Desirable Incentive Effects of Income Taxation III
This is the third post in a series. I will discuss advantages of income taxation different from the obvious advantage that taking from people with high income hurts them less than taking from people with low income. Here again, I will assume that, in equilibrium, income tax is returned to the people who pay it as a lump sum. I do this to focus on the incentive effects of income taxation.
The first two posts are here and here.
In standard models, these effects are undesirable and amount to a deadweight loss which is second order in the tax rate. However, the standard models rely on standard assumptions which are completely implausible. They are used, because it is guessed that the policy implications don’t depend on the absurd assumptions. The policy implications always, in fact, follow from the assumptions.
In this post, for the third and last time, I will relax the assumption that people are 100% purely selfish and care only about their own consumption and leisure. Instead I will assume that people maximize the sum of their pleasure from consumption and leisure plus a constant far less than one times other people’s pleasure from consumption and leisure.
In this post, I will assume that all people have the same wealth and ability so all have the same income. This rules out egalitarian benefits from income taxation and the interaction of partial altruism and inequality which was the focus of the first two posts.
In the first two posts I assumed that there is perfect competition and that all people are self employed, that they produce goods with labor alone . I noted that both of those extreme assumptions rules out beneficial incentive effects of income taxation. In this post, I will back up that claim. This is fairly obvious so the post will be brief.
First it is clear that the combination of imperfect competition and partial altruism implies beneficial incentive effects of income taxation.
A profit seeking monopolist will charge a markup on marginal cost implying demand sales and production below the level that maximizes the sum of consumer and producer surplus. A perfectly altruistic monopolist will charge marginal cost maximizing the sum of consumer and producer surplus (which is equivalent to maximizing total welfare from consumption and leisure given the assumption of a perfect equality and therefore a representative agent). A partially altruistic monopolist will chose a price between marginal cost and the profit maximizing price.
An income tax whose revenues are rebated lump sum reduces the advantage of pre-tax profits, but does not reduce the contribution of the monopolist’s production to consumer plus producer surplus. So the income tax will cause lower optimal markups and bring the equilibrium towards the perfect competition equilibrium.
I don’t see any reason to restate this argument with equations and algebra. Imperfect competition creates a difference between maximizing profit and maximizing the contribution to social welfare. Iif people care (even a little) about their contribution to social welfare, reducing incentives to maximize profit increases the relative weight they put on social welfare. This is a first order benefit of income taxation.
Similarly, employer-employee interactions can create beneficial effects of income taxation if the employers are partially altruistic. If the employer is a monopsonist, the logic is identical to the logic above.
More generally, if there is involuntary unemployment for any reason, a partially altruistic employer will hire people partly to gain their marginal product and partly to help them. Altruism will cause higher employment. As always, weakening the profit motive means that the un-weakened altruistic motive will have a larger effect.
In particular, there are a large number of plausible efficiency wage models in which firms do not pay the lowest wage they can pay and still hire workers to fill vacancies. In these models there is a profit maximizing wage and deviations from that wage have second order effects on profits. In these models even a very weak altruistic motive can have a large effect on wages. As always, income taxation weakens the standard economic motives but does not weaken altruistic motives. Other things equal it causes employers to pay higher wages. This increase in wages does not lower demand for labor, because it is voluntary – employers prefer to pay higher wages so the higher wages do not discourage them from hiring.
I consider the assumption of partial altruism to be obviously more realistic than the assumption of perfect selfishness. However, I want to address other issues. So, from now on, I will assume that people are selfish.
Before moving on, I should mention one efficiency wage argument which sounds very much like the assumption of partial altruism, but which is quite different. One model of efficiency wages, which has extremely strong support both from hard data and from interviews with employers, is the morale model. The argument is that in employment relationships there is a partial gift exchange – employers pay more than the minimum they have to pay to fill vacancies and workers work harder than the minimum to avoid being fired. Importantly, the workers are assumed to care about whether they are fairly treated and this is separate from their desire for consumption and leisure. Also, obviously, it is not altruism.
Similarly, it is plausible that employers just don’t want workers to feel unfairly treated and to be angry with them. This is a motive different from the concern that angry workers will not work as hard or as well. Especially in a small firm, the proprietor just doesn’t want to work around people who are angry with him or her. The fear of others’ anger and the desire for their gratitude is not true altruism. However, it works just as well and implies the same beneficial effects of income taxation.
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it ought to be obvious that taxes reduce profits.
so do wages.
and gravity and fricition and the second law of thermodynamics.
but only taxes are called dead weight losses, as if the country at large does nothing to increase profits…or make profits possible at all.
this is not a matter of paying for welfare “for” the unfortunate, but using “welfare” as the simplest means of preserving the strength of the country as a whole. or having (forcing) the fortunate to insure themselves against the day when they become unfortunate…so, perhaps, they survive until they become fortunate again, or are needed to fight in the country’s wars.
[“excess” wages are also, if not called deadweight losses by “economists,” are treated as such, or talked about as such, by “business” people.]
it is well that Waldmann and others try to put this on a formal basis, but really, it is better to put it plainly so ordinary people can understand it and not be cowed by the opinions of “experts.”
question for those ho know more than i do. if wages are set at the marginal value added by the last hired worker…that means that ALL workers are paid the wage “earned” by the least productive (in the sense of money added to the company by that worker).
is this correct? does it mean something in terms of “a fair wage”?
High marginal tax rates on personal income have all sorts of incentive effects. If you have a 2/3 marginal tax, it costs you a premium to extract money from a corporation. Adding $1M to your salary means adding $3M to the corporate budget.
In competition between executive wages versus worker wages, it turns out that raising workers’ wages doesn’t cost executives all that much. You can give a worker an added $1K take home pay for much less than it would cost to give an executive that same increase. Alternately, an executive would see a $1K payroll increase as costing him much less assuming salaries came from the same pool.
This all sounds strange, but if you followed business and accounting back during the high tax, high growth era, you’d be familiar with this kind of reasoning both in the business press, business books and in movie comedy.
it hurts my head to think about it. what i do know is that right wingers and the press in general talk about high marginal tax as if it was applied to the whole tax. so if a 70% marginal taxis imposed on incomes over one million dollars, people think the poor rich guy has been taxed seven hundred thousand dollars, when in fact if his income is one million and one dollars, he will only have been taxed an extra seventy cents.
besides, they have magic ways to reduce their “taxable” income.
i was very glad to read recently in an old book that the New Dealers got through these things by ignoring the experts and just doing what they thought would work…. trying something else if it didn’t.
Doesn’t mean i have any objection to honest people trying to make expert sense of it all.
Yes in standard models all workers are paid what the least productive last marginal worker produces. That’s what leaves some revenue to pay a return on capital (it can be literally rent if the firm rents a building as many do). It also can be pure profit – money left after paying wages, for materials, and a normal return on fixed capital.
@Kaleberg you are ahead of me. You anticipate posts IV (asymmetric information) and V collective bargaining, MacDonald and Solow).
The fact is very very clear — CEO compensation was not absurdly high back when the top marginal tax rate was 91% and not even when it was 70%. The argument works in fact. Does it work in theory.
I can’t comment on your Effects II post, but I looked it up and the opposite of anonymous is onymous. Spell check does no recognize it, but Webster’s does.