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As the Bush-era tax cuts are set to expire in 2010, ambitious health care legislation has passed Congress, and entitlement programs are growing at unsustainable rates, U.S. policymakers face important questions about the optimal size and scope of federal spending. The federal government finances its spending mostly through labor taxes, including taxes on income, payroll, and consumption--taxes that generate significant disincentives for employment. In The Impact of Labor Taxes on Labor Supply: An International Perspective, Richard Rogerson contends that the unintended consequences of increased labor taxes would be too large for policymakers to ignore.

Rogerson compares fifty years of time series data from the United States and fourteen other OECD countries. He finds that a 10 percentage point increase in the tax rate on labor leads to a 10 to 15 percent decrease in hours of work. Even a 5 percent decrease in hours worked would mean a decline in labor output equating to a serious recession. While recessions are temporary, permanent changes in government spending patterns have long-lasting repercussions.

Although government spending provides citizens with many important benefits, such benefits must be weighed against the disincentivizing effects of increased labor taxes. Policymakers who fail to account for the decrease in labor output risk expanding government programs beyond their optimal scale.

Richard Rogerson is the Rondthaler Professor of Economics and a Regents’ Professor at the W. P. Carey School of Business at Arizona State University.