Reversed Psychology: Tax Cuts and Work
by Bruce Webb
In comments to his last post A Response to Megan McArdle, Again Cactus put the following up as a summary of the Economic Right’s approach to tax cuts:
1. tax cuts mean people are encouraged to work harder
2. people work harder
Another version of this was posted, without apparent irony, on a MY post on the soda tax. How to Think about Public Health Taxes (bolding mine but actually echoed when MY later quoted himself)
Think about the case for taxing income, via the income tax and FICA. Why do it? Well, to get the money. That’s how we finance Social Security, the Department of Defense, Medicare, interest payments on the national debt, Medicaid, federal aid to schools, veterans’ health care and benefits, the FBI, etc. Now what’s the case against taxing people’s income? Well, it’s that it discourages work and it discourages investment. And that’s bad for the economy. Now we go back and forth over whether any given expenditure has a value that outweighs the economic costs. Liberals, like me, tend to think that a relatively high level of expenditure is justified whereas folks on the right tend to disagree.
But that simply shows, and not for the first time that some of our progressive wunderkinden have simply internalized the central tenet of supply side voodoo, the idea that income taxes are a tax on work and capital gains taxes are a tax on investment, and that like proposed taxes on soda or existing taxes on liquor and gasoline the more you tax something the less people are inclined to expose themselves to that tax.
This I think is a profound misunderstanding of the psychology of work and investment. Those who care about why I would think that and those who are just dying to mock the whole idea can follow me below the fold.
Now there are some people who work just for the sake of work itself. In fact a lot of people will spend many hours on work that comes with no monetary compensation at all. We call these people ‘hobbyists’ and ‘unpaid volunteers’. And I suppose if you taxed these people directly on their time there would be some tendency to reduce that time, or at least the time reported to the tax man. But most people do not approach work as some sort of dispensable hobby, instead work is the means to some other desired end whether that end be subsistance, or fame, or fortune with its attendant material objects, or in some cases simple sociality (e.g. some people live to organize office birthday parties). Mostly though people are one way or another working for the paycheck.
But even the paycheck amount is not an end in itself, at least not for everybody, and particularly not for those people who work outside the hyper-competitive world of Wall Street, not every clerk dreams of being office supervisor, not every framer dreams of being site superintendent. some times what you have is good enough.
And when we examine history we can see that in most times and most places this is the norm, sure there are always strivers and always some measure of economic mobility but particularly in largely pre-industrialized societies people tend to end up at some equilibrium. And that equilibrium point is mostly established by a desired level of consumption.
I first came across a formalized version of this in Chayanov’s The Theory of Peasant Economy. I just now ran across a pretty good version of Chayanov’s overall thesis here Russian History Encyclopedia: Peasant Economy
Perhaps the greatest theorist of the peasant economy was a Russian economist named Alexander Chayanov, who lived from 1888 to 1939. Chayanov published a book entitled Peasant Farm Organization, which postulated a theory of peasant economy with application for peasant economies beyond Russia. He argued that the laws of classical economics do not fit the peasant economy; in other words, production in a household was not based upon the profit motive or the ownership of the means of production, but rather by calculations made by households as consumers and workers. In modern terminology, the family satisfied rather than maximized profit.
According to Chayanov, the basic principle for understanding the peasant economy was the balance between the household member as a laborer and as a consumer. Peasant households and their members could either increase the number of hours they worked, or work more intensively, or sometimes both. The calculation made by households whether to work more or not was subjective, based upon an estimate of how much production was needed for survival (consumption) and how much was desired for investment to increase the family’s productive potential. Those estimates were balanced against the unattractiveness of agricultural labor. Households sought to reach an equilibrium between production increases and the disutility of increased labor. In short, households increased their production as long as production gains outweighed the negative aspects of increased labor. This principle of labor production in the peasant economy led Chayanov to argue that the optimal size of the agricultural production unit varied according to the sector of production at a time the official policy of the Communist Party of the Soviet Union was pushing for large collective farms. As a result of this disagreement with Marxist economists and the Party line, Chayanov was arrested in 1930 and executed in 1939.
Chayanov came to his understanding not from a position of armchair theorist but by doing some serious data analysis of the surprisingly (to us) abundant documentation of peasant work life in Czarist Russia. And the result was that he found some very large divergences in work effort over the course of the standard peasant work-life with the peasant couple stepping up their work hours during some periods (for example while children are small and when setting up children with their own holdings) and then dialing it back.
Now even in the Peasant Economy there are strivers who undertake to raise their equilibrium point, your German ‘kleinbauer’ maybe wanting to rise to the status of ‘bauer’ and your ‘bauer’ to ‘grossbauer’, but equally the shift could go the other direction in any given generation, but the whole effort was not particularly driven by the profit motive but instead by the desired outcome.
Which is where supply siders get their psychology reversed. They see the income tax as a tax on work and as such a disincentive to work itself. Just as they see a tax on capital gains as a tax on capital and so a disincentive to invest. The historical reality generally shows the exact opposite, the higher the tax the more you have to work to achieve your desired consumption outcome, and similarly the same is true for investment, more tax means more intensification of investment activity. Now certainly there are limits to how far this process can go, if you tax labor output down to subsistence and sub-subsistence levels you risk your serfs and/or wage employees simply running away, and contrawise if you tax capital at rates up to 98% it is no wonder that the Beatles ran away from England as well. But there is no evidence that current levels of taxation are actually above the sweet spot where taxes mean more work and more capital investment rather than less.
Meaning we need to redraw that Laffer curve to include consumption equilbrium points for various income levels. If a person’s current income is above his own personal equilibrium point he might well react to a tax cut by reducing his hours of work. If instead a tax increase takes him from above equilibrium to below he might react by increasing hours. And the same is true for the investor. If as a group a society’s top 5% or top 1% are living large at current returns and rates, a tax cut might just lead to them commissioning artists or patronizing writers and scholars. Traditionally aristocracies have sought to reduce or eliminate their overall tax burdens, and it was not because they had a burning desire to spend every day working their fingers to the bone. Instead that tax exemption enabled them to maintain or even expand their consumption.
Supply side psychology treats ‘work’ and ‘investment’ as ends subject to direct incentives or disincentives from taxes. But historical reality shows they the are instead means to other ends that include such things as consumption and display. Calculating the impact on any given tax change on any given group requires some deeper understanding of the sociology involved among that group. History is full of instances where people scraped and scrapped behind the scenes simply to maintain appearances at Court or its socio-economic equivalent (think ‘Sunday Go to Meeting Clothes’ among the working classes).
How hard are you willing to work to keep that Bass Boat and the Lake Cabin even as the taxes on them are “killing you”? Are you really going to cut back your overtime in response to a tax increase if it means giving up your Season Ski Pass?