Adjustment Costs, Firm Responses, and Labor Supply Elasticities: Evidence from Danish Tax Records

We show that adjustment costs for workers interact with hours constraints set by firms to determine the effect of taxes on labor supply. We present evidence supporting three predictions of an equilibrium model in which firms post wage-hours packages and workers pay search costs to find jobs. First, observed labor supply elasticities increase with the size of the tax variation from which they are identified. Second, tax changes that apply to a larger group of workers generate larger responses. Third, firms tailor job offers to match workers’ tax preferences. Calibrating our model to match the empirical findings, we find that standard microeconometric methods underestimate structural labor supply elasticities by an order of magnitude.