RDP 2007-05: Labour Force Participation and Household Debt 2. Literature Review

2.1 Previous Empirical Findings

A series of earlier papers have examined the relationship between labour supply and debt in a range of countries using cross-section and panel data. For example, Fortin (1993, 1995) and Worswick (1999) study Canada, Del Boca and Lusardi (2003) study Italy, Aldershof, Alessie and Kapteyn (1999) study the Netherlands, Bottazzi (2004) studies the United Kingdom and O'Brien and Hawley (1986) and Shack-Marquez and Wascher (1986) study the United States. With one exception (Shack-Marquez and Wascher 1986), the findings suggest that debt and its servicing obligations have a positive and significant effect on labour supply. Fortin (1995) and Aldershof et al (1999) find that the effect of debt generally outweighs the negative effect that young children have on female labour supply, while Bottazzi finds the overall effect remains negative. The focus of most of these papers is on housing debt and its influence on partnered female labour supply.

The intertemporal life-cycle model is the commonly used framework in these studies. The significance of debt for labour supply has been interpreted as evidence that credit constraints bind for some individuals. Intuitively, binding credit constraints can be expected to increase labour supply since working is a means by which such constraints can be eased. For example, some individuals may not be able to borrow any funds from financial institutions, while for others, banks may impose an upper bound on the amount of credit available. However, in both cases the individual may be able to relax these credit constraints by working. Those with existing debt may, at some point, have made a decision to work in order to access credit, absent some alternative income source. They may also find that credit constraints bind in the face of an unexpected income or expenditure shock. In this case also, increasing labour supply provides a means to ease the credit constraint and may be less costly than renegotiating a loan or selling assets.[1]

In Fortin (1995) and Bottazzi (2004), credit constraints are introduced into the model through the addition of a mortgage-related borrowing constraint, which is assumed to hold in every period.[2] This style of model is also appropriate to the Australian case. Australian banks typically require that scheduled loan repayments not exceed a nominated proportion of a borrower's regular income. This proportion has traditionally been set at around 30 per cent of gross income, though in more recent years a higher ratio has been used, particularly for higher income earners.

Aldershof et al (1999) incorporate a more general borrowing constraint. Del Boca and Lusardi (2003), on the other hand, model the labour force and mortgage decisions in a simultaneous equation system. To identify the direction of the effect between debt and LFP, they exploit two exogenous changes in the Italian mortgage market, between 1989 and 1993, that served to expand consumers' access to credit.

Each of the above papers includes a role for borrowing constraints. Dau-Schmidt (1997) suggests that debt also imposes a second type of constraint, in that ongoing debt-servicing obligations represent an expenditure commitment that may be difficult to change at short notice in the face of an adverse shock. For example, while a home owner might ultimately sell their home and move to cheaper housing, there may be limited scope to do this in the short run, particularly in the face of significant adjustment costs.

This literature intersects with studies concerned with the effect of the housing tenure decision on labour force supply. These models are not only concerned with home owners, who may be constrained by debt holdings, but also those planning to purchase a home who may be constrained by the need to accumulate a down payment. Yoshikawa and Ohtake (1989) develop a model for Japan and find that a down-payment constraint induced women planning to purchase a home to work more than other women.

Some Australian studies have included a role for housing debt or home ownership as an explanator for LFP, using cross-section or panel data. Shamsuddin (1998), using cross-section data, finds that total mortgage debt has a significant positive effect on the LFP and hours worked of immigrant women. Drago, Wooden and Black (2006), in a panel study using HILDA data, find that the debt-to-income ratio has a significant and positive effect on the propensity for long hours of work. However, Kidd and Ferko (2001) find no significant effect of home ownership on participation and hours worked in an investigation of the effect of the gender wage gap on employment.

Two Australian studies examine this issue using macroeconomic data. Connolly (1996) finds a negative correlation between female full-time LFP and the affordability of home and consumer loans. Connolly and Kirk (1996) find that the affordability of consumer loans and housing costs each affect the LFP of older Australian men.

2.2 The Treatment of Endogeneity in the Literature

The discussion above suggests that while indebtedness may prompt individuals to supply more labour, debt may also depend on the LFP decision, as financial institutions often include employment or current income in their lending criteria. The endogenous determination of debt might also arise as households simultaneously choose a future path for work and debt, say in relation to plans to purchase a home or start a family. However, the case for endogenous debt is not clear cut. In the face of temporary shocks to income (or expenditure), a household might generally treat debt as pre-determined, especially if changing debt quickly involves a large adjustment cost, and be more willing to adjust labour first.

Despite the bias that can occur in the presence of endogeneity, few papers test or control for it. Del Boca and Lusardi (2003) are a notable exception in that they model the participation and mortgage decisions simultaneously. Fortin (1993) finds evidence that mortgage payments are exogenous to the labour force decision using Canadian data. Bottazzi (2004) tests for the endogeneity of the mortgage constraint on LFP in her UK study using house prices as an instrumental variable and also finds that mortgage payments are exogenous to the labour force decision. Section 3.2 details the identification strategy used in this paper to control for the potential endogeneity. Testing suggests that debt is exogenous to current LFP. This result is discussed in Section 5.2.


Other papers assess the importance of credit constraints by using indicators such as whether the person has little or no liquid or total wealth (see, for example, Dau-Schmidt 1997 and Domeij and Flodén 2006) or whether the person has been denied access to credit (see, in particular, Jappelli 1990). [1]

Bottazzi argues that this is reasonable as long as refinancing is possible; on application to refinance, the bank is able to reassess income and reapply the mortgage borrowing constraint. [2]