Work Hours & Income Tax Cuts: Evidence from Federal-State Tax Interactions

We investigate how income tax reductions affect work hours. Our empirical strategy relies on the fact that, in states where taxpayers can deduct federal tax payments from state taxable income, federal tax changes are dampened. We study 2003 tax reforms (JGTRRA) that dramatically reduced federal tax rates on dividends and capital gains, and moderately reduced rates on ordinary income. Difference-in-Difference analysis indicates that work hours decreased most among high income and wealthy taxpayers who were most directly affected by the tax reductions.

The decrease in hours was larger for residents of states in which the effective tax reductions were larger. Conversely, we find possible evidence that larger ordinary income tax rate reductions in the 1980s, accompanied by effective tax increases on capital gains, had the opposite effect and induced an increase in work hours. These results suggest that the effect of tax reductions may depend on the type of income targeted.