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The Speed of Earnings Responses to Taxation and the Role of Firm Labor Demand

Author

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  • Gudgeon, Matthew

    (Tufts University)

  • Trenkle, Simon

    (IZA and IAB)

Abstract

This paper studies the speed at which workers' pre-tax earnings respond to tax changes along the intensive margin. We do so in the context of Germany, where a large discontinuity - or notch - in the tax schedule induces sharp bunching in the earnings distribution. We analyze earnings responses to two policy reforms that shift this notch outward. In a frictionless world, the workers that made up the excess mass at the old notch should all increase their earnings. While some of these workers indeed adjust their earnings rapidly, over 38% do not, and instead take several years to adjust. We propose that heterogeneity in firm labor demand plays a key role in generating the observed differences in the speed of workers' earnings responses and predict that adjustment will be quickest at growing firms. We test and find support for these demand-side effects in our linked employer-employee data.

Suggested Citation

  • Gudgeon, Matthew & Trenkle, Simon, 2020. "The Speed of Earnings Responses to Taxation and the Role of Firm Labor Demand," IZA Discussion Papers 13931, Institute of Labor Economics (IZA).
    • Handle: RePEc:iza:izadps:dp13931
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    References listed on IDEAS

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    1. Raj Chetty & John N. Friedman & Tore Olsen & Luigi Pistaferri, 2011. "Adjustment Costs, Firm Responses, and Micro vs. Macro Labor Supply Elasticities: Evidence from Danish Tax Records," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 126(2), pages 749-804.
    2. Soren Blomquist & Whitney K. Newey, 2017. "The bunching estimator cannot identify the taxable income elasticity," CeMMAP working papers 40/17, Institute for Fiscal Studies.
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    4. Raj Chetty, 2012. "Bounds on Elasticities With Optimization Frictions: A Synthesis of Micro and Macro Evidence on Labor Supply," Econometrica, Econometric Society, vol. 80(3), pages 969-1018, May.
    5. Emmanuel Saez & Manos Matsaganis & Panos Tsakloglou, 2012. "Earnings Determination and Taxes: Evidence From a Cohort-Based Payroll Tax Reform in Greece," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 127(1), pages 493-533.
    6. Goldschmidt, Deborah & Klosterhuber, Wolfram & Schmieder, Johannes F., 2017. "Identifying couples in administrative data," Journal for Labour Market Research, Institut für Arbeitsmarkt- und Berufsforschung (IAB), Nürnberg [Institute for Employment Research, Nuremberg, Germany], vol. 50(1), pages 29-43.
    7. repec:iab:iabfda:201604(en is not listed on IDEAS
    8. Deborah Goldschmidt & Wolfram Klosterhuber & Johannes F Schmieder, 2017. "Identifying couples in administrative data [Identifizierung von Ehepaaren in Administrativen Daten]," Journal for Labour Market Research, Springer;Institute for Employment Research/ Institut für Arbeitsmarkt- und Berufsforschung (IAB), vol. 50(1), pages 29-43, August.
    9. Henrik J. Kleven & Mazhar Waseem, 2013. "Using Notches to Uncover Optimization Frictions and Structural Elasticities: Theory and Evidence from Pakistan," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 128(2), pages 669-723.
    10. Antoni, Manfred & Ganzer, Andreas & Vom Berge, Philipp, 2016. "Sample of integrated labour market biographies (SIAB) 1975-2014," FDZ Datenreport. Documentation on Labour Market Data 201604_en, Institut für Arbeitsmarkt- und Berufsforschung (IAB), Nürnberg [Institute for Employment Research, Nuremberg, Germany].
    11. Tazhitdinova, Alisa, 2020. "Do only tax incentives matter? Labor supply and demand responses to an unusually large and salient tax break," Journal of Public Economics, Elsevier, vol. 184(C).
    12. Alexander M. Gelber & Damon Jones & Daniel W. Sacks, 2020. "Estimating Adjustment Frictions Using Nonlinear Budget Sets: Method and Evidence from the Earnings Test," American Economic Journal: Applied Economics, American Economic Association, vol. 12(1), pages 1-31, January.
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    Cited by:

    1. Kunaschk, Max, 2024. "The effects of minimum wages on employment and prices—Evidence from the hairdressing sector," Labour Economics, Elsevier, vol. 88(C).
    2. Hannah Illing & Johannes Schmieder & Simon Trenkle, 2024. "The Gender Gap in Earnings Losses After Job Displacement," Journal of the European Economic Association, European Economic Association, vol. 22(5), pages 2108-2147.
    3. Moritz Drechsel‐Grau & Andreas Peichl & Kai D. Schmid & Johannes F. Schmieder & Hannes Walz & Stefanie Wolter, 2022. "Inequality and income dynamics in Germany," Quantitative Economics, Econometric Society, vol. 13(4), pages 1593-1635, November.
    4. Gabriela Galassi, 2021. "Labor Demand Response to Labor Supply Incentives: Lessons from the German Mini-Job Reform," Staff Working Papers 21-15, Bank of Canada.
    5. Hannah Illing & Hanna Schwank & Linh T. Tô, 2024. "Hiring and the Dynamics of the Gender Gap," ECONtribute Discussion Papers Series 339, University of Bonn and University of Cologne, Germany.
    6. Galassi, Gabriela, 2021. "Labor Demand Response to Labor Supply Incentives: Lessons from the German Mini-Job Reform," IZA Discussion Papers 14248, Institute of Labor Economics (IZA).

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    More about this item

    Keywords

    labor supply responses to taxation; earnings adjustment frictions; labor demand;
    All these keywords.

    JEL classification:

    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies
    • H31 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Household
    • J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
    • J23 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Labor Demand

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