Work Incentives

WORK INCENTIVES by George F. Break The point of view that high income-tax rates such as have prevailed in this country since World War II seriously sap the work incentives of the American people and thereby deter economic growth has been presented with great vigor and persistence. Typically the conclusion is treated as self-evident or as so reasonable, given a little thought, as to eliminate the need for direct empirical evidence. One may admire the strategy of this line of attack, but further investigation shows the forces involved in it to be largely illusory.

The first three sections of this paper are concerned with the economic factors which determine the influence on work incentives of the taxation of earned income. It will be seen that there are at least as good reasons for believing that such taxation will have a net incentive effect as there are for believing it will have a disincentive effect. In the next two sections a similar analysis is applied to income taxes on property incomes and to excise and sales taxes. Finally, the findings of a number of recent empirical studies of worker behavior are examined briefly. The results are likely to surprise those who have accepted the disincentive argument as conclusive. High income taxes, it would appear, have as yet not had any serious disincentive effects. It is true that some workers have been led to contract their efforts, but at the same time others have been induced to work both harder and longer. Whatever the merits of fiscal policies aimed at lowering income-tax rates may be, the encouragement of greater productive activity on the part of workers does not appear to be one of them.

Incentive and Disincentive Effects of Income Taxation

To many taxpayers the disincentive proposition given at the beginning of this paper probably appears realistic enough. They may reason that "with tax rates as high as they are now it is not worth my while to do any extra work because the income from it after taxes is inadequate." The implication, of course, is that at lower tax rates the additional work would be undertaken. In reaching this conclusion, however, the taxpayer is likely to be thinking in terms of a given base income to which a larger reward from a given amount of extra work is added when tax rates are lowered. This argument overlooks an important fact—that lower tax rates would increase the taxpayer's base income—and at higher income levels, as empirical studies have shown, people typically want to take more leisure time rather than less. A lowering of income-tax rates, in short, exerts two

opposing influences on work incentives: a stimulating one because aftertax rates of pay are higher, and a discouraging one because for a given amount of work taxpayers have more money. Conversely, an increase in tax rates, by lowering wage rates, tends on the one hand to induce greater effort because taxpayers find themselves with less money to spend, but, on the other, makes added effort less attractive by reducing the reward.

Some workers may react to higher taxes by simply tightening their belts, preferring to economize on consumer goods and services and on saving rather than on leisure time. Others may work more, thereby economizing on leisure as well as on other things. Still others may work less, illustrating the disincentive effects of tax increases. These people, it may be noted, show a marked lack of attachment to the rewards from productive activity, since they are led by a fall in earned income as a result of taxation to cut their incomes still further by reducing their efforts.

Such a reaction is, of course, possible. To elevate possibilities of this sort to the rank of inevitabilities, as some of the more ardent critics of income taxation are prone to do, seems, however, more than a little extreme.

Another way of describing the effects of income taxes on work incentives is in terms of the value to the worker of the disposable income obtainable from the last unit of work he does. "Value" in this case does not refer simply to the number of dollars earned but more fundamentally to the usefulness of those dollars to the worker and his family. When tax rates rise the value received from a unit of effort is reduced since fewer dollars are brought home to the family coffers, but the usefulness of each dollar is increased since the family has fewer total dollars to spend. If, on balance, the value of the income earned by the last unit of effort decreases, the worker will tend to work less as a result of the increased tax rates; if, on the other hand, the value increases he will continue to work as much as before and may well wish to expand his supply of labor. Opposite results occur when tax rates are lowered. Again we note the existence of opposing lines of influence and the indeterminacy of the final outcome at this level of analysis.