Trends and Fluctuations in the Household's Marginal Rate of Substitution Condition: Time Series Evidence from the OECD

There is a large literature, including work by Hall (1997), Chari, Kehoe, and McGrattan (2002), Gali, Gertler, and Lopez-Salido (2002), and many others that has studied the gap between the household's static marginal rate of substitution condition (MRS) between consumption and leisure and the real wage using postwar U.S. data. However, there is very little international evidence on deviations in this condition. This paper presents a comprehensive international analysis by documenting deviations in this condition using annual and quarterly data from 19 OECD countries over the last 40 years. We use standard balanced growth preferences in the analysis and find that there are very large and non-stationary deviations in this condition over time in almost all the countries. In particular, the gap between the marginal rate of substitution and the real wage grows as much as 60 percent over this period. We also find very similar patterns in this gap across some regions. There is a large gap in most European countries indicating that households either experienced a large decrease in the incentive to work, or a large increase in the marginal disutility of working. We next use Mendoza and Tesar's time series data on tax rates to see how much tax rate changes can account for these MRS gaps. We find that changes in taxes account on average for about half of this gap. However, for half of the countries that we study, the residual MRS gap remains large and non-stationary. This suggests that either the tax rates households face differ significantly from the Mendoza-Tesar rates, or that there are other quantitatively important factors driving a wedge between the MRS and the after-tax real wage rate