Monday, October 25, 2004

Market vs Non-Market labor

The standard model of the effect of income taxes on wages has a worker deciding how to split his time between labour and leisure. Either he goes to work to earn a wage, or he sits at home watching TV. While more money is good, sitting at home is also good.

The model has leisure acting as a normal good, which means that the more money you have, the more leisure you would like. But note that the more money you make, the more expensive that leisure becomes in opportunity cost, that is, if you make $10/hour your hour of TV "costs" $10, but if you make $100/hour each episode of Sienfeld costs, essentially a new TV. The net result is that these two forces sort of cancel out and the effect of taxes on how much people work is pretty low.

According to this interesting post by Arnold Kling, this years Nobel prize winner in Economics, Edward Prescott, argues that labor is much more sensitive to taxe rates than presumed. He splits a worker's choice between "market" activities and "non-market" activites, so either you work and earn a wage or you stay at home at do non-wage work, which could include cooking, cleaning, child rearing, gardening, home improvement, etc. This household activity is not captured in GDP numbers but it is as real work as anything done for a paycheck.

In this model, raising taxes makes paid labor much less attractive compared to (unpaid) labor at home, and so shifts economic activity from the workplace to the home. Since work at home is not taxed, it means that raising tax rates will not increase tax receipts much -- people will just shift out of the labor market.

I don't know which of these models is closer to the truth, and it seems like the sort of thing that we ought to have enough empirical data to measure by now. Certainly the example of Europe suggests that people are quite sensitive to tax rates and will leave the labor force if they go up, but there are many factors at work there and it is hard to disentangle them all.

I also don't know what combination of higher taxes and lower benefits will be put in place to deal with the boomer cash crunch, but look for young people figuring out how to transfer wealth back to them from old people. In particular, I'd look for young people beginning to live and home and rely on parents for child care.

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