For a interesting primer on this topic, read this first. A reader wonders if "high income taxes distort work incentives," meaning, do higher taxes really cause people to work less? More money is more money, right, and as long as you're getting more, you'll work to get more?
I was debating this with a friend recently and he said that higher tax rates are not a disincentive to working more. He presented the following table of income and tax:
| Income | Tax | After tax |
| 10,000 | 0 | 10,000 |
| 50,000 | 4,000 | 46,000 |
| 100,000 | 14,000 | 86,000 |
| 1,000,000 | 284,000 | 716,000 |
- Income from $1 to $7,300, tax bracket is 10%
- Income from $7,301 to $29,700, tax bracket is 15%
- Income from $29,701 to $71,950, tax bracket is 25%
- Income from $71,951 to $150,150, tax bracket is 28%
- Income from $150,151 to $326,450, tax bracket is 33%
- Income $326,451 and above, tax bracket is 35%
The disincentive occurs at the margin. In our hypothetical example, the $10,000th dollar earned is all yours, but the $10,001st dollar you only get to keep 90 cents. Anytime you do a dollar's worth of work and only get to keep 90 cents, that's a disincentive to work for that dollar. It's true, you're 90 cents richer, but you had to work a dollar's worth for it. At the highest rates in the U.S. an extra dollar of work nets you 65 cents. It stands to reason that if you only get to keep 65 cents of the next dollar you earn, you'll take pause before you work for that extra dollar.
An excellent write-up of how tax policy could be used more effectively in the U.S. has this to say about Europe and their experience with higher tax rates:
According to research by Nobel laureate Edward Prescott and by economists Steven Davis and Magnus Henrekson, the high tax rates in Europe have reduced work effort and distorted the industrial mix. The Davis-Henrekson study reports that a tax increase of 12.8 percentage points...reduces work for an average adult by 122 hours per year. It also reduces the employment-population ratio by 4.9 percentage points and increases underground economy by 3.8% of GDP.You can debate whether the end result is good or bad (maybe working less is a desirable outcome), but to say that taxes (at least at the higher levels we have here in the U.S. and in Europe) do not distort work incentives is not accurate.
OK, just for the sake of accuracy (as the friend you were debating who drew the original table of income and tax), I never said that income tax is not a disincentive to work more. I said that income tax is not a disincentive to earn more. There are many ways to earn more money besides working more hours.
ReplyDeleteYou were arguing in favor of consumption taxes that will discourage negative behaviors. One problem with these is that if they succeed, the revenues they generate will be reduced, and the government will have to raise other taxes to make up the difference.
I was arguing that the better approach is to provide tax incentives for activities which will encourage the opposite of the behaviors you would wish to discourage. So rather than taxing gasoline to try to get people to drive less, you create tax incentives to people who use alternative transportation and to companies that develop alternative technologies that reduce pollution and oil consumption.
You say, "There are many ways to earn more money besides working more hours". Are you talking about investments, like bank accounts, that earn interest? True, you don't have to work more hours for these to make you money, but even investment income faces disincentives from taxes. Like your time, presumeably, you have a choice with where you can invest your money. For example, I could invest my money in an investment that would pay me some interest, or I could use the money to buy a new bike which would not bring me more money wealth. If I would only receive 65 cents for every dollar of the return on my investment, that might discourage me from choosing the investment and I might buy the new bike instead.
ReplyDeleteIf you don't have to do anything to get the extra wealth, of course taxes don't matter. Taxes only matter when you have to make a choice between how you'll allocate your resources, whether that choice involves time, money, whatever. (I mean, I wouldn't reject a raise because of taxes, as I wouldn't tell the bank that the interest rate is too high because it bumps me into the next higher tax rate.)
If someone just gives you money, even if you only get to keep 1% of it, you'll still take it, because you didn't have to do anything do get it and more money is more money. But if you have to do something, and you will only get 1% of the value back from it, you may choose to not do that thing.
As for consmuption taxes the objective of the tax is what matters...I'll address this topic in a future post. But for a preview, read this about the subsidies for Toyota hybrids. He says, "Look, I have nothing against hybrid powered cars...It’s just that, personally, I don’t like being forced to pay for someone else’s car. But that’s just me." And me too.
I've always thought that the argument against certain taxes that goes, "Why should I pay a tax to support something I don't actually get a benefit from?" is absurd and anti-Democracy. We all pay taxes for things we don't derive direct benefit from. And we all pay taxes for things we don't want to pay for. I don't get a choice about paying for the war in Iraq, and as much as I hate that war, I don't think I should have a choice about it. If everyone were free to allocate their tax payments as they choose, it would be pandemonium. At least if someone else drives a Prius, I do derive some benefit, just as I derive some benefit when you ride your bicycle because you aren't polluting my air, even if I am because I'm driving my SUV.
ReplyDeleteAnyway, the guy who pays more taxes because he's driving an SUV isn't paying for my Prius. He's paying for his SUV by choosing not to take advantage of the incentive. And in my system, you get an even bigger incentive by not buying a car at all. So you won't be paying for my Prius either.
And I was not talking specifically about investing as a way of making more money. I was talking about, say, working at Target versus working at Wal-mart if Target pays more. There might be other reasons to work at Wal-mart (it's closer to home, for instance), but if two jobs are equal in every respect except how much they pay, you'll always take the higher paying job, right? Even if your tax burden goes up, right?
Your argument about the investment versus the bicycle doesn't make any sense to me. I think I am too dense or too practical to understand how anyone would go out a bicycle because the tax on their savings made investing not worth while--unless what they really wanted was the bicycle.
"If everyone were free to allocate their tax payments as they choose, it would be pandemonium."
ReplyDeleteIt's not pandemonium, it's Congress.
Stated correctly, the decision to work or not really depends on the type of non-income incentives. Namely: welfare benefits. If these tax benefits proceed it would take effectively take away the decision to work.
ReplyDelete