Tax Cuts and Labor Supply Elasticity

Dietrich E. Vollrath on why tax cuts don’t lead to growth:

We think that if you lower the tax rate, and hence raise the returns to inputs, we should get more of them. But to “supercharge” growth in GDP, or to have any appreciable effect on GDP at all, you need that the elasticity of that input supply with respect to those returns is really big.

For labor, there appears to be good evidence that this elasticity is in fact small. There is not some pent-up store of workers and human capital out there that is just a 35% tax bracket away from getting off their ass and going to work. This labor supply elasticity is found to be essentially zero in almost every case, with the exception of married women. You can see some citations on this in the review paper by Saez, Slemrod, and Giertz (SSG). With an elasticity close to zero, no matter how much you lower the tax rate, and raise the return to labor (i.e. the wage), you can’t induce a substantial increase in labor supply. And without a substantial increase in labor supply, you don’t get a big increase in GDP. Continued….

The second thing reducing the impact of tax cuts on GDP is that taxes are not levied on only the transactions that are part of GDP, they are levied on all kinds of transactions. Think of the fact that every year there are billions (and maybe trillions) of individual transactions that take place in the economy. Some of those transactions involve payment for a real input like labor or capital, which means they are part of GDP. But some of those transactions are purely financial, and so are not [included in GDP]. But the tax code does not make this distinction; you are not taxed only on your transactions that contribute to GDP, you are taxed on all (okay, most) of your transactions where you receive some money.