JSPES, Vol. 26, No. 1 (Spring 2001 )
pp. 303-320

Capital Income Taxation, Labor Supply, and Work Effort

G.C. Ruggeri and Weiqui Yu

Although it is well-known that in life cycle models of consumption and labor supply, capital income taxation affects the labor supply through the normal income effect, this interaction may be widespread. Based primarily on graphic tools, three channels through which capital income taxation may affect labor market behavior, in a manner that it increases labor supply or work effort thereby reducing the distortionary effect caused by a wage tax, are identified: first, capital income taxes alter the lifetime labor supply when workers are constrained on hours of work; second, they affect labor supply in the case where consumers target a certain level of lifetime consumption; finally, they influence work effort in an efficiency wage model. Although the magnitude of these effects must be determined through careful empirical investigations, there are indications that it may be quite significant. Constraints on hours of work affect the majority of the employed labor force and surveys indicate that a large portion of well-to-do baby boomers target consumption rather than maximize lifetime earnings. The large cohort of baby boomers has also accumulated large financial assets for the purpose of purchasing additional leisure through earlier retirement. These financial assets increase the ratio of non-labor income to labor income and may affect the work effort of a large share of the working population.