A new study from Lars Ljungqvist, at the Stockholm School of Economics, in collaboration with New York University and other institutions, investigates how tax reforms influence labor market behavior. The study examines how individuals and couples make decisions about working hours, career length, and savings under different tax policies.

The researchers used a detailed economic model that includes singles, married couples, and divorcees with diverse abilities and life circumstances. They assessed two key policies: a flat-rate tax combined with either an earned income tax credit (EITC) or a negative income tax (NIT).

While a switch from a progressive to a flat-rate tax system leads to a more efficient aggregate labor supply, it also reduces the welfare of those with the lowest incomes. To mitigate the latter adverse distributional effects, the flat-rate tax reform is combined with either the EITC or a NIT. Of those two programs, the study found that the EITC had a stronger effect on encouraging labor force participation, particularly among those with lower incomes.

"Our findings show that the EITC's focus on rewarding work makes it a more effective tool for improving the welfare of lower-income people than the NIT, since the NIT can disincentivize labor force participation because of its guarantee of a minimum income without working," says Lars Ljungqvist, Professor of Economics at the Stockholm School of Economics.

The study's model also accounted for how individuals balance their careers over time - known as “time averaging.” This factor helps explain why some individuals extend their working years while others retire early. The researchers identified that social security policies, particularly those that implicitly penalize working after age 65, can deter older workers from continuing in the workforce.

Better support for vulnerable workers

The study highlights how high labor supply responsiveness at the extensive margin amplifies the positive effects of EITC, especially among lower-income workers. By encouraging people to remain employed rather than relying on guaranteed payments as provided under the NIT, the EITC is a more efficient way to increase the welfare of lower-income workers.

"Tax reforms need to consider the wide range of household situations and career paths,” Ljungqvist added. "Our research suggests that targeted incentives, like the EITC, can improve welfare outcomes without distorting work incentives as much as alternative policies.”

The findings contribute to ongoing debates about optimal tax policies and social security design, with implications for policymakers seeking to balance equity and efficiency in labor markets.