Taxes in Our Model: Take 2

Our first and only heterogeneous agent model is constructed with two types. The steady state balanced growth path is developed, the model is calibrated to the U.S. income distribution and implications of reducing capital taxes are re-examined once distributional consequences are considered.

GENERAL EQUILIBRIUM FEEDBACK REGARDING THE EMPLOYMENT EFFECTS OF LABOR TAXES

A higher labor tax rate increases the equilibrium real interest rate and reduces the equilibrium wage in a heterogeneous-agent model with endogenous savings and indivisible labor supply decisions. I show that these general equilibrium (GE) adjustments, in particular of the real interest rate, reinforce the negative employment impact of higher labor taxes. However, the representative-agent version of the model, which generates similar aggregate employment responses to labor tax changes, implies that GE feedback is neutral. The cross-country panel data reveal that the negative association between labor tax rates and the extensive margin labor supply is significantly and robustly weaker in small open economies where the interest rate is less tightly linked to domestic circumstances. This empirical evidence supports the transmission mechanism of labor tax changes for employment in the heterogeneous-agent model.