Do Income Taxes Mean Less Work?

February 21, 2014

Income taxes reduce the overall labor supply, says Matt Mitchell of the Mercatus Center.

Thirty years ago, a report from James Gwartney and Richard Stroup in the American Economic Review concluded that income taxes lead to a reduction in the labor supply. Recently, the Congressional Budget Office's (CBO) report on the Affordable Care Act and its impact on labor force participation confirmed that conclusion.

There are two ways to look at the income tax:

  • One is that the income tax encourages people to work more, because the tax reduces their income. Therefore, workers are driven to make more money in order to meet their pre-tax standard of living. This is called the income effect.
  • The other way to look at the tax is that it discourages work, because it makes non-work a less expensive alternative. This is called the substitution effect. Time off becomes much more attractive because it costs less to forgo income.

Which of these incentives ultimately controls?

While the two work against one another, the substitution effect wins out once government spending is introduced into the mix. The government does not just tax a person's income, but it then uses that revenue to subsidize others. Transferring those funds offsets the income effect (because individuals feel that they can afford to work less), leaving the substitution effect in place.

Understanding these principles, the CBO's report that the Affordable Care Act reduces work incentives should not have come as a surprise.

Source: Matt Mitchell, "Does an Income Tax Make People Work Less?" Mercatus Center, February 13, 2014.

 

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