How the Supply of Labor Responds to Changes in Fiscal Policy

Report
October 25, 2012

In choosing how much to work, people respond to incentives that are partly determined by taxes on income from that work and by government benefits that vary with income. Those responses play a critical role in CBO’s analysis of the effects of changes in fiscal policy on economic outcomes.

CBO uses two models of the economy to analyze the medium- and long-term effects of federal tax and spending policies: a Solow-type growth model and a life-cycle growth model. The models take different approaches toward capturing the ways in which the supply of labor responds to changes in fiscal policy. The Solow-type growth model uses estimates of how much the labor supply changes at a given point in time in response to a change in after-tax compensation that would result, for example, from a change in tax rates. The life-cycle growth model uses estimates of the responsiveness of the labor supply that depend on how people expect their after-tax compensation to change over time. CBO reviewed the extensive research literature on the magnitude of those responses, and this report describes the values the agency will be using in future analyses.