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How the Supply of Labor Responds to Changes in Fiscal Policy 1 (October 2012)

handle is hein.congrec/cbo10921 and id is 1 raw text is: OCTOBER 2012 How the Supply of Labor Responds to Changes in Fiscal Policy In choosing how much to work, people respond to incentives that are partly determined by taxes on income from that work and by government benefits that vary with income. Those responses play a critical role in the Congressional Budget Office's (CBO's) analyses of the effects of changes in fiscal policy on economic outcomes. CBO uses two models of the economy to analyze the medium- and long-term effects of federal tax and spend- ing policies: a Solow-type growth model and a life-cycle growth model.' The models take different approaches toward capturing the ways in which the supply of labor responds to changes in fiscal policy. The Solow-type growth model uses estimates of how much the labor supply changes at a given point in time in response to a change in after-tax compensation that would result, for example, from a change in tax rates. The life-cycle growth model uses estimates of the responsiveness of the labor supply that depend on how people expect their after-tax compensation to change over time. CBO recently reviewed the extensive research literature on the 1. For a description of the two models and further discussion, see Congressional Budget Office, The Fconoic frnpact of the Pre, rideiit, 2013 Budget (April 2012), pp. 2-3 and 13-18. Both the Solow-type growth model and the life-cycle growth model address changes in the economy's underlying productive capacity, often measured as potential gross domestic product. The potential to produce goods and services is the key determinant of the nation's output over the medium term and the long term. However, economic activity deviates from its potential level in response to changes in demand for goods and services. Therefore, to analyze the short-term effects of federal tax and spending policies, CBO uses different models that focus on changes in such demand. magnitude of those responses, and this report describes the values the agency will be using in future analyses. Responses at a Given Point in Time Changes in taxes on labor income and in government benefits can create two countervailing pressures on peo- ple's willingness to work, a substitution effect and an income effect: Substitution Effect. Increased after-tax compensation for an additional hour of work-from a tax cut that reduces marginal tax rates, for example-makes work more valuable relative to other uses of a person's time.2 That substitution effect by itself suggests that such a policy change would increase the number of hours worked. Income Effect. Increased after-tax income from a given amount of work-such as from a tax cut, which reduces average tax rates-allows people to maintain the same standard of living while working fewer hours.3 That income effect by itself suggests that such a policy change would decrease the number of hours worked. Because the substitution and income effects of tax rate cuts tend to push the labor supply in opposite directions, 2. The marginal tax rate is the taxes paid on an additional dollar of income, in this case labor income. 3. The average tax rate is total taxes paid as a share of income.

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