[This post was originally written for my employer’s blog, Show-Me Daily.]
In one of Christine Harbin’s recent posts here at Show-Me Daily, she made the point that having higher sales taxes or excise taxes is a boon for stores just across the state line. A commenter by the name of Dempster Holland cited this to justify using the income tax, rather than sales tax, as a revenue mechanism, because that way the state won’t lose tax revenues from people who cross the border.
I countered with the idea that when analyzing the effect of taxes at the margin, we must consider that, although sales taxes push consumption into other states, income taxes reduce production. It is also true that income taxes will push some production into other states, but for people near the border it’s easier to keep your job and change the state in which you shop. Holland responded to this with a highly unexpected comment: “I [believe] that higher income taxes cause people to work more in order to secure more take-home pay. This would increase production.” He went on to say, in a later comment:
On the income tax question, think through the following thought experiment. You are earning a certain income, with certain tax deductions and therefore a certain take home pay. From that take home pay, you have developed a certain spending pattern. Now your taxes go up. You can either reduce your standard of living, borrow money or earn more income. One thing you would prefer is to earn more income, and that means more work and therefore more productivity in society.
At some point. of course, the extra work won’t be worth it–but I would bet that is when you hit 80 per cent or so. In any event, not many people would work less, even the well off who are basically type A people to begin with
The idea that people will work more when their take-home pay is reduced is obvious at face value, but begs for analysis, because it falls apart on deeper examination.
The work that anyone does — the thinking, lifting, moving, and showing up — are the price that you pay in exchange for something you want: your paycheck. Workers then use their paychecks to get things they want or things they need, always aware of their limited resources: time and money. To suppose that someone will work longer hours when their wage is reduced is analogous to saying that people will buy the same number of potatoes when the price of potatoes rises. It will be true for some, and not true for others. Very important in this analysis is the idea that leisure time has value. When you work, you get value from the wages your receive; when you are not working, your time is your own to spend in a way that allows you to get the most enjoyment out of it that you can.*
If somebody has the option of working 41 hours instead of 40, and they earn $10 per hour, they must consider that extra $10 worth giving up their time to work that 41st hour, rather than going home to do chores, say, or spend time with friends or family. If the employer is willing to pay that amount for that much work, it reflects that the employer is getting at least that much value out of the worker’s efforts, and the worker can thus make the decision to work or not to work. At the margin, things are efficient in this scenario. Workers work until their leisure-time value exceeds their work-time value, and no more.
Now let us introduce an income tax. If suddenly each worker’s take-home pay is reduced by 5 percent, should we assume that everyone will work more to make up the difference? If you have the choice between working an extra half day at work every week, in order to make up the lost money, or reducing consumption instead — for instance, by staying home instead of going out one weekend per month — many people will choose to spend less rather than work more. In fact, the reduction in pay will likely make many people work less than they did before, because the relative value of their free time has increased in comparison to their new, lower net wages.
It would be wonderful from a benevolent planner’s perspective if every income tax increase led to a commensurate increase in productivity, but this is not the case — and, indeed, it would be lamentable if it were. We are fortunate that we live instead in a world where people can work fewer hours for more money as time goes on. The contention that people will work more hours if their pay is cut is, in economic terms, an argument that the supply of labor is inelastic — that is, that a decrease in the price for labor will result in very little decrease in the quantity of labor supplied. Different types of labor have different elasticities, and different people at different times have different levels of willingness to sell their labor at different prices.
One last point: Holland brought up the idea of taxing wages instead of sales in response to the idea, often repeated by our scholars, that Missouri would experience faster economic growth if it were to replace its state income tax with a broad-based, revenue-neutral sales tax. For the reasons I have just said, income taxes are problematic, but there’s one other reason that Missouri should prefer sales as a source of revenue: volatility. Any responsible state budget must account for the volatility of revenue streams. If your revenue in a given year is half of what it was in the previous year, budgeting becomes very difficult. The relative stability of sales taxes, compared to income taxes, is one of the best reasons to prefer them for state revenue.
* A slightly more technical point about the value of leisure time: Everybody can spend their time in two broad ways — working or taking leisure. We assume that people derive some utility from their leisure and some utility from the money that they receive for working. If their pay is cut, the relative value of their leisure hours goes up, subject to diminishing returns. Therefore, for many people, we can expect that they will work less when their pay is reduced.