News Flash: Nobel Laureate Criticizes Bush Tax Cuts! explains how income and payroll taxes form a “tax wedge” that distorts labor markets.
This is how I was taught labor economics:
The traditional view looks at the elasticity of labor supply in terms of the choice between labor vs. leisure. That is, you either work longer, or you lie around watching TV and eating Bon-Bons. In that framework, if you get a higher wage, that makes working more profitable, but it also gives you more income, making leisure more attractive. These two effects more or less cancel one another out, it was thought, so that you do not increase labor supply very much in response to a higher wage.
This is how Nobel prize-winning economist Edward Prescott sees the labor market:
Prescott re-casts the trade-off as between “market time” and “non-market time.” In addition to TV and Bon-Bons, you spend some of your non-market time producing goods and services, such as home-improvement projects, meals cooked at home, housework, and child care. Thinking of the choice in those terms, an increase in your wage rate could have a significant effect on your labor supply. The higher your wage rate, the more it makes sense for you to “outsource” household chores. If I can earn enough in six hours of work to pay for someone else to do eight hours of household chores, then I can get more hours for TV and Bon-Bons by increasing my “market time.” Working six more hours but spending eight fewer hours on household chores gives me a net saving of two hours.This use of market time to increase leisure time is an application of one of the most basic concepts in economics — comparative advantage. An accountant could put together the bookshelves that she just bought from Ikea, but her comparative advantage is using spreadsheets, not screwdrivers. She and the economy are better off if she does more work as an accountant and pays a professional to assemble her bookshelves.