Measuring the labor supply effect of income taxation using a life-cycle labor supply model: A case of Indonesia

The focus of this study is to estimate a life cycle model of labor supply including taxes for a developing economy by applying two methods of estimation. The first method is the cohort approach and the second approach is the consumption approach. The idea of the cohort approach is to create a simulated representative individual's life path by stratifying the sample according to the age of the head of household. The consumption approach, on the other hand, eliminates all future variables in the labor supply equation by proxying the marginal value of wealth ($\lambda)$ with consumption.The two approaches enable me to use cross section data to estimate a life cycle model. Estimating a life cycle model using cross-section data avoids the attrition problem encountered in panel data. Both approaches also introduce techniques to handle the measurement error problem; i.e., the moving average in the cohort approach and the instrumental variables in the consumption approach. The consumption approach, however, is better than the cohort approach because it avoids cohort bias and it enables us to correct selection bias using Heckman (1979) technique. This adjustment is very important especially in the estimation of female labor supply.The results show that the compensated intertemporal elasticities of labor supply with respect to the wage rate tend to be larger than those found for developed economies. However, as in developed economies, Indonesian women are more tax sensitive than men. It is also shown that for males, the higher the education level and family income, the less sensitive the labor supply with respect to the wage rate. For females, however, the higher the education level, the more elastic labor supply with respect to the wage rate. Children have a positive and significant effect on female labor supply, indicating that they represent a financial burden in the family, which induces wives to work outside the home to get additional income. Extended family members have a negative effect on female labor supply, but a positive effect on male labor supply. (Abstract shortened by UMI.)U of I OnlyETDs are only available to UIUC Users without author permissio