Chapter 27 - Labor Supply: A Review of Alternative Approaches

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Abstract

This chapter surveys existing approaches to modeling labor supply and identifies important gaps in the literature that could be addressed in future research. The discussion begins with a look at recent policy reforms and labor market facts that motivate the study of labor supply. The analysis then presents a unifying framework that allows alternative empirical formulations of the labor supply model to be compared and their resulting elasticities to be interpreted. This is followed by critical reviews of alternative approaches to labor-supply modeling. The first review assesses the difference-in-differences approach and its relationship to natural experiments. The second analyzes estimation with non-linear budget constraints and welfare-program participation. The third appraises developments of family labor-supply models including both the standard unitary and collective labor-supply formulations. The fourth briefly explores dynamic extensions of the labor supply model, characterizing how participation decisions, learning-by-doing, human capital accumulation and habit formation affect the analysis of the lifecycle model. At the end of each of the four broad reviews, we summarize a selection of the recent empirical findings. The concluding section asks whether the developments reviewed in this chapter place us in a better position to answer the policy-reform questions and to interpret the trends in participation and hours with which we began this review. © 1999 Elsevier Science B.V. All rights reserved.

Introduction

Consistent with its tradition, research on labor supply during the past decade has been at the forefront of developments in empirical microeconomics. At the same time, an important component of this research has rebuffed sophisticated estimation approaches in favor of simple methods for evaluating behavioral responses underlying hours-of-work decisions. The attention devoted to the study of labor supply arises from intense interests in assessing the consequences of a wide array of public policies, ranging from tax and welfare programs to the alteration of institutional features of labor markets. A further motivation concerns the curiosity of economists in explaining the factors underlying the dramatic changes in employment patterns that have occurred in recent years, trends that show no evidence of stabilizing in the near future.

After presenting a brief overview of the phenomena stimulating recent analyses of labor supply, this chapter pursues its main purpose of reviewing the empirical developments and findings produced by this research. It focuses on work done since the surveys of Pencavel (1986) and Killingsworth and Heckman (1986), which ably summarized the labor supply literature in the previous Handbook of Labor Economics. We draw widely on existing research in the labor supply literature. Our discussion of methodological developments presents simplified examples to highlight essential ideas, not attempting to attribute each development to specific authors and, thus, omitting most references in this discussion. We do not claim originality in this survey, and our discussion of applications refers to many of the studies that have made the major contributions to this research area since the earlier Handbook surveys. It is inevitable that we have omitted references and we apologize for such omissions.

The influence of governmental programs on people’s employment and hours of work is often a critical consideration in the design of policies. Indeed, the primary objective of many recent reforms in both tax and welfare programs in North America, the UK, Scandinavia and other parts of Europe has been to encourage participants to increase their work effort. Few decades match the most recent in terms of how much change has occurred in tax and welfare policies. Understanding labor supply behavior is vital in formulating proposals that build in work incentives while providing income support.

This chapter begins with a cursory description of how tax and welfare policies have changed in recent years, considering how these changes enter the picture of labor supply and its empirical analyses. For this discussion, we focus on reforms in the US and the UK. This is not simply because of our own local knowledge but also because these two countries have been at the forefront of introducing welfare and tax reforms designed to encourage work effort – in particular, the move toward in-work benefits. These “Welfare to Work” proposals form a particularly attractive background against which to motivate labor supply analysis as they are generally reforms directly aimed at addressing the decline in participation among certain types of workers. The analysis of participation in work is key to the evaluation of welfare-to-work reforms and this is the margin over which labor supply responses may be most responsive. However, to properly evaluate the impact of a welfare-to-work policy reform, such as the Earned Income Tax Credit in the US, requires a careful examination of the balance between the labor supply decisions of those individuals already working who may now face a higher benefit (or credit) reduction rate and the labor supply decisions of those individuals who may be induced to enter by such a reform. We provide a detailed analysis of how recent policy reforms in the US and UK have changed the shape of the budget constraint facing many workers.

Any analysis of labor supply requires an understanding of the background changes in wages, participation and hours of work. In Section 3, we provide an analysis of labor supply facts highlighting the important changes in labor market participation and in the dispersion of wages. As a comparison with the US and the UK, we document the changes in these aspects of labor supply for two additional countries: Germany and Sweden. It is these changes in participation and working hours that labor supply models attempt to explain. The success of labor supply models will be judged largely in terms of their ability to explain and enhance our understanding of the changes in participation and hours.

Having motivated our analysis of labor supply with important policy questions and labor supply facts, our aim in the remaining sections is to present a comprehensive evaluation of alternative approaches to modeling labor supply. This seeks to achieve three broad objectives: to make different studies comparable by providing a unifying framework by which the results of each can be interpreted; to provide a description of the mechanics of implementing each approach and the data and assumptions required; and to identify gaps in our knowledge which can motivate future research. We have attempted to review the state of empirical knowledge on labor supply responses, and we end each section with a discussion of relevant empirical results.

The unifying framework we develop in Section 4 is designed to compare across alternative basic labor supply specifications. It should be noted at the outset that individual labor supply responses may be reflected in the choice of hours across firms rather than within any establishment. Complexities that arise from non-linear taxation, fixed costs, welfare programs, dynamics, etc. are taken up in detail in the following sections. A simple multi-period framework is used to compare across alternative static formulations, two-stage budgeting models, the Frisch model and fully-specified lifecycle models. The aim is not to dictate a single approach to estimation, but rather to evaluate precisely what can be learned from different datasets and different approaches to estimation. The wage coefficient in each approach is related to alternative elasticity measures and we ask which measure is appropriate for the evaluation of policy reforms. Even the simplest tax reform typically involves an unanticipated shift in the profile of wages. None of the standard elasticity measures fully reflects responses to such a shift and Section 4 precisely documents what is required to answer such policy questions.

5 Policy reforms and the natural experiment approach, 6 Estimation with non-participation and non-linear budget constraints, 7 Family labor supply, 8 Structural dynamic models consider alternative aspects and approaches to labor supply that have been adopted in the literature. We begin with a review of the application of difference in differences and natural experiments in labor supply estimation. Our aim here is to emphasize the structural assumptions underlying this approach and to relate the estimated parameters to those needed for policy analysis. A number of influential studies that have used this approach, and related approaches, are then reviewed.

Procedures by which a researcher can fully account for non-linear taxation, fixed costs, welfare participation and missing wages in estimation and simulation motivate the discussion in Section 6. Again, the emphasis here is to lay out the precise assumptions and restrictions placed on behavior by alternative models. The practical issue of how to account for multiple program participation and the interactions between the tax and benefit system are highlighted. The empirical literature in this area is vast. This aspect of labor supply continues to attract considerable research interest, reflecting the recurring importance placed on the labor supply responses to tax and benefit reforms.

Placing the labor supply problem in a context where there is potentially more than one supplier of labor in the household is covered in Section 7, which reflects two important developments in this area. The first is to acknowledge the complex set of incentives faced by multiple workers once the full tax and welfare system is accounted for. The second is the introduction of alternative models of labor supply decision-making when multiple workers are located in the same family. These alternative models that seek to account for collective choices that are solutions to bargaining within the family are still in their infancy as far as empirical application are concerned. However, we are able to compare them to the standard “unitary” model and review the empirical literature that has developed to date.

Our review of alternative formulations of the labor supply model is completed in Section 8 with a discussion of dynamic models. Here we highlight generalizations of the basic multiperiod model described in Section 4 that allow for human capital and non-participation. The first-order conditions for the standard multiperiod model can be severely distorted in the presence of human capital choices. Human capital choices, or purely exogenous learning by doing, can break the separability of the intertemporal decision rule that allows simple Frisch and two-stage budgeting formulations. This is also shared by models that allow for habits. We describe the appropriate adaptation of the multiperiod model to cover these extensions and review the results from the empirical literature. We also consider the complications that arise in these models once non-participation and fixed costs are allowed for. We evaluate the trade-off between realism and computational tractability and set up the standard discrete dynamic programming formulation for this problem.

In Section 9, we conclude this chapter with a brief assessment of what has been achieved by recent research on labor supply and ask whether we are now in a better position to answer the policy-reform questions raised in Section 2 and better able to understand the labor supply facts described in Section 3. We document a large number of significant contributions across a wide range of labor supply issues but we also identify significant gaps in our knowledge which will continue to place research on labor supply at the forefront of research in labor economics for some time to come.

Section snippets

How have tax and welfare policies changed?

In few decades have we seen the marked changes in tax and welfare policies that have occurred since the early 1980s. In the US, the number of tax brackets sharply diminished with the passage of the federal tax reform in 1986. In the UK, the number and level of higher brackets were reduced following the 1979 move away from direct taxation and towards indirect taxation. Sweden and other European countries subsequently followed this direction in reforming their income tax systems during the late

Recent empirical trends

In conjunction with the large changes in tax and benefit policies detailed in Section 2, the 1980s and early 1990s have seen dramatic changes in participation, hours of work and hourly wages. In this section, we provide a brief documentary of these changes, drawing on evidence from the US, the UK, Germany and Sweden.

It is the changes in participation and working hours that labor supply models attempt to explain. The success of these models must therefore be judged according to their ability to

A framework for understanding labor supply

Evaluating and interpreting labor supply estimates requires economic models to provide a context for comparison. Estimates often diverge simply because studies focus on evaluating behavioral responses corresponding to different wage and income effects. Sometimes empirical analyses are not precise about what model underlies their estimates. Is a static or a lifecycle model used? What do substitution effects hold constant? Does the analysis recognize taxes and joint decision-making by family

Policy reforms and the natural experiment approach

“Natural experiments” have gained considerable popularity recently, and the simplicity of this estimation method will undoubtedly make its popularity enduring among empirical economists for some time to come. This method often goes by the name of the difference-in-difference estimator. This section interprets the essence of this approach, and it relates those applications that estimate how tax and welfare policies influence labor supply to the empirical models surveyed elsewhere in this

Estimation with non-participation and non-linear budget constraints

To analyze how tax and welfare policies influence hours of work, there has been a steady expansion in the use of sophisticated statistical models characterizing distributions of discrete-continuous variables that jointly describe work and program participation. Considered at the forefront of research in this area, these models offer a natural mechanism for capturing the institutional features of both tax and welfare programs. This section describes how to estimate the effect of these programs

Family labor supply

This section considers two important developments to the family labor supply model. The first concerns the extension to cover non-participation and non-convex budget constraints. The second refers to the development of a collective framework for the study of family labor supply. Both are likely to be critical to our understanding of the impact of tax and welfare reforms discussed in Section 2 and our interpretation of the changing patterns of female and male labor supply documented in Section 3.

Structural dynamic models

This section explores extensions of the standard multiperiod model, introduced in Section 4, to allow for important dynamic features of labor supply behavior. The first considers the problem of participation, which plays a fundamental role in understanding all aspects of lifecycle behavior. Empirical models incorporating participation are obviously important for the analysis of female labor supply and retirement decisions. However, even in the simple case of continuous hours decisions examined

Closing comments

The aim of this chapter has been to critically review existing approaches to modeling labor supply and to identify important gaps in the literature that could be addressed in future research. We began with a look at the kind of policy reform proposals that labor supply models are now required to address and the set of labor market facts that labor supply models are designed to interpret. In the sections that followed, we developed a unifying framework and provided a brief assessment of each

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    We would like to thank John Pencavel for providing the US data Christian Dustmarm for the German data, Howard Reed for the British data, and Lennart Flood for the Swedish data. Jed DeVaro and Mika Kuismanen provided able research assistance and many helpful comments. We also thank Soren Blomquist, James Heckman, Ian Walker and Valerie Lechene for comments on sections of earlier drafts. Blundell thanks the ESRC Centre for the Microeconomic Analysis of Fiscal Policy at IFS for financial support. MaCurdy gratefully acknowledges research support from NIH grant HD32055-02. Opinions expressed in this chapter are those of the authors and do not represent the official position or policy of any agency funding this research

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