Labor Supply Behavior and the Design of Tax and Transfer Policy

This paper argues that recent empirical evidence on labor supply behavior – showing stronger participation responses than hours-of-work responses – has important implications for the design of tax and transfer policy. Based on a review of recent research in this field, we conclude the following: (i) Conventional ways of evaluating the impact of tax-transfer reforms on economic efficiency have to be revised. (ii) Optimal redistributional policies may well involve negative marginal tax rates at the bottom of the earnings distribution. (iii) The introduction of the Earned Income Tax Credit (EITC) in the United States in the mid-1970s and the large expansions of the credit during the past two decades did not involve a trade-off between efficiency and equality as suggested by previous estimates. Instead, the EITC has improved both equality and efficiency. (iv) For most European countries, redistribution to the working poor involves a substantially lower trade-off between efficiency and equality than traditional redistributional policies targeted to those out of work. ∗This paper has been written on the occasion of Claus Thustrup Kreiner’s inaugural lecture as full Professo