Edited by Ramón Gómez-Salvador, Ana Lamo, Barbara Petrongolo, Melanie Ward and Etienne Wasmer
Chapter 2: Tax-effects on Work Activity, Industry Mix and Shadow Economy Size: Evidence from Rich Country Comparisons
2. Tax eﬀects on work activity, industry mix and shadow economy size: evidence from rich country comparisons1 Steven J. Davis and Magnus Henrekson INTRODUCTION Taxes on labour income and consumption expenditures encourage households to substitute away from the legal market sector in favour of untaxed activities – leisure, household production and the shadow economy. We investigate these substitution responses by relating measures of employment, market work hours, shadow economy size and the industry mix of market production activity to tax rate diﬀerences among rich countries. Our objective is to assess the long-run total response of these outcomes to persistent diﬀerences in tax rates on labour income, payrolls and consumption – collectively, personal taxes. By ‘total response’ we mean the direct eﬀects that work through labour supply and demand plus indirect eﬀects that involve government spending responses to available tax revenues. As in Brennan and Buchanan (1980), Krusell et al. (1996), Persson and Tabellini (2002) and Becker and Mulligan (2003) we recognize that taxing capacity aﬀects government expenditures. In turn, many expenditure programmes aﬀect labour supply incentives. Leading examples include government programmes for unemployment and disability insurance. Our sample of rich countries oﬀers a modest number of data points. Despite this limitation, the broad-brush comparisons that we undertake are useful for several reasons. First, a focus on national outcomes provides information about the combined eﬀect of taxes working through labour supply and labour demand channels. In this regard we stress that tax eﬀects...
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