The Tax-Transfer System and Labour Supply

This chapter gives an overview of the male labour supply literature, focusing on what that literature implies for the design of the tax-transfer system. According to conventional wisdom, male labour supply is rather insensitive to tax rates. This, in turn, implies that the welfare losses from taxation are small. However, I will argue that: (i) the literature is not really so uniform in its conclusions as the conventional wisdom suggests, and (ii) much of the literature that does find labour supply is unresponsive to after-tax wages is not actually relevant for the setting of tax policy. This is because much of this literature has ignored human capital. I will argue that once one accounts for the effects of income taxation on the incentive to accumulate human capital, one finds evidence that labour supply is much more sensitive to income taxation than previously thought. This implies that optimal tax rates are correspondingly lower.