Taxes, Hours and Employment

Edward C. Prescott

Reykjavik, Iceland, July 26, 2007

Cutting Taxes to Increase Prosperity

2

Two Economic Diseases

– Low productivity

– Low market hours

Output per person is productivity times market hours

per person

3

Examination

Prescott, M.D.

4

Statistics for 2004 relative to U.S.

Economy GDP per Person 16-64

Hours per Person 16-64

GDP per Hour

E.U.-15 6969 7878 8989

U.S. 100 100 100

Japan 77 102 76

5

Diagnosis

• E.U.-15 has a case of the low labor supply disease

• E.U.-15 also has a mild case of the low productivity

disease

6

Is Europe Getting Sicker?

Decade Productivity Growths

1984-1994 1994-2004

Europe 20% 15%

U.S. 15% 21%

7

Answer

• Maybe there is a productivity growth problem, but probably not

• No doubt that Europe has the low hours disease

• But reforms are on the way, and Europe’s health will

improve

8

European Productivity

• The European Union is a good system

– Has led to high productivity

• For 40 years prior to World War II, European productivity

53% of U.S. level

• Since 1990 about 90% of U.S. level

9

Hours per Week per Person 16-64

Year U.S. Spain France Germany

1985 97 65 75

1995 100 6666 71 76

2005 100 8787 69 74

10

When Did the Sickness Develop?

• Europe didn’t have the low hours disease in the early 1970s

– Then 23.8 hours per person per week

– Now European hours 18.3

• U.S. hours increased from 23.5 to 25.4 in this period because of 1986 Tax Reforms

11

What Caused the Sickness in Europe?

• Western Europe increased marginal effective tax rate from 40% to 60%

• U.S. kept its tax rate at 40%

A 60% tax rate means on margin if someone works more and produces 100€ worth of output, get to keep 40€

12

U.K. Is Not That Sick

• U.K. market hours only fell from 25 per working-age

person per week in early 1970s to 23.3 today

• But …

13

The British Are Not European

14

What about Iceland?

• Tax system

– Flat rate individual income tax rate, 36%

– Consumption tax rate, 35%

• Value-added tax rate between 14% and 24.5%

• Part of property tax

• Most of excise duties

– Relatively modest payroll tax rate, 6%

15

Iceland: Predicted vs. Actual Labor Supply

• Average hours worked per person 1996-2005

– Predicted: 24.3

– Actual: 26

• Inconsistencies in measurement

– Foreign workers

– Number of part-time workers

– Size of underground economy bigger in U.S. and Europe

16

Is Scandinavia a Problem for the Theory?

• Discrepancy for Scandinavia is not a measurement issue

– With simple theory aggregate hours under predicted by 20-45 percent

• But this theory abstracts from

– Other factors that affect work incentives

17

Features of Scandinavian Welfare States

• Subsidized day care conditional on working

• Subsidized elderly care

• Some government employment not employment

– e.g., those in training programs

18

Findings

• Public expenditures on home good important for explaining labor supply in market and at home

• Accounting for public provision of day care and elderly care in Scandinavia closes half of gap in predicted market work

• Sweden, after its long secular decline relative to other advanced industrial countries, beginning in 1995 has been reforming, has become more prosperousRagan (2005), Stockholm School of Economics

19

What Is the Cure? Tax Rate Cuts

20

What about Side Effects of Tax Cut?

• Won’t this reduce revenues that are needed to

finance social programs?

• The answer is …

21

Answer

• No

• Why: Revenue will not fall

22

Iceland: Corporate Tax Rate Down, Revenue Relative to GDP Up

0.8

0.9

1

1.1

1.2

1.3

1.4

1.5

1.6

1985 1990 1995 2000 2003

15

20

25

30

35

40

45

50

55

% %Corporate Taxes as % of GDP(left scale)

Corporate Tax Rate(right scale)

Source: Iceland Ministry of Finance

23

Cutting Taxes and Preserving the Welfare State

• Shift to some mandatory saving for retirement and nonextraordinary medical expenditures

• Avoid throwing away output

– France 25%

– Iceland 10%

24

Europe Will Cut Tax Rates and Will Boom

• Europe has no choice except to reform

• There will be healthy growth in Western Europe

– with 20% increase in output in 5 years

– and a catch-up to the United States

• Process already started

25

Spain Is Leading the Way

• Spain cut tax rates in 1998 and made other labor

market reforms

• Let’s see how Spain has been doing

26

Dramatic Improvement in Hours

Weekly Hours Worked

14

16

18

20

22

1985 1990 1995 2000 2005

SpainGermany

France

Source: OECD

27

Why Isn’t This Cure Widely Known?

Some History

• Macroeconomists found market hours respond

strongly to incentives

• Microeconomists argued otherwise

28

Who is Right Matters for Evaluating Tax Policies

• Public finance people sided with macroeconomists

– Martin Feldstein and Glen Hubbard (former chairmen of the Council of Economic Advisors) in mid-1980s

• But were ignored

29

Congress Sided with Labor Economists

• U.S. Congress ruled that its budget office must assume

the effect of tax rates on hours is zero

• Congress likes to tax and spend

• Congress does not like to impose dead-weight losses

• Dead-weight loss big if macroeconomists right, small if

labor economists right

30

We Now Know So Much More

• We know theory predicts economic fluctuations of the

nature observed if and only if this labor response is high

(Kydland-Prescott Nobel Prize paper)

31

A Puzzle

• Microeconomists looking at individual behavior were

finding one thing

• Macroeconomists looking at aggregate behavior

were finding something different

• Why weren’t the two findings consistent?

32

Theory to the Rescue

• Microeconomists assumed that people varied the length of the workweek and not the number of weeks worked over the lifetime

• Europeans workers work 40 weeks a year while U.S. workers work 46 weeks a year

• Europeans retire earlier than Americans

33

Model of Life Cycle Labor Supply

• There are two margins of labor supply

– Length of working life

– Hours per employed person

Rogerson and Wallenius (2007), Arizona State University

34

Taxes Reduce Both Margins

• Length of working life important margin

Age

Hours

= .3

= .5

35

Puzzle Resolved

• Macroeconomists permit (and the new generation of labor economists permit) fraction of lifetime worked to vary

• Micro and macro observations are now in conformity

• Same response for all countries (including Japan, Australia, New Zealand, Japan, Chile, Greece and Ireland, as well as the G7 countries)

36

Welfare

• Nonmarket time is valuable

• Because of taxes, the value of time on margin is higher in the business sector than in the household sector

Welfare gains of cutting tax rates are …

37

Welfare Gains and Losses

-20%

-10%

0%

10%

0 0.1 0.2 0.3 0.4 0.5 0.6

Current U.S.

Europe

Iceland

38

Tax Rates Can Be Cut Below U.S. Levels

• How: Shift from tax and transfers to retirement saving

accounts

• Over 25 countries have them

• Singapore and U.S. have health savings accounts

39

U.S. Is Shifting

• Big shift in U.S. to savings for retirement

• Even federal government has shifted

• State and local governments have begun to shift

• Like Iceland, everyone will have their savings account

40

What about Transition Costs

Of moving to a saving system?

• There are none

• Switching is a bookkeeping entry that makes some implicit government liabilities explicit

• Honest accounting is good

• Poverty rate would be reduced

41

Conclusions

• Iceland doing well, but could be doing better

• By moving in the direction of a saving system to finance nonextraordinary expenditures