Finance and Economics Discussion Series

Income Taxes, Compensating Differentials, and Occupational Choice: How Taxes Distort the Wage-Amenity Decision

Hui Shan and David Powell
2010-04

Abstract: The link between taxes and occupational choices is central for understanding the welfare impacts of income taxes. Just as taxes distort the labor-leisure decision, they also distort the wage-amenity decision. Yet, there are no estimates of the full response on this margin. When tax rates increase, workers favor jobs with lower wages and more non-taxable amenities. We introduce a two-step methodology which uses compensating differentials to characterize the tax elasticity of occupational choice. We estimate a significant compensated elasticity of 0.05, implying that a 10% increase in the net-of-tax rate causes workers to change to a 0.5% higher wage job.

Keywords: Income taxes, occupational choice, compensating differentials