DP6265 The Impact of Fiscal Policy on Labour Supply and Education in an Economy with Household and Market Production

Author(s): Alison L. Booth , Melvyn G Coles

Publication Date: April 2007

Keyword(s): increasing returns , fiscal policy , household production , labour supply

JEL(s): H24 , J13 , J24 , J31

Programme Areas: Labour Economics , Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP6265.asp.asp

This paper considers optimal educational investment and labour supply with increasing returns to scale in the earnings function In so doing we develop the work of Rosen (1983), who first highlighted the increasing returns argument that arises because private returns to human capital investment are increasing in subsequent utilization rates. We demonstrate that increasing returns generates task specialisation - individuals choose to become either home specialists or work specialists. With heterogeneous workers, we show for certain types, that a tax on labour income leads to large, non-marginal substitution effects; i.e. those with a comparative advantage in home production are driven out of the market sector. Tax deadweight losses are consequently large. Consistent with the theory, our empirical results, using a cross-country panel, find that gender differences in labour supply responses to tax policy can play an important role in explaining differences in aggregate labor supply across countries.