A blow to the Prescott theory of labor

Ed Prescott - he of RBC model fame - is also known for advancing a theory of why Americans work more than Europeans. In this 2004 paper, Prescott attributed the difference to taxes - Europeans are taxed much more than Americans, in order to pay for their generous welfare states. Like many other economists (e.g. Greg Mankiw), Prescott thinks that high taxes make people work a lot less.

When I studied the Prescott paper in grad school, the instructor noted that Canada might be an exception to the high-tax, low-labor pattern. Now, David Andolfatto brings us even more dramatic news of Canadian exceptionalism. Andolfatto (a hard-working Canuck himself) breaks down the Canadian labor force participation rate by age and gender, and shows that young and prime-age Canadians work more than do their American counterparts, and that this has been true since around the year 2000:










The effect is more pronounced among the young, and in fact is reversed among the old; Canadians 55+ work less than do Americans of that age. For more data see Andolfatto's blog.

Overall, Canada's labor force participation rate is 67%, to our 64%, despite the fact that their median age is about 4 years higher than ours. Since Canada's unemployment rate is lower than ours, this definitely means that Canadians are working more than Americans. (American people, when employed, actually work slightly more hours than Canadians, but that difference is not enough to make up the difference in employment rates.)

Now let's think about this fact in terms of Prescott's theory. Canada is a somewhat low-tax country by OECD standards, but has a substantially higher tax burden than the U.S. (Note: As many have pointed out, the link I provided represents total tax burden, not the effective marginal tax rate. Prescott's 2004 paper lists America's tax rate as 40% and Canada's as 44%.) Canada uses these taxes to pay for a large welfare state, of which its nationalized health care is a part.

In addition, the crossover in labor force participation happened right around the time that America passed the enormous Bush tax cuts. Right when Prescott's theory predicts that American industriousness should have pulled away from Canada's, the exact opposite happened.

Also note that the labor gap is by far the widest among young people. Since Canada's tax code (including government benefits) is more progressive than America's, the gap in effective marginal tax rates for young people is probably even bigger than the 4% tax rate gap reported in Prescott's paper. This implies that, according to Prescott, Canadian teens should be working much less than American teens, and yet we see the opposite, by absolutely enormous margins.

(Notice that since America has a much bigger ratio of national debt to GDP than Canada, a very forward-looking model, like the kind Prescott likes to use, would predict that Americans would be working even more harder than Canadians, since as we all know, high national debt implies future tax increases!)

In the genteel terminology of academic econ, this Canadian data presents a "puzzle" for Prescott's theory. But I don't really like that terminology; it implies that someday we will inevitably find a reason why tax differences do, in fact, explain cross-country differences in labor. I think we should elevate the alternative hypothesis - that taxes matter only a little in determining how much a country's people work - to a plane of equal prior plausibility.

Thus, I think this Canadian data should make us signficantly more skeptical about the entire idea that taxes largely determine how much people work in different countries.


Update: Frances Woolley, another industrious Canadian (They're everywhere! Auuughhh!), responds. I think her response really validates my points, since it points out lots of other factors besides effective marginal tax rates that can affect labor supply. In other words, Prescott's analysis was just hopelessly simplistic.