Are Taxes Turning Humans into Machines? Using Payroll Tax Variation to Estimate the Capital-Labor Elasticity of Substitution

This paper provides the first quasi-experimental estimate of the micro capital-labor elasticity of substitution. We use a discontinuity in the average payroll tax rate to show that firms decrease both labor and capital when experiencing higher payroll tax rates. We argue that this is consistent with Leontief production functions, implying a micro capital-labor elasticity of substitution of zero. Using a conceptual framework to aggregate micro elasticities, we estimate a macro capital-labor elasticity of substitution of 0.17. Our finding sheds new light on the role of the substitution of labor with capital in the fall of labor shares and on the fiscal externalities imposed by payroll taxes