Do Higher Taxes Make Us Work Less?

621 Dec 24, 2014 9:00 AM EST

In 2010, Harvard economist N. Gregory Mankiw wrote a column in the New York Times warning that if taxes go up, he and people like him will work less:

Here's the bottom line: Without any taxes, accepting [an extra work] assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

Now, Mankiw’s numbers include a little bit of dodgy math, because if there were no taxes, his pretax wage rate would be lower. But the basic point -- that taxes reduce the incentive to work -- is true.

Mankiw has earned a reputation as the world’s Econ 101 teacher, since he writes the country’s most-popular introductory economics textbook. Like most Econ 101 insights, the fact that taxes discourage work comes from pure logic. Taxes raise the price that buyers have to pay and lower the price that sellers get for a product. No wonder taxes make buyers want to buy less and sellers want to sell less.

But as with any economic effect, the important question is: “How much?” Unfortunately, that question tends to get relegated to the background when we have this kind of Econ 101 discussion.

There are reasons to think that taxes, unless they reach very high levels, don’t have a big effect on how much people work.

First, most jobs, even part-time jobs, require a minimum number of hours per week. Few people are likely to quit working entirely because of taxes.

Second, when you tax people, they are poorer, and they need to work more to maintain their standard of living. University of Michigan economists Matthew Shapiro and Miles Kimball find that this almost entirely cancels out the disincentive, leaving total labor supply about the same. Of course, that’s bad, because people enjoy leisure. But the flip side of it is that if people do actually reduce their work to avoid taxes, they enjoy their time off.

When you look out at the world, you see lots of circumstantial evidence that taxes don’t have a crushing effect on the labor supply.

For example, in a recent blog post at the NYT’s Upshot, Neil Irwin reports that countries with higher taxes and more generous welfare systems also tend to have a higher share of the population in the labor force:

Why bother being industrious, after all, if you can get a check from the government for sitting around.

Here’s the rub, though: The idea may be backward.

Some of the highest employment rates in the advanced world are in places with the highest taxes and most generous welfare systems, namely Scandinavian countries. The United States and many other nations with relatively low taxes and a smaller social safety net actually have substantially lower rates of employment.

Also, if you look at the U. S.'s past, you see that although taxes have come down over time, people are not working more than they used to.

Although these facts don’t prove that the effect of taxes is small, they turn out to be consistent with the microeconomic evidence. When microeconomists try to estimate the degree to which taxes make people stop working -- this is called the “Frisch elasticity of labor supply,” since economists love making up long, technical-sounding names for things -- they find that it just isn’t that large.

So taxes at the levels now seen in Western countries don’t seem to be doing a lot to discourage people from working. Of course, at some level of taxation, this would change -- if you raised tax rates to 100 percent, people wouldn’t work at all in the formal sector. But at the tax rates we now face, the difference created by a 3 percentage point change in the top marginal tax rate probably isn't going to cause very many high-income people to drop out of the workforce.

So why do economists such as Mankiw spend so much time warning about the dangers of moderate tax increases on the well-off? It might be because they are morally opposed. Mankiw has written essays arguing that taxing high-income people at higher rates isn't fair. But we shouldn’t let moral concerns cloud our judgment of the facts.


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Category: Taxes

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