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Is Prescott right? Welfare state policies and the incentives to work, learn, and retire

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  • Bas Jacobs

Abstract

This paper bolsters Prescott’s (2004) claim that high taxes are responsible for lacklustre labor market performance in continental European countries. We develop a lifecycle model with endogenous skill formation, endogenous labor supply, and endogenous retirement. Labor taxation distorts not only labor supply, but also education and retirement decisions. Actuarially unfair pensions further exacerbate labor tax distortions on retirement. Education subsidies can nevertheless cushion the adverse impact of taxation on skill formation. Feedbacks between education, labor supply, and retirement are important. The model is simulated with realistic behavioral elasticities that are consistent with microeconometric evidence. If, besides labor supply, also learning and retirement are endogenous, the uncompensated (compensated) elasticity of the tax base equals 0.46 (0.85), which is more than twice as large as the standard uncompensated (compensated) labor supply elasticity of 0.18 (0.40). Furthermore, life-cycle interactions between education, working and retirement are quantitatively important and the interactions raise all behavioral elasticities substantially. For example, the uncompensated labor supply elasticity increases with one-half due to life-cycle interactions (to 0.26). We demonstrate that low European labor supply can be fully explained by taxation without relying on unrealistically high labor supply elasticities. Reducing labor market distortions, cutting benefit levels, lowering tax rates, and making (early) retirement actuarially fairer, therefore boosts labor supply, delays retirement, and stimulates skill formation. In addition, high education subsidies are needed in large welfare states to off-set explicit and implicit tax burdens on human capital investment.
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  • Bas Jacobs, 2009. "Is Prescott right? Welfare state policies and the incentives to work, learn, and retire," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 16(2), pages 253-280, April.
    • Handle: RePEc:kap:itaxpf:v:16:y:2009:i:2:p:253-280
    DOI: 10.1007/s10797-008-9090-z
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    2. Andrés Rodríguez-Pose & Vassilis Tselios, 2012. "Welfare Regimes and the Incentives to Work and Get Educated," Environment and Planning A, , vol. 44(1), pages 125-149, January.
    3. Chen, Been-Lon & Lai, Chih-Fang, 2015. "Effects of labor taxes and unemployment compensation on labor supply in a search model with an endogenous labor force," Journal of Macroeconomics, Elsevier, vol. 43(C), pages 300-317.
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    5. Margaret K. McKeehan & George R. Zodrow, 2019. "Balancing Act: Weighing the Factors Affecting the Taxation of Capital Income in a Small Open Economy," World Scientific Book Chapters, in: George R Zodrow (ed.), TAXATION IN THEORY AND PRACTICE Selected Essays of George R. Zodrow, chapter 12, pages 347-396, World Scientific Publishing Co. Pte. Ltd..
    6. Kinnunen, Helvi, 2008. "Government funds and demographic transition : alleviating ageing costs in a small open economy," Research Discussion Papers 21/2008, Bank of Finland.
    7. Gustafsson, Johan, 2023. "Public pension reform with ill-informed individuals," Economic Modelling, Elsevier, vol. 121(C).
    8. Been-Lon Chen & Chih-Fang Lai, 2016. "Relative effects of labor taxes on employment and working hours: role of mechanisms shaping working hours," Journal of Economics, Springer, vol. 117(1), pages 49-84, January.
    9. Been-Lon Chen & Mei Hsu & Chih-Fang Lai, 2015. "Relative Effects of Labour Taxes and Unemployment Benefits on Hours Worked Per Worker and Employment," Pacific Economic Review, Wiley Blackwell, vol. 20(2), pages 282-309, May.
    10. Gustafsson, Johan, 2021. "Public Pension Reform and the Equity-Efficiency Trade-off," Umeå Economic Studies 992, Umeå University, Department of Economics.
    11. Kinnunen, Helvi, 2008. "Government funds and demographic transition: alleviating ageing costs in a small open economy," Bank of Finland Research Discussion Papers 21/2008, Bank of Finland.
    12. Margit Schratzenstaller & Fanny Dellinger, 2017. "Genderdifferenzierte Lenkungswirkungen des Abgabensystems," WIFO Studies, WIFO, number 60797.
    13. Gustafsson, Johan, 2021. "Implications of Pension Illiteracy for Labor Supply and Redistribution," Umeå Economic Studies 993, Umeå University, Department of Economics.
    14. Frank N. Caliendo & T. Scott Findley, 2020. "Myopia, education, and social security," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 27(3), pages 694-720, June.

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    More about this item

    Keywords

    Skill formation; Human capital; Labor supply; Retirement; Tax policy; Benefit systems; Pension policy; Welfare state; H2; H5; I2; I3; J2; J3;
    All these keywords.

    JEL classification:

    • E20 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General
    • H20 - Public Economics - - Taxation, Subsidies, and Revenue - - - General
    • H50 - Public Economics - - National Government Expenditures and Related Policies - - - General
    • I20 - Health, Education, and Welfare - - Education - - - General
    • I30 - Health, Education, and Welfare - - Welfare, Well-Being, and Poverty - - - General
    • J20 - Labor and Demographic Economics - - Demand and Supply of Labor - - - General

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