Theoretical Study on Effects of Reference-Dependent Preferences on Labor Supply Decisions under Personal Income Taxation

Abstract

Based on the reference point dependence theory in behavioral economics, this paper explores the labor supply decision-making of workers under the individual income tax system. Traditional labor economics holds that workers are rational and decide their working hours based only on their absolute income and the utility of their leisure, but this ignores the influence of reference points on people in reality. Drawing on the prospect theory proposed by Kahneman and Tversky, this paper establishes a labor supply theory model that includes reference point dependency preferences, taking the gain or loss of after-tax income relative to the reference point as the main factor of the laborer's utility function. The results show that when after-tax income is less than the reference point, workers have a loss aversion tendency and will increase their working hours to make up for the "loss". When the after-tax income is higher than the reference point, workers are less interested in more money and may reduce their working hours. By studying the effects of different tax rate structures, the formation of reference points (historical income, social comparison, expected income), and the loss aversion coefficient on the elasticity of labor supply, it can be concluded that reference point dependence preference leads to the non-linear and asymmetric characteristics of the labor supply curve, and obvious "ratchet effect" and "income target effect" occur in tax system reform. The findings of this paper help to understand the mechanism of action of personal income tax policy from a micro perspective, and are of great value for improving tax system design, estimating the impact of tax reform on labor supply, and enhancing the efficiency of tax policy.