Is Prescott right? Welfare state policies and the incentives to work, learn, and retire

This paper bolsters Prescott’s (Fed. Reserve Bank Minneap. Q. Rev. 28(1):2–13, 2004) claim that high taxes are responsible for lackluster labor market performance in Continental European countries. We develop a life-cycle model with endogenous skill formation, endogenous labor supply, and endogenous retirement. Labor taxation distorts not only labor supply, but also education and retirement decisions. Actuarially unfair pensions further exacerbate labor tax distortions on retirement. Education subsidies can nevertheless cushion the adverse impact of taxation on skill formation. Feedbacks between education, labor supply, and retirement are important. The model is simulated with realistic behavioral elasticities that are consistent with microeconometric evidence. If, besides labor supply, also learning and retirement are endogenous, the uncompensated (compensated) elasticity of the tax base equals 0.46 (0.85), which is more than twice as large as the standard uncompensated (compensated) labor supply elasticity of 0.18 (0.40). Furthermore, life-cycle interactions between education, working, and retirement are quantitatively important and the interactions raise all behavioral elasticities substantially. For example, the uncompensated labor supply elasticity increases with one-half due to life-cycle interactions (to 0.26). We demonstrate that low European labor supply can be fully explained by taxation without relying on unrealistically high labor supply elasticities. Reducing labor market distortions, cutting benefit levels, lowering tax rates, and making (early) retirement actuarially more fair, therefore, boosts labor supply, delays retirement, and stimulates skill formation. In addition, high education subsidies are needed in large welfare states to offset explicit and implicit tax burdens on human capital investment.