Do Taxes Explain European Employment? Indivisible Labour, Human Capital, Lotteries and Savings

Thomas Sargent and Lars Ljungqvist

No 6196, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Adding generous government supplied benefits to Prescott's (2002) model with employment lotteries and private consumption insurance causes employment to implode and prevents the model from matching outcomes observed in Europe. To understand the role of a 'not-so-well-known aggregation theory' that Prescott uses to rationalize the high labour supply elasticity that underlies his finding that higher taxes on labour have depressed Europe relative to the US, this paper compares aggregate outcomes for economies with two arrangements for coping with indivisible labour: (1) employment lotteries plus complete consumption insurance, and (2) individual consumption smoothing via borrowing and lending at a risk-free interest rate. The two arrangements support equivalent outcomes when human capital is not present; when it is present, allocations differ because households' reliance on personal savings in the incomplete markets model constrains the 'career choices' that are implicit in their human capital acquisition plans relative to those that can be supported by lotteries and consumption insurance in the complete markets model. Nevertheless, the responses of aggregate outcomes to changes in tax rates are quantitatively similar across the two market structures. Thus, under both aggregation theories, the high disutility that Prescott assigns to labour is an impediment to explaining European non-employment and benefits levels. Moreover, while the identities of the non-employed under Prescott's tax hypothesis differ between the two aggregation theories, they all seem counterfactual.

Keywords: Aggregation theories; Employment lotteries; Human capital; Indivisible labour; Labour supply elasticity; Labour taxation; Social and private insurance (search for similar items in EconPapers)
JEL-codes: E24 E62 (search for similar items in EconPapers)
Date: 2007-03
New Economics Papers: this item is included in nep-dge, nep-eec, nep-ias and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (35)

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