EIB Papers Volume 13. n°1/2008 - European Investment Bank

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100 Volume13 N°1 2008 EIB PAPERS Box 3. Wage elasticity of labour supply and estimates of the economic cost of public funds To examine the link between the elasticity of labour supply and the economic cost of public funds recall from Figure B1 and Box 1 that the conventional cost of public funds has been defined as the decline in the private surplus relative to the additional tax revenue. Both the decline in the private surplus (CDEB + DAE) and the additional tax revenue (CDEB) would be smaller for a flatter – that is, more wage-elastic – labour-supply curve. This is clear from Figure B3, which replicates Figure B1, but includes for comparison a more elastic labour-supply curve S * . For this 0 curve, the decline in the private surplus is CRPB + RAP and additional tax revenues amount to CRPB (implying an excess burden equal to RAP). The ratio between the two and, thus, the cost of public funds is the larger the greater the labour-supply elasticity is. Figure B3. Excess burden, cost of funds, and elasticity of labour supply – conventional approach Wage B C F O P R D E A L1 S0 S0 * D0 D1 L0 Labour supply and demand (in hours worked) Note: S 0 * can be understood to present a more elastic ordinary labour-supply curve than S 0 . Alternatively, it might be understood to be the compensated labour-supply curve associated with the uncompensated (that is, ordinary) labour-supply curve S 0 . Instead of interpreting S and S 0 * as two different labour-supply curves, one can, alternatively, 0 interpret them as two curves highlighting different aspects of households’ response to a change in wages. This takes us to an important subtlety we have ignored so far. The link between wages and labour supply comprises two effects. For one thing, higher wages make leisure less attractive relative to work, enticing households to work more and reduce leisure. This so-called substitution effect implies a positive link between the wage rate and labour supply – consistent with upward-sloping labour-supply curve as shown in the diagram above. For another, higher wages boost households’ income, thereby making leisure more affordable and, thus, increasing households’ demand for leisure and reducing their supply of labour. This so-called income effect implies a negative link between the wage rate and labour supply, suggesting a downward-sloping labour-supply curve – in contrast to what is shown in the diagram above.
Cognizant of the substitution effect and the income effect of a wage change, there are two ways to picture households’ response to a wage change. One rests only on the substitution effect triggered by a wage change, thereby considering only that lower wages render work less attractive relative to leisure. The income effect of lower wages – implying that lower wages reduce the affordability of leisure – is assumed to be compensated. Suppose S * in Figure B3 0 shows this hypothetical ‘compensated’ labour-supply response. The other way to look at things is to picture a curve that reflects actual labour supply, accounting for both the substitution effect and the income effect of a wage change. For a fall (increase) in wages, the substitution effect entices households to reduce (increase) their supply of labour whereas the income effect makes them supply more (less). As the substitution effect and the income effect work in opposite directions, this type of labour-supply curve must be steeper (that is, picture a smaller cut in labour supply for a given wage cut) than the one capturing only the substitution effect. Suppose S in Figure B3 is this labour-supply curve. As the income effect 0 is not compensated, it is called the ‘uncompensated’, or ordinary, labour-supply curve and the underlying wage elasticity of supply is labelled ‘uncompensated’, or ordinary, supply elasticity. An upward-sloping uncompensated supply curve like S assumes that the substitution effect 0 is larger than the income effect. This is not necessarily so. In fact, the uncompensated supply curve might combine an upward-sloping segment for relatively low wages (the substitution effect dominates the income effect) and a downward-sloping, or backward-bending segment for high wages (the income effect dominates the substitution effect). Each type of labour-supply curve has been used to estimate the economic cost of public funds. For the compensated, relatively elastic supply curve, estimates should be based on the decline in surplus of CRPB + RAP and the hypothetical increase in tax revenue of CRPB , thereby resulting in (conventional) marginal cost of public funds of 1 + RAP/CRPB. For the uncompensated, relatively inelastic supply curve, estimates should be based on the decline in surplus of CDEB + DAE and an actual increase in tax revenue of CDEB, thereby resulting in (conventional) marginal cost of public funds of 1 + DAE/CDEB, which is larger than the estimate based on the compensated supply curve. That said, Jones (2005) suggests that some researchers have combined estimates of the ‘compensated’ decline in the private surplus based on S * with estimates of the actual 0 changes in tax revenue based on S – and vice versa. 0 As in Boxes 1 and 2, Figure B3 shows the case of introducing a wage tax, although in interpreting the diagram, we had an increase in the tax rate on wages in mind. Drawing a diagram for an increase in the tax rate is straightforward and only slightly more complex. Using elasticity estimates from the empirical literature and country-specific information on income, marginal and average tax rates, and effective tax rates on participating in the labour-market, Kleven and Kreiner simulate the economic cost of funds under alternative elasticity assumptions; they do this for both a proportional change in the marginal tax rate of all income groups (distinguishing ten groups) and a change in the marginal tax rate of one income group at a time. Table 2 contains a subset of their simulations of a proportional tax change. EIB PAPERS Volume13 N°1 2008 101
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Preface This year the European Inve
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Infrastructure investment, growth a
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Government investment is not the sa
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Different types of government inves
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Infrastructure accounts for one-thi
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A common feature for the new member
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The share of transport in governmen
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The proxies are subject to caveats.
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The shares of infrastructure and ho
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Government transport investment has
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