Are high tax rates damaging?

In an earlier post, I pointed out that low earners face enormous marginal tax rates. But how damaging is this?

Common sense says tax rates of 80% or more deter people from getting better paid jobs and so are both economically inefficient and unjust, because they trap workers into low pay.

However, a paper by Reamonn Lydon and Ian Walker, just published in Fiscal Studies (this pdf is an earlier version), suggests this is not the case.

They compared the wage growth of people receiving tax credits with that of non-recipients.

Now, if tax credits deter people from taking better-paid jobs, you’d expect people receiving them to have lower wage growth than non-recipients. But this isn’t the case. Lydon and Walker conclude:

At worst, recipients of WFTC have similar wage growth, on average to that of non-recipients.

Of course, this is not a definitive finding. It’s impossible to control for all the countless things that influence wage growth, and so impossible to identify a pure tax credit effect. But what we can say is that the disincentive effect of high withdrawal rates don’t leap out from the data.

Why not? Here are four possibilities:

1. Tax credits subsidize low wage jobs that offer training and hence higher future wage growth. Walker and Lydon found that mothers (but not men) getting tax credits were more likely to take up training than non-recipients.

2. People are motivated by pre-tax income - perhaps because it’s this that proxies for status, which is what people pursue as much as money.

3. People want higher-paid jobs not because they offer more post-tax income, but because they offer more job satisfaction (contrary to Smith’s theory of compensating advantages.)

4. Our behaviour is determined by our early socialization, more than by current incentives. So, if we’re brought up to believe it’s a good thing to try harder, we do so even if it’s not. Assar Lindbeck has suggested that this is one reason why the Swedish economy did so well for many years in the face of high tax rates; it was only when a new generation of workers entered the labour market that performance suffered.

All this raises a question. If effective tax rates of 80-90% or more on lower earners are no big obvious disincentive, what exactly is the argument against a tax rate of, say, 50 or 60% upon higher earners?

Comments

[John East]

"If effective tax rates of 80-90% or more on lower earners are no big obvious disincentive, what exactly is the argument against a tax rate of, say, 50 or 60% upon higher earners?"
Disincentivising or not, one thing that is wrong with a 50/60% tax on the rich is that the money would go to the state to be wasted on bureaucracy and malinvestment. If left in the hands of the rich it would either be invested where they see the best opportunity for profit, i.e. invested efficiently, or they would spend it, thus stimulating economic activity.
This of course is also a powerful argument against the 80/90% effective tax rates on the poor.
Us and them today is not the rich against the poor, it's the population against the state.

[James G.]

Speaking from my own experience in Germany.

Almost all of the guys who worked for me on my team were paid at around the point where any extra money would be taxed at the more progressive upper rate. All of them could get paid overtime (time and a half evenings and Saturdays, double-time Sundays and holidays) and it was readily available. Almost all of them said they could have used a little bit of extra money. But they almost never took overtime.

It was when they worked overtime that they became aware of just how much the state was taking out of their pay packs and they could see the marked difference. If you worked every single weekend for a month, you're left feeling tired and just marginally better off than had you not worked the weekends at all, as you would end up bringing home less money, for the amount of work you did, than your normal paychecks afford you.

Completely disincentivises people from wanting to work more if they'd like to make more money.

After having seen how taxes disincentivise workers, I can imagine how they would disincentivise job creators like capitalists who pay even more of a premium for creating wealth.

[Andrew Duffin]

What James G said.

I too was once a supervisor of quite well-paid manual workers who worked continuous shifts.

With a few exceptions it was quite difficult to get them to work even lucrative double-time shifts as overtime. "I'm not staiying here all night for the tax-man" was a common refrain.

Incentives do matter.