Monday, October 27, 2008

How taxes affect the incentive to work


Greg Mankiw has a terrific post that sums up how the tax proposals of McCain and Obama would affect his incentive to work more on the margin.
If there were no taxes, then $1 earned today would yield my kids $28. That is simply the miracle of compounding.

Under the McCain plan, a dollar earned today yields my kids $4.81. That is, even under the low-tax McCain plan, my incentive to work is cut by 83 percent compared to the situation without taxes.

Under the Obama plan, a dollar earned today yields my kids $1.85. That is, Obama's proposed tax hikes reduce my incentive to work by 62 percent compared to the McCain plan and by 93 percent compared to the no-tax scenario.

10 comments:

TimW said...

Think taxes will reduce the incentive to work? What about the idea of "nationalizing" 401K plans:

http://investmentnews.com/apps/pbcs.dll/article?AID=/20081012/REG/310139971

Scott Grannis said...

The only thing worse would be actually nationalizing 401(k) plans the way the Argentine government now wants to do.

Beware politicians who want to get their hands into your pocket.

Tadeh said...

Correct me if I'm wrong, but this analysis is only looking at one effect and not both effects: substitution and income. I haven't brushed up on my economics for a while, but this argument can go the other way, which follows:

One would work more to make up for the loss of income due to higher taxes.

Your argument was:

One will work less, since more is taken away by taxes.

If I remember correctly, there wasn't a for sure answer as to which effect is stronger.

Scott Grannis said...

Tadeh: Good point to bring up. Those who advocate higher tax rates must assume that people will work at least the same or harder in order to make up for what they lose in taxes. The Laffer Curve helps explain why this isn't necessarily the case. Surely there is some point at which higher taxes discourage work effort. As tax rates approach 100% there is no question but that work effort will be discouraged. I don't think we know what the tipping point is (unless we experiment) but I side with Laffer in believing that raising taxes from current levels will in fact discourage work effort. Especially here in California where top marginal rates could approach 60% under a full-Obama scenario.

I would add that higher tax rates will almost certainly encourage tax avoidance.

All of the studies I have seen show that there is a significant dynamic effect resulting from changes in taxes that is routinely overlooked by politicians: higher tax rates never produce the desired increase in tax revenues, and lower tax rates always result in a smaller decline in revenues than projected.

Tadeh said...
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Tadeh said...

Right, I didn’t' remember the Laffer Curve. I can see this tax avoidance happening with people in the upper middle to higher income bracket.

Let's take a hypothetical example for the sake of looking at someone in the lower income bracket.

Joe makes $2000/month gross and nets $1700 with the hypothetical tax rate.

Joe has rent, car payments, insurance, and misc. expenses that total $1500. Very little is left over, as it is for many low income people, as a higher percentage of income is spent on necessities.

If taxes go up to point where Joe cannot net at least $1500 to pay for his necessities, then Joe must work more than usual to make ends meet.

This may be an exaggerated example, but this may be the point for many lower income people, where increase in taxes (across the board) will make them work more and not less.

Scott Grannis said...

The only thing wrong with your example is that a guy making 2000/mo doesn't pay any income taxes to begin with (after std deduction). Isn't it the case that the bottom 38% of taxpayers pay zero income tax?

Scott Grannis said...

The only thing wrong with your example is that a guy making 2000/mo doesn't pay any income taxes to begin with (after std deduction). Isn't it the case that the bottom 38% of taxpayers pay zero income tax?

Tadeh said...

Scott, you are most probably right. I made those numbers up just to prove my point without any research.

wowgolds987 said...
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