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Indivisible Labor and the Welfare Effects of Labor Income Tax Reform

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  • Toke Ward Petersen

Abstract

This paper investigates the importance of the usual assumption of divisibility. In the labor market a finite set of choices is introduced: between working full or part-time or not to work at all. To add realism and to ensure smooth aggregate behavior the option of limited overtime for individuals working full time is introduced. The simulations show that indeed indivisibilities matter - the results obtained in each of the two models are markedly different. The impact of the policy experiment (a move from progressive to proportional taxation of labor income) is much larger in the case where the labor supply is continuous; the welfare gains of the switch from progressive to proportional taxation is almost 150 percent larger with continuous labor supply. The sensitivity analysis shows that this result depends on how the indivisibilities are specified, but in almost all cases are the welfare gains from the tax reform more than twice as large in the continuous model.

Suggested Citation

  • Toke Ward Petersen, 2001. "Indivisible Labor and the Welfare Effects of Labor Income Tax Reform," DREAM Working Paper Series 200102, Danish Rational Economic Agents Model, DREAM.
    • Handle: RePEc:dra:wpaper:200102
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    File URL: http://www.dreammodel.dk/pdf/W200104.pdf
    File Function: First version, 2001
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    References listed on IDEAS

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    1. Hansen, Gary D., 1985. "Indivisible labor and the business cycle," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 309-327, November.
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    3. Keshab Bhattarai & John Whalley, 2003. "Discreteness and the Welfare Cost of Labor Supply Tax Distortions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(3), pages 1117-1133, August.
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    5. Rogerson, Richard, 1988. "Indivisible labor, lotteries and equilibrium," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 3-16, January.
    6. Lars Haagen Pedersen & Peter Stephensen, 1999. "Earned Income Tax Credit in a Disaggregated Labor Market with Minimum Wage Contracts," DREAM Working Paper Series 199901, Danish Rational Economic Agents Model, DREAM.
    7. Gilbert Ghez & Gary S. Becker, 1975. "A Theory of the Allocation of Time and Goods Over the Life Cycle," NBER Chapters, in: The Allocation of Time and Goods over the Life Cycle, pages 1-45, National Bureau of Economic Research, Inc.
    8. Toke Ward Petersen, 2001. "General Equilibrium Tax Policy with Hyperbolic Consumers," Computing in Economics and Finance 2001 189, Society for Computational Economics.
    9. Graversen, E.K. & Smith, N., 1998. "Labour Supply, Overtime Work and Taxation in Denmark," Papers 98-06, Centre for Labour Market and Social Research, Danmark-.
    10. Cogan, John F, 1981. "Fixed Costs and Labor Supply," Econometrica, Econometric Society, vol. 49(4), pages 945-963, June.
    11. Toke Ward Petersen, 2001. "The Optimal Level of Progressivity in the Labor Income Tax in a Model with Competitive Markets and Idiosyncratic Uncertainty," DREAM Working Paper Series 200104, Danish Rational Economic Agents Model, DREAM.
    12. Levy, Frank & Murnane, Richard J, 1992. "U.S. Earnings Levels and Earnings Inequality: A Review of Recent Trends and Proposed Explanations," Journal of Economic Literature, American Economic Association, vol. 30(3), pages 1333-1381, September.
    13. Toke Ward Petersen, 2001. "Interest Rate Risk over the Life-Cycle: A General Equilibrium Approach," DREAM Working Paper Series 200103, Danish Rational Economic Agents Model, DREAM.
    14. Gilbert Ghez & Gary S. Becker, 1975. "The Allocation of Goods Over the Life Cycle," NBER Chapters, in: The Allocation of Time and Goods over the Life Cycle, pages 46-82, National Bureau of Economic Research, Inc.
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    16. Toke Ward Petersen, 2001. "General Equilibrium Tax Policy with Hyperbolic Consumers," DREAM Working Paper Series 200101, Danish Rational Economic Agents Model, DREAM.
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    Cited by:

    1. Toke Ward Petersen, 2001. "The Optimal Level of Progressivity in the Labor Income Tax in a Model with Competitive Markets and Idiosyncratic Uncertainty," DREAM Working Paper Series 200104, Danish Rational Economic Agents Model, DREAM.
    2. Toke Ward Petersen, 2001. "Interest Rate Risk over the Life-Cycle: A General Equilibrium Approach," DREAM Working Paper Series 200103, Danish Rational Economic Agents Model, DREAM.

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    More about this item

    Keywords

    indivisible labor; discrete labor supply;

    JEL classification:

    • C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • H2 - Public Economics - - Taxation, Subsidies, and Revenue

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