The Effect of Income Taxation on Consumption and Labor Supply

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We estimate the incentive effects of income taxation in a life‐cycle model of consumption and labor supply without intratemporal strong separability. We find that consumption and hours worked are direct complements in utility; both increase with a compensated increase in the net wage. The compensated net wage elasticity is about 0.3, nearly double estimates for U.S. men from a linear labor supply specification. Estimated intertemporal elasticities indicate significant intertemporal smoothing of utility. The estimated marginal welfare cost of government revenue is 6%–20%, which is about half the estimated welfare cost when additivity between consumption and leisure is incorrectly imposed.