Corner Solutions and Backwards-Bending Labor Supply Curves

If taxing an activity makes people do less of something, why might replacing the income tax with a consumption tax not lead to a large increase in industriousness? The first two factors, related to corner solutions, will mostly apply to wage workers. The third applies to upper income workers.

Reason 1: Corner Solutions: For firms that pay on an hourly basis, there is a natural tendency not to exceed 40 hours. Each week, many employees ask to work overtime and are denied. Certainly, if their take home pay were to increase as a result of an income tax cut, they might ask more often, or more workers might ask for overtime, but that does not mean that employers would grant that overtime. It’s cheaper for firms to use more workers at the base wage than it is to use fewer workers and pay time and a half. (Now, if we could combine an extension in the base work week with a shift to consumption taxes, then we might be on to something! Ari? Karl?).

Another Corner Solution: Many workers pay no income taxes (though they do pay payroll taxes). Reducing the income tax will not affect these employees’ incentives to work.

One caveat to both of these is that, because employers also pay taxes on the labor that they hire, reducing those taxes would in fact increase the incentive to hire more workers (whether this would be sufficient to offset the employment-depressing effects of the distortions described in the previous post is unclear).

Reason 2: The Backward-Bending Labor Supply Curve. Suppose you are currently making an after-tax wage of $60.00 an hour, netting roughly $125,000 per year based on a 40 hour work week. What would you do if you were to get a raise to $80.00 an hour (or elimination of the tax cut raised your take-home wage to $80/hour)? As it turns out, if you study workers’ behavior, different people do different things. For some, they will work harder (think of an hour off work as now costing $80.00 instead of $60.00—people generally do less of something, in this case leisure, when its price increases). But for many, they will actually work less. What explains this contradiction? When people make more money, they consume more of almost everything. “Almost everything” in this case includes leisure. So, paradoxically, the incentive to work can actually fall as the returns to work increase! Another way to think of this is to imagine the increase in your effective wage from $60 to $80 (due, say to eliminating the income tax). At $80 per hour, you could work only 35 hours a week and make $145,000 per year–$20,000 more to buy stuff with and 5 more hours of leisure and family time per week. The punchline of the story is that cutting the income taxes of those who make a lot of money will not necessarily induce those people to work more.

Ignoring this effect when setting the consumption tax rate could also lead to a shortfall in revenue. If revenue targets are premised upon people working the same or more hours and then spending the additional income on consumption (which will then be taxed), then there will be shortfalls due to people spending the additional income on leisure (that is, not working). (Now if we could combine eliminating the income tax with a tax on leisure, this might not be a problem—Ari? Karl?).


P.S. I don’t anticipate every post being as wonky as this one and the previous one.