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Labor Supply, Endogenous Wage Dynamics and Tax policy

In this paper we analyze analytically, quantitatively, and empirically a framework where labor supply has three distinct roles. First, as usual, it increases contemporaneous earnings. Second, because of incomplete asset markets, it provides some partial insurance for idiosyncratic labor productivity shocks. And last, labor supply also works as investment in future earnings potential (human capital). In this sense, in our model, wage dynamics is partially endogenous.
We focus on three main issues using this framework. First of all, in this environment, the monetary return of an additional hour is not equal to the current hourly wage as in the standard models of labor supply. Rather, it is augmented by the expected net present discounted value of all the earnings increases this hour's choice implies for the future. Consequently, labor supply does have an insurance role not only in the static sense (low current hourly wages can be partially o set by high current hours) but also from a dynamic precautionary perspective. Given that this dynamic effect of labor supply is stronger for high wage earners, this implies that this mechanism amplifies contemporaneous cross-sectional inequality. Second, the above observation has some strong implications on the measurement of labor supply elasticity. Third, a low Frisch elasticity is usually bad news for macroeconomists, but, in our framework, we can have a low elasticity and yet expect significant responses of aggregate labor supply and human capital when the progressivity of the tax system is decreased. This is the case because, in our environment, progressivity does not only change the distribution of contemporaneous wages but also the dynamic gains associated with an additional hour. Since, in this environment, labor supply is an investment good as well, this mechanism may lead to a permanently higher level of human capital (a similar mechanism operates in Guvenen, Kuruscu, and Ozkan (2009)). Some preliminary results show that this is indeed the case. More precisely, in our model with the dynamic effect of labor supply and low elasticity of labor supply, a reduction in progressivity has a higher aggregate effect than in a model which is identical but the wage process is exogenous.

[Long Abstract], [Slide]
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