Indonesian income taxation and labor supply: A cross-section analysis

This study estimates the labor supply response of workers to the income tax in Indonesia. It begins by developing a model of work-leisure choice and deriving a labor supply function. A progressive tax is then introduced into the model and the problems of estimation that arise because of the progressive tax are discussed. The model is then estimated and the compensated and uncompensated labor supply elasticities are calculated. The data set is from Indonesia's National Social-Economic Survey for the 1982 interviewing year. Based on these estimates, the deadweight loss of the income tax is derived.The two estimation techniques used are ordinary least squares (OLS) and ordered probit (OP). Ordinary least squares produces consistent estimates of a labor supply model which takes into account a progressive income tax if the stochastic error is attributable to omitted variables and the wage rate is independently determined from hours worked. Ordered probit takes into account the possibility of measurement errors in variables, which are commonly found in data sets containing hours of work, wage rates, and other components of income. Denying this possibility often results in biased estimates.The study finds that there is no significant difference between the results of these two procedures. The magnitudes of the compensated work-wage elasticities for the OLS estimation range from.33 to.58, whereas those for OP range from.22 to.51. The compensated elasticities for females are generally higher than those for males.This study makes an important contribution to the literature on developing countries by providing estimates of labor supply elasticities for a developing country. The elasticities turn out to be similar in magnitude to some of those estimated for developed countries in that they are relatively small. The main difference lies in the range of the magnitudes which, in part, reflects the richness of the data sets in developed countries.The labor supply elasticities are important for tax policy for several reasons. The uncompensated elasticities are needed to measure the revenue effect of a rate change while the compensated elasticity is important to the determination of the efficiency cost of a tax. Based on the results above, the estimates of the deadweight loss per dollar of wage tax revenue range from.0128 to.06 depending on the marginal tax rates. These estimates can be used together with estimates obtained from other taxes to see the overall efficiency of a tax system.U of I OnlyETDs are only available to UIUC Users without author permissio