Labor Supply Responses to Taxes and Transfer Payments Essay -- America

A good understanding of labor supply reactions to tax and transfer policies is necessary for achieving related policy goals. Income support programs intend to alleviate poverty and create a more equitable society. However, the reaction of the labor supply can derail the intended results and need to be carefully evaluated for effective policy. Economic theory suggests that as taxes and transfer payments increase, the amount of hours and/or number of employees will decrease (Borjas 2005). The exception is transfer payments with work requirements, where the labor supply moves in the same direction as benefits. In the labor market, individuals have two basic choices: how many hours to work (intensive), and whether or not to work at all (extensive). If the labor supply has largely intensive reactions, certain types of programs, such as food stamps, are most effective, when EITC type programs are more effective for extensive reactions. Government tax and transfer policies affect the labor supply because when the real wage changes the labor supply reacts. This paper will look at the response of the U.S. labor supply to changes in taxes and transfer payments. It will determine if the response is concentrated towards intensive or extensive margins and observe the direction and magnitude of the changes. Understanding labor supply responses is crucial for governments desiring to reach intended policy goals. Labor market behavior can have significant long run effects on potential output. According to the Congressional Budget Office, the size and quality of the labor force, capital stock, and the efficiency of production, determine a country’s potential output. When policies influence relevant factors, such as the size of the labor force, the... ...e to participate at a paid wage lower than they would typically require. More people working expands the tax base while reducing the amount of transferred income. The government is able to collect more revenue and still provide a guaranteed income level. (Dickert et al.1995; Browning 1995). EITC type programs can help the government achieve its objectives with minimal negative effects to the economy. Not all labor markets have identical sizes or types of responses to government decisions. The direction and magnitude of each response will inform policy makers about optimal decisions. Section II of this paper reviews the empirical literature on tax and transfer policies and the labor market. Section III discusses the methodology. Section IV summarizes the results of this study. Section V presents the conclusion as well as identifies areas for further research.