Work Incentives

High income taxes, then, do not necessarily have important disincentive effects. Some workers, it is true, may work less hard because of the influence of high tax rates. Others, however, may be led to increase their efforts, and a good many people may be virtually unaffected. Additional evidence is needed before any useful conclusions can be drawn. Fortunately, both theory and observation can help provide that evidence.

The Effects of Inflexible Monetary Commitments

Most of us have more than a nodding acquaintance with relatively fixed monetary commitments of one kind or another. Monthly payments on a home mortgage or rental to a landlord, life-insurance premiums, contributions to pension and annuity funds or to prepaid medical plans, union or professional dues, and other fixed costs of earning income, periodic payments incurred when consumer durables are bought on time, the obligation to support and educate children or to care for elderly relatives— all fall in this category. Possession of such commitments tends to make the taxpayer react to an increase in income taxes by increasing his efforts to earn income. The disincentive effect of lower take-home rates of pay is more than offset by the incentive push of a lower level of income when living expenses are not easily contracted.

High income taxes, therefore, are likely to have incentive effects on workers with large families, on young people who are setting up homes and acquiring their stock of consumer durables, and upon all who, for whatever reason, have become heavily indebted to others. A period following a rapid rise in consumer and mortgage debt, when higher taxes may well be called for because of strengthening inflationary pressures, is relatively favorable to the imposition of higher income taxes since their incentive effects will be intensified and their disincentive effects lessened by the previous growth in fixed-debt obligations. For similar reasons, a high and rising birthrate is favorable to high income taxes. On the other hand, Government policies which reduce the pressure of fixed monetary commitments on the worker, such as baby bonuses, provision for old age and retirement, for temporary periods of unemployment, or for sickness and injury tend, by themselves, to strengthen the disincentive effects of income taxation. These adverse tendencies, however, will be offset to the extent that Government benefits of this sort are closely matched by contributions on the part of the beneficiary.

A worker is also effectively committed to the maintenance of a given level of living in the face of an increase in income taxes if that level of living represents the minimum necessary for continued physical existence in his society. On the lowest income groups, therefore, income taxes may be ex

pected to have incentive effects. At higher income levels the purely physical pressure of minimum subsistence is absent, but it may be replaced by equally effective social pressures—well-defined modes and standards of living which the workers feel they must maintain.

Fixed monetary commitments of various kinds, therefore, exist at all income levels. Together they provide an important set of factors which strengthen the incentive effects of high income taxes at the expense of the disincentive effects.

The Effects of Changes in Personal Exemption Allowances

A raising or lowering of personal exemption allowances has a powerful effect upon income-tax revenues because of the large proportion of income taxed at the lowest bracket rates. Such changes are also likely to affect work incentives. Unfortunately we can specify the result definitely only for those who remain in the same tax bracket both before and after personal exemptions are altered. For them the marginal rate of tax, and hence take-home rates of pay on the last units of work done as well as on any additional units that might be done, remains constant, while disposable incomes rise or fall as exemption allowances rise or fall. The sole effect on incentives, therefore, comes from the changes in disposable income, larger exemptions tending to reduce effort and smaller exemptions to increase it.

A large number of taxpayers, however, will be shifted into a different tax bracket when personal exemptions are changed. For them both marginal and average tax rates—i. e., take-home rates of pay and disposable incomes—change, and opposing influences on work incentives are again set in motion. Increased exemptions, for example, stimulate desires for more leisure time as a result of increased disposable incomes, but increased rates of pay at the margin make work more attractive. The strength of the latter effect will differ at different points on the income scale since rate changes from one tax bracket to the next are not uniform. By far the largest change, of course, occurs at the bottom of the tax scale where the rate plummets from 20 percent to zero for the income receiver who moves down out of the first bracket.