The Effects of Taxation on Labor Income

Steven Davis and Magnus Henrekson look at “rich” countries and their different tax rates to assess the impact of taxes on things like work effort, household production, and the shadow economy. The results are pretty much what one would expect,

The authors stress that taxes affect work activity directly through labor supply-and-demand channels and indirectly through government spending responses to available tax revenues. They find that higher tax rates on labor income and consumption expenditures lead to less work time in the legal market sector, more time working in the household sector, a larger underground economy, and smaller shares of national output and employment in industries that rely heavily on low-wage, low-skill labor inputs.

The estimated tax effects are large for the authors’ preferred tax measures. Cross-country comparisons in the mid-1990s indicate that a tax hike of 12.8 percentage points (one standard deviation) leads to 122 fewer hours of market work per adult per year and a 4.9 percentage point drop in the employment-to-population ratio. It also increases the size of the shadow economy by 3.8 percent of official GDP, and it reduces by 10 to 30 percent the share of national output and employment in “Retail Trade and Repairs,” in “Eating, Drinking, and Lodging,” and in a broader category that includes “Wholesale Trade and Motor Trade and Repair.” The evidence suggests that tax rate differences among rich countries are a major reason for large international differences in market work time and in the industry mix of market activity.

In other words, taking part of people’s wages means they’ll work less for pay. Shocking I know, but given the way some liberals veiw taxes this kind of research is necessary. This is another reason why always raising taxes to deal with the Social Security problem isn’t always going to be the answer. Eventually you’ll start to get less money even though the rates are going up. A tax on wages basically lowers the wage for the worker. The worker really doesn’t care what is pre-tax wage rate is, but is instead concerned about the after-tax wage rate. A worker could have a pre-tax wage of $1,000, but if after taxes it is only $3.50 you might find that the only people applying for the job are pimply faced teenagers looking for some weekend fun money.

This part of the article is also interesting,

Second, countries with high tax rates on labor income and consumption expenditures have relatively generous tax-funded programs for social security, disability insurance, sick leave assistance, unemployment insurance, and general assistance. The benefit sides of these programs also alter labor supply incentives in ways that discourage market work activity and increase employment in the underground economy.

Which makes sense. If a person is working at a given job because of the benefits, then providing those benefits via the government and taxes that person might quit his job. Now maybe this is a good thing, or maybe not. But it is something that is not at all considered when there is campaign talk of nationalized/subsidized health care.

FILED UNDER: Economics and Business
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Dave Schuler says:

    We already have a subsidized health care system. We subsidize health care providers in the form of licensing, patents, and restrictions on prescription drugs. We subsidize health care consumers in the form of Medicare, Medicaid, the VA health care system (larger than British Public Health), deductibility of health insurance from income taxes, and government contributions to government employee health plans. So which side of the equation do you want to eliminate and how do you plan to do it? And why would your choice (or the status quo) be better than a fully nationalized system?

  2. Tig says:

    I am the worst economist in the world, and yet, when people say I ought to be makin’ a lot more money, I often say, “Yeah. so I can pay more in taxes?” I figgered out a long time ago that workin’ to pay more taxes was a stupid thing to do. It has taken me quite a few more years to discover that workin’ to pay overhead ain’t a real smart move either.

  3. Steve says:

    Dave,

    A fully nationalized system will basically be trying to treat a private good as a public good. Demand will sky-rocket and costs will spiral out of control…until the government clamps down on it and rations health care resources and perhaps even starts doing things like euthanasia and other less savory things (sterilization to certain couples who want large families as with China).

    Arnold Kling has some good ideas on this topic. If I get some time I’ll see if I can find them and post them.

  4. ken says:

    I am the worst economist in the world, and yet, when people say I ought to be makin’ a lot more money, I often say, “Yeah. so I can pay more in taxes?” I figgered out a long time ago that workin’ to pay more taxes was a stupid thing to do. It has taken me quite a few more years to discover that workin’ to pay overhead ain’t a real smart move either.

    It sounds like people who know you think you are not living up to your potential. I have known people who also complain that its taxes, or government regulations, or overhead costs, or something else that keeps them from succeeding. Meanwhile, other people build up market share, serve customers, pay their taxes, absorb the overhead, deal with government regulations and thrive in spite of it. Don’t blame others for your lack of ambition or lack of success.

    The is an example of the insidious menace that conservative philosophy holds for our future. It teaches people that they cannot be expected to work hard and earn good money because the government will just take it away. Funny though how that argument never seems to work with immegrants. Unlike native born Ronald Reagan you never hear of Arnold Schwartzenegger turning down another movie role just because he would have to pay taxes on his income.

  5. Steve says:

    In fairness to Reagan, he might have been working at a time when the top marginal tax rates were very high. Why take on a job for $1,000,000 when you only get to keep $100,000 of it? Schwarzenegger on the other hand, IIRC, got into movies after said top marginal tax rates had fallen dramatically…due to Reagan.

  6. ken says:

    Reagan was a B-movie actor at best. His pay scale would be nowhere near one million dollars. Even so, after a few movies under ones belt, even bad ones, an actor in Hollywood lived quite well in those days. Reagan turned down jobs because he was lazy. He blamed it on taxes but that was clearly false as first rate big name actors like Cagney, Bogart and others were not only making more movies that he was but were getting paid the million dollars (or more) per movie for doing so.

    Conservatives seeking justification for their sloth ought not to blame anyone outside of themselves.

  7. Dave Schuler says:

    Steve:

    I’ve read Kling on the subject. I’m asking a different question. My question is why is a 2/3 subsidized program (what we have now) better than a 100% subsidized program?

  8. Steve says:

    At least right now there are some market incentives at work. The are some decisions made on cost, probability of success, etc. With 100% nationalization, those decisions will all be made by bureaucrats (ulitmately).

  9. ken says:

    Market incentives? Decisions made on the basis of cost?

    When you want to take a date to a movie and dinner but can only afford one or the other, that is where market incentives come in. You make a choice based on cost.

    When you need a quadruple heart bypass but cannot afford one you can’t just settle for a double bypass instead. Neither can you substitute a cheaper knee replacement for a kindey transplant.

    Right now medical care is dependent upon the amount of wealth or what kind of insurance a person has. It’s kind of an all or nothing thing. Either you get the kind of medical treatement needed and return to health, or you don’t and die sooner than you should.

    It is my observation that people who favor eliminating the social safety net aspect of our current system have never had to make a medically necessary decision in their lives, let alone one where their choices where limited by a budget inadequate to purchase the required treatment.

  10. Attila Girl says:

    When you need a quadruple heart bypass but cannot afford one you can’t just settle for a double bypass instead. Neither can you substitute a cheaper knee replacement for a kindey transplant.

    But the number of tests you get, and the number of second decisions you seek, can be determined by the funds available.

    Right now medical care is dependent upon the amount of wealth or what kind of insurance a person has.

    As with many other material issues in life.

    It’s kind of an all or nothing thing. Either you get the kind of medical treatement needed and return to health, or you don’t and die sooner than you should.

    And who is it that decides when it is you “should” have died? Lifespans are going up at an astonishing rate due to medical advances. Everyone benefits, even if they aren’t receiving “state of the art” treatment.

    In fact, the fact of a continuum of care is one of the problems many conservatives have with socialized medicine. We hear the stories about Canadians who cannot get procedures we have access to in any kind of timely fashion because their bureaucrats decide it isn’t absolutely necessary, and we shudder. We are told that many come to the U.S. to get procedures done that are perfectly routine here, and we don’t want any part of that.

  11. Steve says:

    Ken,

    Thank you for proving my point. Nationalizing health care would remove almost all considerations of cost…at least until the government slammed the door shut and started rationing things…on the basis of “need” (read costs).

    Right now medical care is dependent upon the amount of wealth or what kind of insurance a person has.

    I shall assume ignorance on your part ken and htat you are not being deliberately misleading. If you need a quadruple bypass and can’t afford it you get…a quadruple bypass. That is how the U.S. health care system works. This is actually one of the problems. If you are young and healthy and have few assets then getting insurance is a suckers game. Hell even if you are unhealthy and have few assets you might be better off not trying to get coverage and just let the State, Feds or whomever pick up the tab.

    It shouldn’t take a great deal of brain power to see that the above drives up health care costs for those who are insured as the hospitals look for a way to recapture that lost revenue. Suddenly that $0.30 aspirin is $30.00.

    It is my observation that people who favor eliminating the social safety net aspect of our current system have never had to make a medically necessary decision in their lives, let alone one where their choices where limited by a budget inadequate to purchase the required treatment.

    The problem is that nobody wants to pay for anything. They want insurance to cover everything. Insurance doesn’t work that way. For insurance to work, the event being covered against has to be somewhat rare. Hence living to 65 is not insurable since a large percentage of the population lives to that age. Further, as you get older you chances of living that long are increasing. Hence as when you are 64 the “premium” would essentially be the same as the costs.

    I know nobody buys insurance to live to 65, but think of it as buying insurance for medical problems. As you get older some medical problems become more and more common. As they become more common the premium gets larger. Hence the idea of having the young people pay for the “insurance” (it really isn’t insurance, but a subsidy for one of the wealthiest demographics). Naturally if you are going to have a large part of your consumption subsidized why should you save.

    If savings acts in part as capital for future productivity (i.e. machinery, plant, and equipment) then a lower saving rate could mean a lower future growht rate. Ironically this is precisely what the Social Security Administration is forecasting.

    And ken, I’d appreciate it if you’d stop demonizing those you don’t agree with. Feel free to do so, but be warned I will start insulting you right back.

  12. ken says:

    “The problem is that nobody wants to pay for anything.”

    This in a nutshell is your argument. It is wrong. California just voted a huge bond issue to fund stem cell research. Californians knew that cost money. Californians regularly vote for school bonds, hospital bonds, and other spending programs to fund desired levels of government service.

    People are willing to pay for what they want and what they need. The problem lies in the difference between an individual persons ability to pay for a quadruple bypass operation (or whatever)and the need for one. Hence the need for insurance or other methods of sharing the costs. Take this to its logical concusion and I think we come up with some kind of government safety net as the ultimate provider of health service. We might as well acknowledge this as true and discuss the best ways for government to handle this task rather than argue over whether the goverment should have this role or not.

    I don’t know what point you thought I was making about national health care. The countries that have socialized medicine are western democracies and the people have been free to replace it with American style health care but have chosen not to. Whatever problems you seem to think are unbearable apparently are no big deal to people who actually enjoy universal health coverage.

  13. Steve says:

    Ken,

    Ever heard of the fallacy of decompostion? Just because a bond measure passes does not mean that everybody supported it. Further, it doesn’t mean that people want to pay the full cost. Bond measures are a classic example. Here is a simply example.

    Population: 100
    Cost of Bond: $240
    Cost per person: $2.4
    People in favor of the Bond: 60
    Cost per supporter: $4

    Clearly the people who are in favor of the bond measure are spreading the costs to those who don’t want it. They are in effect getting a subsidy. This is especially true for things like school bonds and people who don’t have children.

    Further, there are other problems with voting as a mechanism for allocating resources. Your response extremely weak.