ed Prescott here. But I don't want to get in a fight with David Card. After all, he's got a John Bates Clark award and I don't.

Update: I emailed David to see if he wanted to comment, and he sent me this reply:

Thanks Greg. I am aware of Prescott's argument that the money collected in taxation goes back to the workers so the right analysis is one that ignores the income effect.

I don't think that is the right story myself: what fraction of the extra taxes that european workers pay do you think they view as yielding a rise in net income? My feeling is closer to 0 than 100%, but I can understand the alternative opinion. In that case, of course, the "cost" of bigger government is much smaller.

As my colleague Robert Barro pointed out to me, "Card is more likely to be correct the closer government expenditure is to being useless and vice versa for Prescott. Something of a role reversal."