Effects of labour taxes on hours of market and home work: the role of international capital mobility and trade

The Prescott hypothesis that permanently higher marginal tax rates on labour income fully explain the decline in market hours worked in Europe (relative to North America) over three decades is subject to a theoretical investigation. The Prescott model consists of isolated economies that are not linked by international capital mobility or international exchange of goods. We study a two-country model with free international capital mobility. We find that imposing higher marginal labour tax rates in one country leads to international capital inflows into that country, which acts to counteract the negative employment effect of higher taxes. Market hours worked in the low marginal labour tax rate country fall with an increase in its net foreign assets. With identical preferences, total market hours worked are equalized across the two countries. With factor price equalization, the international equalization of hours worked result still holds with goods trade substituting for international capital mobility.