Josef Sigurdsson, Institute for International Economic Studies

Stockholm University

“Labor Supply Responses and Adjustment Frictions: A Tax-Free Year in Iceland”

Abstract

How does labor supply respond to a temporary wage change? To answer this question, I study an unexpected and salient tax reform in Iceland in 1987 that resulted in a year free of labor income taxes, but creating only minimal income effects, offering an ideal natural experiment. I first construct a new employer-employee dataset from digitized administrative records for the population. I then use two complementary research designs to estimate Frisch elasticities. The first design, which is standard, exploits the progressivity of the tax system and identifies an intensive-margin elasticity of 0.4. The second design, which is new, uses similarities in life-patterns of labor supply and identifies an extensive-margin semi-elasticity of 0.07. Guided by a combination of machine learning and causal estimation, I uncover three key mechanisms behind these responses. First, the young and those close to retirement drive the extensive-margin response. Second, workers with temporal flexibility and the hourly paid have substantially higher elasticities than constrained workers. However, constrained workers take up secondary jobs, which contribute 7% of the overall responses. Third, married women are more responsive than their husbands. Husbands, but not wives, respond negatively to their spouses' tax cuts, inconsistent with unitary household models. My results imply that voluntary changes in work are key to the transmission of aggregate shocks, but the responses depend on labor-market and demographic structures.

Contact person: Claus Thustrup Kreiner