Indivisible Labor and the Welfare Effects of Labor Income Tax Reform

Billede af publikationens forside
04-09-2001
DREAM

This paper investigates the importance of the usual assumption of divisibility. In the labor market a finite set of choices is introduced: between working full or part-time or not to work at all.

Abstract

This paper investigates the importance of the usual assumption of divisibility. In the labor market a finite set of choices is introduced: between working full or part-time or not to work at all. To add realism and to ensure smooth aggregate behavior the option of limited overtime for individuals working full time is introduced.

The simulations show that indeed indivisibilities matter - the results obtained in each of the two models are markedly different. The impact of the policy experiment (a move from progressive to proportional taxation of labor income) is much larger in the case where the labor supply is continuous; the welfare gains of the switch from progressive to proportional taxation is almost 150 percent larger with continuous labor supply. The sensitivity analysis shows that this result depends on how the indivisibilities are specified, but in almost all cases are the welfare gains from the tax reform more than twice as large in the continuous model.