I have been making this argument in various forms for a while on this blog, but I think it might be helpful to go back to basics. Here is my basic point:
The idea that taxes decrease our incentive to work runs counter our basic observations about how human beings behave
Why?
Well the basic thing that taxes due is reduce your take home pay. If you work the same number of hours you earn less for every hour worked.
There are two basic effects here that have been long recognized by economists.
The substitution effect: The substitution effect says is that since I am getting less money for each hour I work I should work fewer hours. My reward from work is less, so I substitute away from work towards other things.
The income effect: The income effect says that taxes make me poorer. When people are poorer they “need” to work more to pay for the things they want. Therefore, taxes should make me work harder.
The question is, which one of these effects is more powerful?
In the absence of very strong evidence to the contrary we should believe that the income effect is slightly more powerful.
Why?
A few different reasons.
First, introspection. What would you do if your pay got cut? Would it make sense to say, well I got a pay cut so I might as well not put in as many hours? Or would it make sense to say, well I got a pay cut so I am going to have to put in more hours or find a second job?
You could probably think of scenarios in which both make sense, but the latter seems more natural for most people. This should push our estimate towards the income effect being stronger
Second, wage rates have gone up dramatically over the last 200 years. Does it seem like people are working more or working less than they did 200 years ago. It really seems like they are working less. There are lots of confounding factors of course, but the overwhelming sense is that when people made less money they “had” to work harder.
Third, high income people don’t seem to be working that much more than low income people despite the fact that a natural propensity towards work can make one high income.
Indeed, the data show us that low income folks used to work a little more, but now they work a little less than high income folks. Yet, if the income and substitution effects were balanced for each person we would still expect higher income people to work more.
That’s because working hard can lead to more education, more experience and more promotions. Being hard working is also associated with having a conscientious personality type which is itself more valuable.
So if someone was simply born with a stronger propensity to work, we would expect that person to earn more income per hour. Thus we when look at the data we should see that all these high income people are working lots of hours.
Yet, we actually don’t see that. We see only a mild effect and even then that effect is not robust over time. Sometimes, high income folks are working less.
Fourth, household leisure is one of the most common rewards from work. When people think about the return to working hard, many of them mention material consumption. However, very often they mention, leisure enjoyed by themselves or other members of their family. In particular, people mention leisure enjoyed by their children.
Here is a quote from John Adams that gets at what I am talking about
I must study politics and war that my sons may have liberty to study mathematics and philosophy. My sons ought to study mathematics and philosophy, geography, natural history, naval architecture, navigation, commerce, and agriculture, in order to give their children a right to study painting, poetry, music, architecture, statuary, tapestry, and porcelain.
Adams is saying that the goal of his labors is to free up the labor enjoyed by his descendants. Even in advocating lower tax rates Greg Mankiw displays similar sentiments.
I don’t want to move to a bigger house or buy that Ferrari, but I hope to put some money aside for my three children. They will never lead lives of leisure, but I hope they won’t have to struggle to find down payments to buy their own homes or to send their kids to college.
In short, he saying that he hopes his work will be paid off by decreasing the amount of work his children have to do.
We might find this a noble goal and we may decide that we don’t want to stand in the way of the Mankiw family’s pursuit of happiness. These are important questions.
However, to the narrow question of “will taxes cause people to work less” we have to note that even if taxes do cause parents to work less – which is questionable in itself – they may do so by causing children to work more.
Now there might be all sorts of reasons why you might feel lower taxes are better than higher taxes. Not least among these might be that you feel the government is inefficient at providing services.
I just don’t think the idea that taxes will cause people to work less is among them.
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Wednesday ~ May 18th, 2011 at 3:28 pm
Ryan P
Note, though, that even if you believe that as a whole, income effects balance substitution effects, this doesn’t mean marginal tax rates don’t diminish work, effort, or human capital formation (especially in the long run) — raising my bracket but not any of the lower brackets has a substitution effect but very little income effect.
The real argument lying behind the claim that taxes decrease work incentives is that there is deadweight loss — this claim doesn’t depend on substitution being greater than income, but on substitution being greater than zero. That’s clearly the case.
Wednesday ~ May 18th, 2011 at 3:39 pm
Th
You just expressed half of the argument I make when people say raising taxes will reduce incentive to work. The other half is that, even if true, it is a good thing. If demand is close to constant, one person working less offers another person an opportunity they may not now have.
Many years experience in construction supply proved this many times over. If an electrical or plumbing contractor thought it was too much trouble to expand to meet demand, an existing competitor stepped up or a new competitor entered the market. Reagan used to say that the 90% marginal tax rate meant that actors would only do a couple of movies a year and then take the rest of the year off. When was the golden age of movies, again?
Wednesday ~ May 18th, 2011 at 3:42 pm
Ryan P
Yes, less output is good. Output is fixed. Deadweight loss is impossible. Labor is a lump. Demand has zero elasticity.
Wednesday ~ May 18th, 2011 at 6:44 pm
Th
It is not less output, you twit. The output shifts to another source. Can you not read?
Wednesday ~ May 18th, 2011 at 6:51 pm
Ryan P
Hey, I also said output is fixed. But you’re right, clearly the logical loops fried my brain.
So we’re agreed on the rest though, right?
Friday ~ May 27th, 2011 at 8:35 am
Barry
“Reagan used to say that the 90% marginal tax rate meant that actors would only do a couple of movies a year and then take the rest of the year off. When was the golden age of movies, again?”
IIRC, he stated that actors would make four movies a year, and then take the rest of the year off. And that if taxes were lower, he wouldn’t be testifying before Congress, but rather off making movies.
Reagan’s movie output in those years looked more like random D6 rolls than output capped by a tax boundary, and after taxes were lowered, he was right back in front of Congress, rather than off making taxes.
Friday ~ July 1st, 2011 at 6:53 pm
Dismayed
We were *all* better of when Reagan made fewer movies.
Wednesday ~ May 18th, 2011 at 3:47 pm
Gimlet
I’ve always thought the bigger effect was on risk-taking behavior in higher-income business owners (particularly those who don’t do the S-corp/dividend thing for their own compensation). So, I guess more of an effect on overall economic growth and job creation than on hours worked.
Thursday ~ May 19th, 2011 at 9:20 am
Nick Bradley
I think the effect is bigger for those who have control over how much effort they put into earning. For a sales manager or business development guy, high marginal tax rates discourage exerting that marginal effort.
Wednesday ~ May 18th, 2011 at 3:52 pm
Ben Ray
Well said and I agree with your logic. I am more on the side that most work is more efficient if done by the private sector, so minimized size in many government sectors is just good management of resources. To your point though about taxes de-incentivizing individuals, does your logic work the same for increased taxes on large & small businesses &/or capital gains. Also, how do tax increases in those areas effect the goal of stimulating the economy and growth of the American economy and overall wealth of its people? I’d like to walk thru that analysis.
Thursday ~ May 19th, 2011 at 9:39 am
Nick Bradley
I think that one of the reasons the private sector is more efficient is due to cost controls. competition exerts pressure on firms to minimizer costs — and the best way to do that is usually through becoming more efficient.
In the public sector, cost constraints are not usually encountered. However, it can be. Cuts to the Defense programs cause the program offices to find ways to be more efficient. So, if you implemented a long-term spending freeze in the Federal Government, whether real, nominal, or somewhere in-between, government programs would be forced to become more efficient over time. For example,
If you capped annual spending growth at inflation, federal spending would be back do 20% of GDP in 9 years. If you knew that your real budget wouldn’t increase for the next 9 years, you could find ways to become more efficient.
Wednesday ~ May 18th, 2011 at 3:52 pm
Matt E.
This lumps in low-income workers with high-income workers, I believe erroneously. Intuitively, it seems that lower income workers would be more likely to make decisions around the income effect, and that higher income workers would be more likely to make decisions around the substitution effect.
This seems inline with consumption behaviors as well. Low-income people trade time for money while high-income earners do the opposite. The wealthy don’t spend time bargain hunting, pay people to clean their house/mow their lawn/shovel their driveway, etc. Low-income people are the ones doing the cleaning/mowing/shoveling, and they’re also more apt to bargain-hunt.
Proponents of more taxation might likely reply “so what? If they’re wealthy, they don’t need to work more.” The problem is that most of the high and very high income workers are the workers providing the bulk of employment. If they’re working less, they’re putting in less effort to grow the economy. Even when they just sock their earnings away in a bank, it still helps grow the economy. That money (minus reserve requirements) can be lent out to people looking for a loan, whether it be for personal consumption, to start a business, or to order more inventory.
Both the substitution effect and the income effect seem logically likely to me, but simply for different income brackets.
Wednesday ~ May 18th, 2011 at 6:15 pm
Lord
Who is to say taxes reduce output? Taxes are spent too. Who is to say the rich will choose to invest that money and employ those people? They may have the money but not the desire. Who is to say their working less will grow the economy less? They may be occupied with seeing their children don’t have to work leading it to grow less. Micro arguments never address macro concerns.
Wednesday ~ May 18th, 2011 at 7:11 pm
rjsigmund
you really cant generalize…everyone has different motivations…
Wednesday ~ May 18th, 2011 at 7:31 pm
e
“Third, high income people don’t seem to be working that much more than low income people despite the fact that a natural propensity towards work can make one high income.”
I don’t think this is right. If you think the income effect dominates for future wages, then the effect should be dramatically stronger for total wealth since, wealthy people have probably had more of their prime earning years, high incomes are more variable so people who got lucky are wealthier and can’t expect the same returns going forward, and frankly the wealth effect is determined by variation in actual wealth and not income. So if you were right I would expect significant reduction in the hours worked of the wealthy but you see the opposite. You are right though about the correlation of work habits and income.
I think that Scott Sumner mentioned that when French marginal tax rates were at US levels, they worked the same amount as Americans, and now with much higher rates they work much less. That seems like a better piece of evidence than yours to me.
Wednesday ~ May 18th, 2011 at 8:29 pm
Matt
Ryan P got it right by focusing on the difference between an across the board tax change and a marginal tax change.
If taxes are increased across the board then for all workers to maintain their income they will have to “work” more. For hourly workers, this means more hours (overall impact is less leisure for hourly workers and more tax revenue). For salary workers, this means seeking out higher incomes through higher “productivity” or acquiring more skills/education (one could argue this has a clear benefit for society as these are the “idea” workers that produce breakthroughs). At this higher end I would expect a weak substitution effect, but likely the income effect is the obvious winner as Karl suggests. Still, across the board tax increases are essentially off the table in Washington so this may all be moot.
Marginal tax increases, on the otherhand, will not effect those at the lower end and furthermore, the effect will be different for those “at the margin”, or those who face higher taxes beyond a certain (within reach) income level. Raising the taxes on marginal income but maintaining taxes on base income make one less likely to pursure the marginal income. The substitution effect is a lot stronger, while the income effect is only relevant for those fairly well beyond the income cut (say 250K). Would we see Warren Buffet work less because his taxes are raised 5% on average? Probably not, but we wouldn’t see him work more either.
Wednesday ~ May 18th, 2011 at 9:52 pm
Scott Sumner
Rule number one of tax analysis–at the aggregate level there is no income effect, only a substitution effect!!!
I must have seen this argument 100 times, and it’s always based on the fallacy of composition. Higher taxes don’t directly reduce aggregate income (they redistribute income), so aggregate hours worked are only affected by the substitution effect.
Yes, it’s possible that taxes have an indirect income effect. Perhaps they indirectly cause real GDP to fall, and impoverish a country. (Perhaps by reducing capital accumulation, or wasting money on bridges to nowhere.) In that case people might want to work harder. But that’s hardly an argument for higher taxes. If we assume that taxes have no effect on real GDP at current employment levels, then they should reduce hours worked through the substitution effect. That’s why people work shorter hours in high-tax Europe, and longer hours in low-tax Singapore and HK.
(Note, in theory you could have a tax system that didn’t redistribute wealth at all—in which case there’d be no substitution effect either.)
Thursday ~ May 19th, 2011 at 1:54 am
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Thursday ~ May 19th, 2011 at 3:32 am
teageegeepea
I had always heard that high income folks work a lot more hours, low income folks work less and often don’t have full time jobs at all.
Duncan Kennedy made a similar income effect argument against private property that I found interesting.
Scott Sumner previously reconciled Prescott’s macro findings with contrary micro findings here.
Thursday ~ May 19th, 2011 at 3:27 pm
Lord
These are not the only effects either. Consider if Mankiw retired and another professor took his place, and an associate professor took his, an assistant took his, a post-doc took his, a grad student took his, .. a fry cook took his, and a teenager took his. Each would have something to learn and would bring with them a set of experiences and insights. If each innovated, some small and some large, the economy could grow as a result by more than Mankiw not working, so it is not just a substitution effect at play. Whether Mankiw has more or less incentive to innovate is not necessarily the relevant criteria. If higher rates induce him to save and invest more to defer taxes until later when retired, it may promote more innovation. If they persuade him to retire, his replacement may be so persuaded. A priori there is no way to know.
Friday ~ May 20th, 2011 at 10:37 pm
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