NCPA - National Center for Policy Analysis


March 23, 2005

Taxes on labor and consumption are more widely used in Europe than in the United States. However, the consequences of these taxes are severe. A new paper from the National Bureau of Economic Research finds that higher tax rates on labor income and consumption expenditures lead to less work time in the legal market sector, more time working in the household sector, a larger underground economy and smaller shares of national output and employment in industries that rely heavily on low-wage, low-skill labor inputs.

After comparing several rich countries with varying levels of taxes in the mid-1990s, the authors estimate that:

  • A tax hike of 12.8 percentage points leads to 122 fewer hours of market work per adult per year and a 4.9 percent drop in the employment-to-population ratio.
  • It also increases the size of the shadow economy by 3.8 percent of official gross domestic product (GDP).
  • Additionally, it reduces the share of national output and employment in retail, automotive repair, wholesale trade, and food service by 10 to 30 percent.

The authors argue that tax rate differences among rich countries explain the large international differences in market work time and in the industry mix of market activity. Taxes on labor and consumption twist labor demand away from less skilled workers, amplifying their negative effects on aggregate employment. Moreover, countries with higher labor income taxes have more generous social programs. This further alters labor supply incentives in ways that discourage market work activity and increase employment in the underground economy.

Source: Les Picker, "Effects of Taxes on Labor Income," NBER Digest, December 2004; based upon: Steven Davis and Magnus Henrekson, "Tax Effects on Work Activity, Industry Mix, and Shadow Economy Size: Evidence from Rich-Country Comparisons," National Bureau of Economic Research, Working Paper No. 10509, May 2004.

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