Do Taxes Explain European Employment? Indivisible Labor, Human Capital, Lotteries, and Savings [with Comments and Discussion]

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 labor supply elasticity that underlies his finding that higher taxes on labor have depressed Europe relative to the United States, this paper compares aggregate outcomes for economies with two arrangements for coping with indivisible labor: (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 labor is an impediment to explaining European nonemployment and benefits levels. Moreover, while the identities of the nonemployed under Prescott's tax hypothesis differ between the two aggregation theories, they all seem counterfactual.

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