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Prescott on Tax Rates

In today’s Wall Street Journal, Edward Prescott – co-winner of this year’s Nobel Prize in Economic Science – reports the findings of his research on marginal tax rates. He concludes his essay with this remark:

The bottom line is that a thorough analysis of historical data in the U.S. and Europe indicates that, given similar incentives, people make similar choices about labor and leisure. Free European workers from their tax bondage and you will see an increase in gross domestic product…. The same holds/ true for Americans.

So, the much-ballyhooed cultural differences allegedly separating Americans (or Anglo-Americans) from continental Europeans don’t really explain the observed differences in work patterns across these countries. In fact, the reason Americans work so much more in the market than do Europeans is that Americans’ taxes are lower at the margin.

This finding is important, if not astonishing. More interesting is another of Prescott’s findings, namely, that people in at least some European countries work just as long and as hard as do Americans, but they do so outside of the commercial, taxable market. Here’s Prescott again:

Further, a recent study has shown that Germans and Americans spend the same amount of time working, but the proportion of taxable market time vs. nontaxable home work time is different. In other words, Germans work just as much, but more of their work is not captured in the taxable market.

I would add another data set for certain countries, especially Italy, and that is nontaxable market time or the underground economy. Many Italians, for example, aren’t necessarily working any less than Americans — they are simply not being taxed for some of their labor. Indeed, the Italian government increases its measured output by nearly 25% to capture the output of the underground sector. Change the tax laws and you will notice a change in behavior: These people won’t start working more, they will simply engage in more taxable market labor, and will produce more per hour worked.

Prescott’s WSJ essay offers several other superb insights. I urge you to read it.