The labor-supply elasticity and borrowing constraints:: Why estimates are biased

The intertemporal labor-supply elasticity is often a central element in macroeconomic analysis. We argue that assumptions underlying previous econometric estimates of the labor-supply elasticity are inconsistent with incomplete-markets economics. In particular, if the econometrician ignores borrowing constraints, the elasticity will be biased downwards. We assess this bias using artificial data generated by a model in which we know the true elasticity and real-world data from the Panel Study of Income Dynamics. When applying standard econometric methods on the artificial data, we estimate an elasticity that is 50 percent lower than the true elasticity. We find evidence of a similar bias when using real-world data. (c) 2005 Elsevier Inc. All rights reserved.