Working Paper

Robust Inference for the Frisch Labor Supply Elasticity

Abstract: The Frisch labor supply elasticity plays a key role in many economic policy debates, but its magnitude remains controversial. Many studies estimate the Frisch elasticity using 2SLS regressions of hours changes on wage changes. But a little appreciated power asymmetry property of 2SLS causes estimates to appear spuriously imprecise when they are shifted away from the OLS bias. This makes it difficult for a 2SLS t-test to detect a true positive Frisch elasticity. We illustrate this problem in an application to NLSY97 data. We obtain an estimate of 0.60 for young men, but the t-test indicates it is insignificant. In contrast, the Anderson-Rubin (AR) test – which avoids the power asymmetry problem – implies the estimate is highly significant. The same power asymmetry issue that afflicts the t-test here will arise in many IV applications. Thus, we argue the AR test should be widely adopted in lieu of the t-test.

Keywords: continuously updated GMM; Labor supply; 2SLS; LIML; weak instruments; Frisch elasticity; Anderson-Rubin test;

JEL Classification: C12; J22; D15; C26;

https://doi.org/10.21034/iwp.81

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Opportunity and Inclusive Growth Institute Working Papers

Publication Date: 2023-11-17

Number: 081