Income Taxation, Transfers and Labour Supply at the Extensive Margin

This paper presents a unified parametric approach to estimate the impact of taxes and transfers on the participation decision. We extend existing structural form methodologies by considering the effect of both taxes and transfers. In our framework, participation probabilities are determined by the comparison of disposable income in and out of the labour force, consisting of the (often non-observed) amount of transfers and non-labour income an individual gets if not working and the gains to work (GTW; change in disposable income if accepting a job offer, the sum of net wages and lost transfers). Identification is achieved by utilizing a multitude of tax and transfer reforms. Unlike in the existing literature, our results allow a general assessment of the efficiency and effectiveness of government interventions into the labour market, and more importantly, a micro-based prediction of the impact of tax and welfare reforms.The underlying theory leads to a structural probit equation which relates participation probabilities to gains to work from a full time job, the total amount of non-labour income (including the hypothetical amount of transfers one gets or would get at zero hours worked) and other individual characteristics. The unobserved hypothetical amount of transfers are backed up using individual characteristics and the welfare system’s details for every given year. The estimation process follows the often used three step procedure, as e.g. in Kimmel and Kniesner (1998). The key element of the identification is the careful choice of labour demand shifters, i.e. the variables which have no (or negligible) impact on labour supply directly, but strongly impact the wage and hence impacts activity indirectly. We argue that county dummies and (once we control for individuals’ lifecycle position with a large set of dummy variables) individuals’ age are such variables.Using data from the Hungarian Household Budget Survey, we find that a single equation can already explain a large heterogeneity of individual responsiveness to taxes and transfers: there are large differences among subgroups, driven partly by a composition effect, and partly by a different share of lost transfers in the GTW. The most responsive subgroups are low-skilled, (married) women at child-bearing age and elders, while prime-age higher educated individuals are practically unresponsive to tax and transfer changes at the extensive margin. As an illustration, we fed the main changes of the Hungarian personal income tax and transfer system of 2012 into this framework. We find that the complete elimination of the employee tax credit scheme, a reduction in the tax rate (from 20,3% to 16%) below the average monthly income and a 1 percentage point increase in the social contribution rate overall lead to a decrease in aggregate activity by about one percent.