Explaining Hours Worked Across and Within Countries: Income Effects vs. Taxes and Transfers

Why are aggregate hours worked per adult lower in rich countries than in poor countries? Why is the individual hours-wage gradient positively sloped within rich countries and negatively sloped within poor countries? To answer these questions we build a model in which hours worked at the individual and aggregate level are shaped primarily by two distinct forces. The first force is preferences in which income effects dominate substitution effects in labor supply. The second force is the larger tax-and-transfer systems of richer countries, which lowers labor supply of all workers, particularly those with the lowest earning ability. In spite of its simplicity, the model performs well in quantitatively explaining the cross-country patterns of hours worked at the individual and aggregate level. Counterfactual exercises using the model predict that income effects are the most relevant factor for understanding how aggregate hours worked vary with GDP per capita across countries. Both income effects and tax-and-transfer systems are necessary to explain why individual hours-wage gradients turn from negative to positive with a country’s development level. These conclusions hold in an extended model that includes capital accumulation, self-employment, transitory income shocks and extensive and intensive labor supply decisions. We conclude that ignoring either one of the two forces in models of aggregate labor supply could lead to misleading inferences about the importance of income effects or taxation in determining aggregate hours worked.