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Heterogeneity in Labor Supply Elasticity and Optimal Taxation

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  • Marios Karabarbounis

    (University of Rochester)

Abstract

Standard public finance principles imply that workers with more elastic labor supply should face smaller tax distortions. This paper quantitatively tests the potential of such an idea within a realistically calibrated life cycle model of labor supply with heterogeneous agents and incomplete markets. Heterogeneity in labor supply elasticity arises endogenously from differences in reservation wages. I find that older cohorts are much more responsive to wage changes than younger and especially middle aged cohorts. Both a shorter time horizon and a larger stock of savings account for this difference. Since the government does not have direct information on individual labor supply elasticity it uses these life cycle variables as informative moments. The optimal Ramsey tax policy decreases the average and marginal tax rates for agents older than 50 and more so the larger is the accumulated stock of savings. At the same time, the policy increases significantly the tax rates for middle aged workers. Finally, the optimal policy provides redistribution by decreasing tax rates of wealth-poor young workers. The policy encourages work effort by high elasticity groups while targets inelastic middle aged groups to raise revenues. As a result, total supply of labor increases by 2.98% and total capital by 5.37%. These effects translate into welfare gains of about 0.85% of annual consumption.

Suggested Citation

  • Marios Karabarbounis, 2012. "Heterogeneity in Labor Supply Elasticity and Optimal Taxation," 2012 Meeting Papers 655, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:655
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    References listed on IDEAS

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    Cited by:

    1. Shantanu Bagchi, 2016. "Differential Mortality and the Progressivity of Social Security," Working Papers 2016-03, Towson University, Department of Economics, revised Aug 2016.

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