Labor Income Tax and Output: A Structural VAR Analysis

Abstract

This paper analyzes two channels through which a change in labor income tax may affect output. First, a tax cut provides higher work incentives, thereby increasing the aggregate output through an increase in the aggregate labor supply. Second, a tax-cut increases disposable income and the aggregate demand. An increase in the aggregate demand leads to a higher level of aggregate output. The first channel is believed to have a permanent effect on output movements, while the latter has only a temporary effect. This paper captures these two effects by defining two disturbances on the basis of the existing economic theory.