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The Effect of Income Taxation on Consumption and Labor Supply

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November 2004 (Revised from April 2003). We estimate the incentive effects of income taxation in a life-cycle model of consumption and labor supply that relaxes the standard assumption of strong separability within periods. Our model permits identification of both within-period preference parameters and life-cycle preference parameters such as the inter-temporal substitution elasticity. Results indicate that consumption and hours worked are direct complements in utility, and both increase with an increase in the after-tax share and with a compensated increase in the net wage. The compensated net wage elasticity is about 0.3, nearly double the standard estimates for men in the United States that ignore within-period non-separability between consumption and hours and rely on linear preferences. Given our estimated inter-temporal elasticity of substitution of about –0.96, the Frisch specific substitution elasticities of consumption and labor supply with respect to the after-tax wage are about 0.1 and 0.5, indicating significant inter-temporal smoothing of utility. Depending on consumption measure, static estimates of the marginal welfare cost of revenue-neutral taxation are 6–20 percent, which is about half the estimated welfare cost when additivity between consumption and leisure is incorrectly imposed.

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  • Jamaes P. Ziliak & Thomas J. Kniesner, 2003. "The Effect of Income Taxation on Consumption and Labor Supply," Center for Policy Research Working Papers 54, Center for Policy Research, Maxwell School, Syracuse University.
  • Handle: RePEc:max:cprwps:54
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    JEL classification:

    • J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies

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