Relative effects of labor taxes on employment and working hours: role of mechanisms shaping working hours

High labor income taxes are one of the most important explanations advanced for the large decline of labor supply in Europe over the past 30 years. While in some countries the decline comes evenly from employment and hours per worker, in others it comes mostly from hours per worker, or predominantly from employment. This paper studies why labor taxes have different relative effects on employment and hours per worker. We show that different hour-shaping mechanisms are one of the underlying reasons. In the mechanism when hours per worker are bargained by matched job-worker pairs, a higher labor income tax would reduce both employment and hours per worker. As the worker’s hour-bargaining share is larger, hours per worker are decreased by more and employment is decreased by less. In the mechanism when hours per worker are determined exclusively by the household, this goes to the case when the worker has a one-hundred percent hour bargaining power. In this situation, when the leisure utility is linear in hours, the effect on employment is zero and all negative effects are on hours per worker. At the other extreme, in the mechanism when hours per worker are effectively regulated, a higher labor tax only reduces employment with a zero effect on hours. We calibrate the model and show that the quantitative effects of Europe’s increases in average effective tax rates in the past 30 years are consistent with the theoretical predictions. Copyright Springer-Verlag Wien 2016