Why is it assumed that higher taxation leads to reduced incentives?

Question

This is probably the argument offered against high taxation that I hear the most:

it reduces incentives to work harder, hence ultimately hurts the economy.

What is the justification for this? I'm sure it's true since that's what everybody says, but it doesn't seem clear to me at all.

The only explanation I've been able to find online is that when people are rewarded less for their work, they work with less vigour and less creativity. But why is that necessarily true? If I'm making, say, 1000 dollars a week after taxes and suddenly, due to a shift in the tax rates, I overnight start making 800 dollars a week after taxes ... why would that induce me to work less? Shouldn't I be working the same as before? Because if I don't, I'd be making less than 800 dollars per week? In fact, if I can only meet my budget with 1000 dollars a week, then wouldn't I be induced to work more so that I could make up that deficit of 200 dollars and get back to my desired income level?

In fact, in economic theory, there's the notion of decreasing marginal utility, i.e. that the more we earn, the less we care for it. So if you earn 10.000 dollars, and I give you another 5000 dollars, that'll be massive for you. But if you earn 10 million dollars, and I give you another 5000 dollars, you probably wouldn't even notice it. So by that logic, shouldn't higher tax rates lead to people working harder, since they now earn less than before and therefore value each extra dollar more than they did before?

I'm looking for both statistical or intuitive answers to clear my misconceptions.

EDIT: I should say, I am specifically interested in why higher tax rates reduce incentives to work. Whether or not higher tax rates are ultimately bad for the economy (e.g. through reduced consumption and investment) is not what I'm asking for.

EDIT2: I found another argument, which I also find don't find completely obvious. So the argument goes that if you were asked to work 1 extra hour, you might be more likely to do so if taxes were low. However, I would again make the argument that if taxes are low, you are already making more money than before. So when your boss comes to you and asks if you want to work 1 extra hour, you might say 'yeah, sure, taxes are low so there's good money in it', but might you not also say 'no, thank you, taxes are low so my current income is quite satisfactory and I'd rather go enjoy spending it than work harder'?

Answer 1

There are two opposing effects, which you've described fairly well:

Substitution effect: in which marginal tax rates increase. People tend to work fewer hours because other uses of their time become relatively more attractive.

This is what people usually mean when they say "reduces incentives to work".

Income effect: in which after-tax income drops from what people would have otherwise earned. People tend to work more hours because having less after-tax income requires additional work to maintain the same standard of living.

This is what you've outlined; working harder to make up the difference.

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Which "wins" depends greatly on what end of the wage scale we're talking about. The more money you have, the more you can afford to work less. If you're making enough money that cutting back your work won't hurt you all that much, then yes, the substitution effect is likely going to be stronger. If you're living paycheck to paycheck and need every dollar, the income effect will likely be stronger.

However, work isn't always that straightforward. Many jobs at the lower end of the scale simply don't allow employees to just decide they're going to work more. Overtime is expensive for employers, there may not be demand, and part-time workers in particular can't be bumped up into full-time in some places because then more benefits and such kick in, making the expense not worth it to the company.

On the other hand, medium-high-wage workers are often on a salary contract, and can't do much of anything to shift their hours either, short of renegotiating.

(And yes, both of these types of workers can technically just "get another job" which would do it, but for many people that's simply not as easy as it sounds. For someone with health issues, even a temporary lapse in benefits can hurt you badly financially. For someone looking for a mortgage, banks really love to see that you've worked in one place for a couple years. Etc and so on.)

The place where the substitution effect is felt strongest is at both ends of the scale. People that have large amounts of money from non-traditional jobs (self-employed, inherited wealth, investments, etc) are free to work less or not at all if they can afford it.

Those at the low end may run into a loss of benefits such as SNAP if they make just a bit more, which lowers their effective pay, so it may benefit them not to increase their effort, unless they can increase it enough that they get "over the hump".

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But yes, for those middle-income earners who have the flexibility to work overtime and make up the difference, the income effect is probably stronger. They're not so well off that they can afford to work less, and not so poor that they receive benefits.

Answer 2

Would you work at all if the tax rate is 100%?

It all comes down to opportunity cost. Suppose welfare benefits are 20k a year and you can only claim them by not working. Would you take a 20k/year job at all? Considering you get the same amount of money and the difference is 8 hours of your time every day, the answer for any rational person is no.

Let's suppose you make 40k a year and get taxed 10% of it. So now you have 36k left over and the opportunity cost is 16k a year for 8 hours of your time every day.

Now suppose tax rates double to 20% to increase benefits to 30k. This would be the case if half the people are taxed and the other half is on benefits, and the government spends 50% of its tax revenue on welfare. Now the opportunity cost is 2k a year for 8 hours of your time every day, 8x less than before and most people would say no to that.

Increasing tax rates reduces the opportunity cost by a far greater amount than the tax increase. Also there is the issue of fairness and rich people who can afford to not work can simply refuse to work if they feel that they are being taxed unfairly.

So in your example, before the tax the opportunity cost of working is $25/hr. After the new taxes the opportunity cost of working goes down to $20/hr. There is absolutely no incentive to work more, in fact there is only less incentive to work due to simply making less money. Just think about it, would you work long and hard if you made $15/hr or if you were making $100/hr?

Also decreasing marginal utility only really applies to people who can afford to not work and live comfortably. Many people are in debt/ have no savings and so are indifferent to the next dollar for the most part. It is true that millionaires don't care about $5000 dollars as much as people who make $50k/year, but the vast majority of people working care about $5000 all the same.

Answer 3

Paul Graham (the man behing Y-Combinator, which may be more famours than himself) discussed the foundations of this in his essay on income redistibution.

Most of economic growth and job growth and innovation comes not from random types of sectors and companies. Most of it comes from successful startups.

And people who are disproportionately affected by high marginal taxes are just the very people who would be leading said successful startups.

The dilemma comes from the fact that the startup success is not uniform. Most of them near-fail (or fail completely). Remember this fact, that's important. Then, a very very few, succeed spectacularly, in the process making the founders very rich.

Now, here's the rub. Or, more precisely, a game theoretical setup.

An aspiring entrepreneur at such a startup has two path:

Option 1: Get a well paying regular job. Most of them have qualifications to comfortably get upper middle class careers, earning stable 6 digit salaries at the very least.

Payout 1: nearly 100% guaranteed 6 digit income for a safe and stable career working 40-60 hour weeks, presumably earning comfortable 7 digit wealth and comfortable retirement. Minus the taxes

Option 2: Start a startup, hope it goes big. This road requires enormous investment of effort, nerves, time, 80-150 hour weeks, etc...

Payout 2A: Let's say 99% of outcomes: a couple years spent trying to build an unsuccessful or barely successful startup. Even in best case scenario, if you succeed modestly and sell out, or keep running it, you're in about the same 6 digit income and 7 digit acquired wealth range - either from startup itself, OR, from the post-startup "normal" career. Minus the taxes

Payout 2A: Let's say 1% of outcomes: A successful startup. You become super wealthy from either owning shares and/or selling it for much money - say average $500M. Minus the taxes (there's also a super rare Facebook 0.001% chance of getting to be a billionaire of course, but the math's not affected much).

Now, here's the problem.

• Let's say the top marginal tax rate is 40%.

  A person choosing options 1 end up with 7 digit final wealth, less 40% taxes, still in 7 digits. Expected payout is 3M-5M (100K-250K/year salary, 40% taxes, 40+ years career), 100% of time.

  A person choosing option 2, 99% of time ends up with same 3M-5M expected payout, and 1% of time, with $300M expected payout early in the game after 10-16 years - which may be worth it to someone inclined to entrepreneurship.

• Let's say the top marginal tax rate is 90%.

  Now, Option 1 still has the same 3-5M expected payout.

  But, Option 2's payout is now just $50M - which at 1% success rate is literally an order of magnitude smaller (expected win $0.5M) than Option 1 - but comes at a tremendous cost of effort previously mentioned.

Which means that, basically, at 90% high end tax rate, a person contemplating whether to do a next startup, may very well choose NOT to bother with the sweat, blood, tears and 150 hour weeks, because game theoretically it's just not working out to be worth it.

Please note that this is different (and, for the world economy, far worse), than the usually considered option "rich person moves to a country with lower taxes". Yes, losing Sergey Brins was bad for Russia, but good for USA and for overall world economy, as he simply started Google elsewhere. Losing the next Sergey Brins and Bill Gateses not to another country, but to a comfortable senior tech manager career, means a chance of NOT having the next Google or Microsoft at all.

If you are thinking "this is just a made up model", compare the rate of successful big name startups in France and in USA - or, in USA now vs. 60s/70s.