taxes, hours and employment edward c. prescott reykjavik, iceland, july 26, 2007 cutting taxes to...
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Taxes, Hours and Employment
Edward C. Prescott
Reykjavik, Iceland, July 26, 2007
Cutting Taxes to Increase Prosperity
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Two Economic Diseases
– Low productivity
– Low market hours
Output per person is productivity times market hours
per person
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Examination
Prescott, M.D.
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Statistics for 2004 relative to U.S.
Economy GDP per Person 16-64
Hours per Person 16-64
GDP per Hour
E.U.-15 6969 7878 8989
U.S. 100 100 100
Japan 77 102 76
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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
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Is Europe Getting Sicker?
Decade Productivity Growths
1984-1994 1994-2004
Europe 20% 15%
U.S. 15% 21%
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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
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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
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Hours per Week per Person 16-64
Year U.S. Spain France Germany
1985 97 65 75
1995 100 6666 71 76
2005 100 8787 69 74
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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
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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€
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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 …
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The British Are Not European
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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%
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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
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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
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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
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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 prosperousRagan (2005), Stockholm School of Economics
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What Is the Cure? Tax Rate Cuts
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What about Side Effects of Tax Cut?
• Won’t this reduce revenues that are needed to
finance social programs?
• The answer is …
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Answer
• No
• Why: Revenue will not fall
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Iceland: Corporate Tax Rate Down, Revenue Relative to GDP Up
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
1985 1990 1995 2000 2003
15
20
25
30
35
40
45
50
55
% %Corporate Taxes as % of GDP(left scale)
Corporate Tax Rate(right scale)
Source: Iceland Ministry of Finance
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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%
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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
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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
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Dramatic Improvement in Hours
Weekly Hours Worked
14
16
18
20
22
1985 1990 1995 2000 2005
SpainGermany
France
Source: OECD
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Why Isn’t This Cure Widely Known?
Some History
• Macroeconomists found market hours respond
strongly to incentives
• Microeconomists argued otherwise
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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
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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
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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)
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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?
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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
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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
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Taxes Reduce Both Margins
• Length of working life important margin
Age
Hours
= .3
= .5
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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)
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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 …
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Welfare Gains and Losses
-20%
-10%
0%
10%
0 0.1 0.2 0.3 0.4 0.5 0.6
Current U.S.
Europe
Iceland
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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
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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
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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
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Conclusions
• Iceland doing well, but could be doing better
• By moving in the direction of a saving system to finance nonextraordinary expenditures