The Speed of Earnings Responses to Taxation and the Role of Firm Labor Demand
99 Pages Posted: 14 Dec 2020 Last revised: 5 Jul 2022
This paper studies the speed at which workers' pre-tax earnings respond to tax changes along the intensive margin. We do so in the context of Germany, where a large discontinuity â or notch â in the tax schedule induces sharp bunching in the earnings distribution. We analyze earnings responses to two policy reforms that shift this notch outward. In a frictionless world, the workers that made up the excess mass at the old notch should all increase their earnings. While some of these workers indeed adjust their earnings rapidly, over 38% do not, and instead take several years to adjust. We propose that heterogeneity in firm labor demand plays a key role in generating the observed differences in the speed of workers' earnings responses and predict that adjustment will be quickest at growing firms. We test and find support for these demand-side effects in our linked employer-employee data.
Keywords: earnings adjustment frictions, labor supply responses to taxation, labor demand
JEL Classification: H24, H31, J22, J23
Suggested Citation: Suggested Citation