The theory of optimal taxation is often based on the neoclassical standard model of the labor market. That model includes the assumption that a household can choose freely how much to work and how much to enjoy leisure time. In such a framework, households derive utility from consumption c and leisure time z: u(c,z), where total time T is divided between labor l and leisure z, i.e. T = l + z. The time spent on labor is remunerated at wage w, so that households have an income y = wl that they can then consume.
In reality, however, households do not have the freedom of that continuous labor-leisure choice. It's rather the binary choice to accept a job or not. Moreover, for example, the neoclassical model predicts that a minimum wage causes unemployment. We do not observe this in reality.
Given the shortcomings of the neoclassical model of the labor market, how useful is it for a) advancing economic theory on optimal taxation and b) informing policy making? Is there a better alternative?
Thank you for quite importance issue. Taxadepends on income of labour. It is tough to find labour avoiding work just because of low wages. Possibility may be misconception during negotiations. Hope to learn more through you block from experts
Dear Max,
Taxes are not only on wage income, wL, but on other income such as capital income as well, say I. So your budget constraint should include the I term as well to read:
Y = WL + I.
So, tax effect should be written as Y = (wL +I)(1-t)
According A. Atkinson and J. Stiglitz, book, “Lecture on Public Economics.” Princeton, 2015, the choice is wider than between just leisure and work, to include “market versus home production,…taxed versus untaxed pecuniary returns.” (p. 47) From the broader views, income and substitution effect come into play, and any prediction of tax impact is ambiguous. One then has to resort to empirical evidence to find out the impact.
The classical alternative model provided by Adam Smith is based on perfect competition. One labor economic text states it this way: “…labor market participants in search of their own selfish goals attain an outcome that no one in the market consciously sought to achieve.” (George Borjas, “Labor Economics, 3rd Edition, McGraw Hill, 2005, p. 163)
Although it would be ideal if we had a single model that was universally applicable, it is rare to develop such a model. Moreover, the illumination of the results of a model might help us to consider and understand some elements that might be obscure. The refinements Lall Ramrattan mentioned are an example along with the income and substitution effects.
The point is that Max Franks makes is germane and implies that if a model is not applicable, either modification or a new model should be considered.
Thank you for your answer! I'm particularly interested in the policy advice and policy making aspect of the whole issue. Is anyone aware of how much the policy making process takes into account state-of-the-art research in the areas of optimal income tax modeling and the reactions of the labor market to taxes?
Hi Max and all,
I think this is a common misconception... The theory of optimal taxation - and in general the economic "orthodox" approach to all issues nowadays - does NOT use the standard neoclassical framework. What uses is the standard MICRO-FOUNDED model of a representative agent optimizing an objective function!!! (in this case you have a household supplying labor to max utility)
You should be able to design your own optimal labor tax problem by selecting the model ingredients that YOU think are important without challenging the "micro" framework. ... For instance:
I. "households do not have the freedom of that continuous labor-leisure choice. It's rather the binary choice to accept a job or not." -----> very important issue already included in a micro-founded model by Hansen (1985) "Indivisible Labor".
II. " Taxes are not only on wage income, wL, but on other income such as capital income as well, say I." (Lall above) -----> Horse race between different taxes, other very important topic analyzed by a large literature.
All the ingredients are out there, WITHOUT challenging the micro-foundation of models based on utility maximization households.
In particular, optimal fiscal policy has already been computed in a large number of models. I'd suggest you put in scholar.google.com "optimal fiscal policy" and the ingredient you want to check (e.g. optimal fiscal policy and indivisible labor) and you start from there.
Dear Benedetto,
thanks for your answer to my -- perhaps a bit provocative -- question. I am aware of the large research output in the field of optimal taxation, going into many details. I would like to focus in our discussion on the following: What I'm wondering about most is how optimal tax research in general feeds into the actual decision making process of how to design the national tax system (the descriptive part of my question) -- and on how it should feed into that process (the normative part of my question).
The mainstream in the optimal taxation literature is based on Mirrlees' seminal work from the early 70ies -- perhaps the most important innovation being the information asymmetry between households and the government. It seems to have taken a while (two or three decades) for this research to have an impact on the actual design of tax systems.
Now I wonder: When today the experts in the finance ministries gather to formulate their recommendations on how to design the tax system, what kind of a description of the labor market do these people have in mind? And -- from a research economist's perspective -- what should they use as a basis. Is the information asymmetry considered to be the most important aspect of the labor market and its taxation? And should it be? If it is so, then the workhorse model of optimal income taxation would indeed be a good basis. Other aspects, however, might be of equal, or higher importance. Then, policy making should be based on a better model.
Max Franks , I'm very much in agreement with Benedetto Molinari here and I don't think his answer is particularly provocative. The neoclassical framework provides a toolbox to the modeller and he or she is free to choose the elements that are most important for the problem that is being studied. As for the specific issue of discrete labour supply, why not look at Saez's heavily cited work ( Saez, E., 2002. Optimal income transfer programs: intensive versus extensive labor supply responses. The Quarterly Journal of Economics, 117(3), pp.1039-1073.) which deals with this specific issue in a US context. Elsewhere, Saez has also looked at the interaction of minimum wages and optimal taxation.
Thanks, Alistair, for pointing me towards Saez' paper, which looks very interesting!
Just for clarification: I did not write that Benedettos anwer is provocative. I meant *my question* to be provocative in order to start the discussion.