The Speed of Earnings Responses to Taxation and the Role of Firm Labor Demand

99 Pages Posted: 14 Dec 2020

See all articles by Matthew Gudgeon

Matthew Gudgeon

Boston University

Simon Trenkle

IZA Institute of Labor Economics

Abstract

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 — or notch — 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.

JEL Classification: H24, H31, J22, J23

Suggested Citation

Gudgeon, Matthew and Trenkle, Simon, The Speed of Earnings Responses to Taxation and the Role of Firm Labor Demand. IZA Discussion Paper No. 13931, Available at SSRN: https://ssrn.com/abstract=3747449

Matthew Gudgeon (Contact Author)

Boston University ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

Simon Trenkle

IZA Institute of Labor Economics ( email )

P.O. Box 7240
Bonn, D-53072
Germany

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