Coping With Challenges Ahead: The Role of Hours Worked Europe vs' United States Edward C' Prescott A

1
Coping With Challenges Ahead The Role of Hours
Worked Europe vs. United StatesEdward C.
PrescottArizona State University and Federal
Reserve Bank of MinneapolisJune 2005
2
Current Social Security System in Most European
Countries Cannot Be Sustained

• Reason
• 1. Population is aging.
• 2. Big retirement benefits are received by the
  old.

3
If Labor Supply Inelastic

• Only choices are
• 1. Default on some promises
• 2. Or increase taxes
• 3. Or combination of both

4
If Labor Supply Elastic

• Can rebuild the Social Security system in a way
  that
• 1. Honors all promises
• 2. Makes everyone better off

5
Labor Supply Is Highly Elastic 3

• Here I mean AGGREGATE LABOR SUPPLY
• Aggregate and micro labor supply elasticity are
  DIFFERENT concepts
• Relevant concept for designing tax system is
  aggregate labor supply elasticity

6
Definition of Aggregate Labor Supply Elasticity

• Holding wealth constant, it is the percentage
  change
• in aggregate labor supply associated with a 1
• change in the after-tax real wage.

7
Evidence That Aggregate Labor Supply Elasticity
Is High

8
Business Cycle Evidence

• Finn Kydland and I (1982) found that if and only
  if this elasticity is high, about 3, does the
  neoclassical growth model quantitatively predict
  all the key business cycle facts. (One of the two
  papers for which we received the Nobel Prize.)
• Many others using dynamic applied general
  equilibrium analysis have also (see Cooley 1995
  volume).

9
Depression Evidence

• Fumio Hayashi and I (2002) find this neoclassical
  growth model accounts for the behavior of the
  economic aggregates in Japans lost decade of
  growth, 1992-2002, if and only if this elasticity
  is about 3.
• See Kehoe and Prescott Depressions Volume (2002)
  for further evidence from a number of other
  studies for this number.

10

11
Cross-Country Labor Supply and Tax Evidence

• I found that the basic theory and the differences
  in tax rates predict the large differences if and
  only if this elasticity is about 3.
• Americans, Chileans, and Japanese all work over
  40 more than Western Europeans because their
  marginal tax rates are 40 and not 60 as in
  Western Europe.

12
Cross-Time Tax Evidence

• I found the reason that labor supply fell by a
  third in Europe between the early 1970s and the
  mid 1990s was that the average effective tax rate
  was increased from 40 to 60.
• An implication of this is that increasing tax
  rates will not increase tax revenue in Western
  Europe.

13
Theoretical Evidence

• Rogerson (1984) and Hansen (1985) use theory to
  establish that aggregate elasticity is much
  greater than individual elasticity.
• Provided the margin of labor supply adjustment is
  the number of employed and not hours per
  employed.
• This is the empirically interesting case.

14
The Principal Margin of Adjustment Is Fraction
Employed

• Over business cycles
• Over seasons
• Over large adjustments to a new balanced growth
  path e.g. growth miracles and depressions
• Over the life cycle people retire

15
Other Factors Matter The Case of Spain

16
Summary

• It is an established scientific finding that
  aggregate labor supply is highly elastic
• All micro and macro evidence supports this
  scientific finding
• People respond to incentives

17
Mandatory Savings Plan

• For health care and for retirement
• Major medical insurance to take care of major
  health expenditures
• Survivor and disability insurance

18
Welfare Would Increase

• Measure of welfare is lifetime consumption
  equivalents.
• Welfare would increase by a third.

19
What About Government Debt?

• Given need for some place to invest all the
  savings, there would have to be a huge national
  debt say 6 GDPs paying market returns of 4
  real per year.
• This debt is implicitly there now with the
  pay-as-you-go systems.

20
What About Low Birth Rates?

• No problem.
• Conclusions are not sensitive to this conclusion.

21
Conclusion

• Mandatory savings accounts are the only way to
  provide for retirement.
• If there was a switch there would be a huge boom
  in Western Europe that would be as big as
  Europes postwar boom.
• My advice to Germany and France is to follow the
  lead of Spain and Sweden.