The Effects of The Korean Income Taxation On Labor Supply And Welfare: A Piecewise-Linear Budget Constraint Approach Combined with IV Estimation

This article presents empirical evidence about the income tax effects on labor supply and welfare in Korea. We first derive the labor supply function in the presence of progressive income taxation, and then conduct estimation of the labor supply equation with the specificities of the Korean income tax system cautiously taken into account. Econometrically, we adopt some sort of a "joint approach" of utilizing a piecewise-linear budget constraint combined with IV estimation to deal with the complex endogeneity in the wage measure: (ⅰ) tax-induced endogeneity, and (ⅱ) measurement error coupled with division bias. Unlike the conventional perception of non-competitive features in a developing country`s labor market, empirical evidence from the Korean data shows (ⅰ) a substantial substitution response to compensated wage changes, and (ⅱ) an equally large income effect. These results are based on two different specifications and Ⅳ estimation techniques for robustness. Our results offer some policy implications: first, a distortion induced by income tax is not negligible in magnitude; second, labor supply responds substantially to temporary innovations, but changes very little to permanent innovations. Finally, policy simulation results using the empirical evidence suggest that excess burden is about 17% and 14% of the total tax revenue in years 1995 and 1996, respectively. The economy seems to be at the increasing part of the Laffer curve.