Prescott on Tax Cuts
By Arnold Kling
In this essay, I explain 2004 economics Nobel Laureate Edward Prescott’s views that the Bush tax cuts were too small.
Prescott re-casts the trade-off as between “market time” and “non-market time.” In addition to TV and Bon-Bons, you spend some of your non-market time producing goods and services, such as home-improvement projects, meals cooked at home, housework, and child care. Thinking of the choice in those terms, an increase in your wage rate could have a significant effect on your labor supply. The higher your wage rate, the more it makes sense for you to “outsource” household chores. If I can earn enough in six hours of work to pay for someone else to do eight hours of household chores, then I can get more hours for TV and Bon-Bons by increasing my “market time.” Working six more hours but spending eight fewer hours on household chores gives me a net saving of two hours.
…The bigger the tax wedge, the more you will tend to do household chores yourself rather than outsource them. Suppose that you earn $40 an hour and it would take you 80 hours to build a deck, although a contractor could build the deck for $2400. On a pre-tax basis, it takes you only 60 hours to earn enough money to pay the contractor, so it makes sense to work more hours and pay the contractor. However, if your income and payroll tax rate together is 40 percent, then you have to work 100 hours in order to be able to take home $2400. Taking into account taxes, you are better off building the deck yourself, because your deck-building labor is tax-free.
The lower the tax wedge, the more likely it is that you will choose to use goods and services to replace household chores, increasing your market time in exchange for more true leisure time. Since many of the goods and services that we buy — from microwavable food to lawnmowing services to wash-and-wear clothing — are designed to save on household labor, the tax wedge is a significant economic factor.
After I wrote this essay, but before it was published, Prescott himself explained his views this way:
I would point you to the data which show that when the French and others were taxed at rates similar to Americans, they supplied roughly the same amount of labor. Other research has shown that at the aggregate level, where idiosyncratic preference differences are averaged out, people are remarkably similar across countries. Further, a recent study has shown that Germans and Americans spend the same amount of time working, but the proportion of taxable market time vs. nontaxable home work time is different. In other words, Germans work just as much, but more of their work is not captured in the taxable market.
I would add another data set for certain countries, especially Italy, and that is nontaxable market time or the underground economy. Many Italians, for example, aren’t necessarily working any less than Americans — they are simply not being taxed for some of their labor. Indeed, the Italian government increases its measured output by nearly 25% to capture the output of the underground sector. Change the tax laws and you will notice a change in behavior: These people won’t start working more, they will simply engage in more taxable market labor, and will produce more per hour worked.
UPDATE: Mark Steckbeck points out
This [shift from market to non-market production] has real effects…this is not an equivalent trade off or a wash, which simply just fails to be accounted for in official national income accounts. High employment taxes reduce real output overall because output per worker–their productivity–is less given workers’ reduced time engaged in a specialized skill
His point is that non-market-time labor tends to be less efficient than market-timer labor. I would add that there are other reasons for the underground economy to be relatively inefficient. Lack of access to capital, for example.
UPDATE 2: Jonah Goldberg writes,
it simply seems to me that a country which sends state goons to companies to make sure no one works overtime and which considers six weeks vacation slave-driving, has some additional anti-work policies in addition to lousy tax rates. Also, aren’t French tax rates themselves a product of cultural differences?
This is a point we have discussed on this blog before, which is that just because tax rates can explain work differences (if indeed they can) does not mean that there are not cultural differences. It could be that a nation’s tax code is a reflection of its culture.
For Discussion. Does Prescott’s argument favor a flatter tax system or an “all holes, no cheese” tax system, which uses tax breaks to favor certain types of income?