Essays in Public Finance and Behavioral Economics

Abstract: Essay I: I study how individuals adjust their labor supply in response to a year with tax free income. Due to a transformation from a retroactive to a pay-as-you-earn tax system, income earned on the Icelandic labor market in 1987 was never taxed. Still, there was no cash-flow shock as taxpayers during the tax holiday (1987) paid taxes on income earned in the year before. This paper has three main results. First, I estimate a Frisch elasticity of 0.07 with a Wald difference-in-differences (DID) estimator by exploiting the progressivity of the tax scheme and the tax holiday. The Wald-DID estimator is biased if the Frisch elasticity differs between tax brackets. Second, I show how to overcome this bias by also exploiting changes in the tax scheme after 1987. This gives elasticities ranging from 0.7 (high income earners) to 4 (low income earners). However, this second approach to identify the Frisch elasticity gives biased results if there are frictions to labor supply adjustments during the tax holiday. Therefore, third and finally, I show that if there are frictions and the elasticity governing the response during the tax holiday is 0.05 (like that found by Martinez et al. (2018) who study a tax holiday in Switzerland) the frictionless elasticity is 0.2 for mid income earners, and 0.4 for high and low income earners. Overall, the paper adds to the literature on intertemporal labor supply responses and on how to deal with heterogeneity when perfect control groups are hard to find.