On the role of unobserved preference heterogeneity in discrete choice models of labor supply

Abstract

The aim of this paper is to analyse the role of unobserved preference heterogene- ity in structural discrete choice models of labor supply. Within this framework, unobserved heterogeneity has been estimated either parametrically or nonpara- metrically through random coefficient models. Nevertheless, the estimation of such models by means of standard, gradient-based methods is often difficult, in particular if the number of random parameters is high. For this reason, the role of unobserved taste variability in empirical studies is often constrained since only a small set of coefficients is assumed to be random. However, this simplification may affect the estimated labor supply elasticities and the subsequent policy pre- scriptions. In this paper, we propose a new estimation method based on an EM algorithm that allows us to fully consider the effect of unobserved heterogeneity nonparametrically. Results show that labor supply elasticities and policy prescrip- tions do change significantly only when the full set of coefficients is assumed to be random. Moreover, we analyse the behavioural effects of the introduction of a working-tax credit scheme in the Italian tax-benefit system and show that the magnitude of labor supply reactions and the post-reform income distribution can differ significantly depending on the specification of unobserved heterogeneity