The effects of taxes and transfers (2): incorporating human capital accumulation in life cycle labor supply models

Following our last class on simple models of life cycle labor supply, we discussed about incorporating human capital accumulation into the individual decision-making process. Now the wages are no longer exogenous. Instead, current wage depends on the amount of labor supplied in the last period, which is a proxy of human capital accumulation. Everything else stays the same. If this model is a more realistic description of the world (which is likely), the traditional estimation of Frisch elasticity (intertemporal substitution elasticity) will be biased downwards. To see this, note that over time wage rates are rising as a result of human capital accumulation, but the returns to “learning by doing” is decreasing (as the individual gets nearer to retirement). The total marginal return on labor supply estimated by Frisch elasticity combines these two effects and understates the true intertemporal substitution effect.

These models are nice, but here are two questions worth considering:

The first question is due to my classmate DS: How should we perceive the process of human capital accumulation?

The model presented above assumes that human capital accumulation happens through working more hours, which implies labor supply and human capital are complements. But they might well be substitutes: think about workers who have accumulated a body of knowledge and can work more efficiently with shorter hours. In this case, the Frisch elasticity might not be downward biased.

The second question is due to my classmate MZ:

Suppose you are at a cocktail party and two people start arguing over the effect of raising or lowering taxes on the incomes of wealthy people. Someone mentions that you are a budding young economist, so the two parties temporarily stop arguing to hear your words of wisdom. What do you say?

After our discussion, I think a fair answer would be that tax changes affect people’s behavior along multiple margins. The more margins we allow people to respond to in our analysis, the more distortionary effects we are likely to find. Obviously, economists rarely agree and even if they agree, it takes a long time for them to channel through policy making and have a real-world impact.

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