Sorry for the many posts but things keep occurring to me that need to be made explicit to make sense out of taxation.
When you do basic economics you use what are called Marshallian demand curves. These represent the real world relationship between the price of an item and how many will be sold.
When economists think about the choice to work, they think that it is basically the inverse of the choice to buy leisure. Imagine that the baseline is you will work as much as your body can withstand. This isn’t actually that far off from the way some humans have lived.
Now imagine that as you get richer you choose to buy something and one of things you “buy” is not working. The reason you buy not working is because every hour you don’t work you lose some amount of money that you could have earned.
So there are two types of things you can buy regular consumption and leisure. Leisure is our term for “not working.”
Given this labor supply, is just the mirror of leisure demand. If people buy more leisure they are buying more “not working” and so they are selling less labor. If people buy less leisure they are thus selling more labor.
Now, Marshallian demands can be “decomposed” into income effects and substitution effects. When the price of something goes down you buy more of it for two reasons. First, because it is cheaper relative to other things. That’s substitution effect. Second, because you are now effectively richer, thats the income effect.
Usually income and substitution effects go in the same direction and magnify each other.
There are a few cases when they go in opposite directions.
One is inferior goods. We won’t go into that right now.
The second is leisure. That’s because the price of leisure going up is the same thing as your wage going up. That means a higher price of leisure makes you richer not poorer.
This is why labor supply is thus has both income effects and substitution effects.
Okay, but here is the rub.
Economists are also very concerned about efficiency. Many efficiency losses can be represented as deadweight losses. You may have learned about calculating deadweight loss by looking at harbinger triangles between the demand and supply curve.
There are a number of problems with this analysis. But, we will focus on one. Marshallian demand curves trace out not only changes in what you choose to do, but changes in your opportunities.
Strictly speaking inefficiency is when you choose to do something that is worse than something else you could have chosen to do. However, if what’s happening to you is that you just don’t have as many opportunities in life and are adjusting to that fact, then that’s not inefficient. That’s just sucky.
To adjust for that economists created what are called Hicksian demand curves. Hicksian demand curves pretend that you are in a world where your possibilities for happiness stay the same, but the prices of things move. The way it works is that if prices move in a way you don’t like you are given enough money to make up for that fact.
Because labor supply is the inverse of leisure demand we can imagine a Hicksian labor supply curve.
If we want to measure the “true deadweightloss” then we have to use Hicksian labor supply. However, because Hicksian labor supply compensates you for any income effects then you are just measuring the substitution effect.
Okay – all of that out of the way.
When we think about policy what policy makers are concerned with is Marshallian labor supply and that makes perfect sense. Its not a misunderstanding of welfare economics.
Suppose that an increase in tax rates had no change in Marshallian labor supply. So the labor market looked basically the same before and after the tax increase. The difference is now the government is using more of your money to pay down debt.
We might even see economic growth pick up depending on where we are in the business cycle.
Yet, if we measured the true deadweight loss using Hicksian demand we would see that it is still there. Its just that the loss is coming all out of lost leisure rather than lost consumption.
The reason that policy makers don’t need to think about this as an “economic effect” is because that deadweight loss is captured by the taxpayer’s desire not to pay taxes.
For example, someone with a mortgage and kids might have a huge income effect that causes them to actually work more. They will express this. “I’ll have to work nights to pay for this tax increase”, they will say. “It will be horrible. I’ll never see my kids.”
They are describing welfare loss of forgone leisure in words and stories. These stories are not lost on policy makers. Thus policy makers do not need economists to remind or correct them about those type of effects.
Most people “get” the welfare loss of taxes when they see immediately that it would be insane to tax your neighbor in order to send you a check and then tax you the same amount in order to send your neighbor the same sized check.
To make sense taxes must buy something special, like aircraft carriers, schools, roads, or checks for people who pull our heart strings like the poor, elderly, sick and disabled.
This implicitly acknowledges a welfare loss to taxation. If there was no welfare loss then it would be neither here nor there whether we taxed you to give to your neighbor and taxed your neighbor to give to you. People would say, sure as long as I end up with the same amount in the end, what do I care. Yet, no one says that.