Economic theory
Behavioral responses
Tax and benefit reforms change incentives to work and earn. PolicyEngine models these behavioral responses using the elasticity of taxable income framework, capturing both substitution effects (changing work effort) and income effects (adjusting for changes in after-tax income).
Substitution effect
When tax rates fall, each hour of work yields more after-tax income. This encourages people to substitute toward more labor and less leisure, increasing earnings.
Income effect
When after-tax income rises (e.g., from a new tax credit), people can afford to work less while maintaining their standard of living, slightly decreasing earnings.
Budget constraint: baseline vs. reform
CBO preset elasticity parameters
PolicyEngine simulations default to static behavior. These CBO elasticity estimates are optional presets for sensitivity analysis, and all parameters are fully adjustable.
Income elasticity (all earners)
CBO, "How the Supply of Labor Responds to Changes in Fiscal Policy" (2012)
Substitution elasticity by income decile
| Decile | Lower | Central | Upper |
|---|---|---|---|
| 0-10% | 0.15 | 0.31 | 0.47 |
| 10-20% | 0.15 | 0.28 | 0.42 |
| 20-30% | 0.15 | 0.28 | 0.42 |
| 30-40% | 0.15 | 0.27 | 0.38 |
| 40-50% | 0.15 | 0.27 | 0.38 |
| 50-60% | 0.15 | 0.25 | 0.35 |
| 60-70% | 0.15 | 0.25 | 0.35 |
| 70-80% | 0.15 | 0.22 | 0.29 |
| 80-90% | 0.15 | 0.22 | 0.29 |
| 90-100% | 0.15 | 0.22 | 0.29 |
CBO, "A Review of Recent Research on Labor Supply Elasticities" (Working Paper 2012-12)
Capital gains elasticity
CBO, "New Evidence on the Tax Elasticity of Capital Gains" (Working Paper 2012-09)