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Tax rates: A surprisingly important factor in labor supply

By Peter Wolf
web posted October 6, 2017

When I was eight-years-old, I was terrified of growing up, and what terrified me the most was getting a job. What job would I get? Would I have enough time to play with my favorite Luke Skywalker Lego set? Would I be able to stay up all night secretly reading Eragon? I had so many questions, and I was scared that in the blink of an eye I would be a twenty-two-year-old graduate looking for a job. I was obsessed with this idea of what type of job I would have, and how it would impact my “schedule”. Well, many economists are also concerned about jobs, trying to figure out which types of policy actions incentivize workers to keep on working. When it comes to workers and jobs, taxes are almost always talked about. In the 2004 article Why Do Americans Work More Than Europeans? (PDF format), the famous economist Edward C. Prescott tackled the idea that tax rates have little to do with labor supply, showing that quite the opposite is true when dealing with countries and employment.

The first idea that Prescott introduces is the fact that Americans work more than Europeans. “Based on labor market statistics from the Organization for Economic Cooperation and Development, Americans aged 15-64, on a per-person basis, work 50% more than the French. Comparisons between Americans and Germans or Italians are similar.” 50% is a very remarkable number and in order to understand just how significant this is, we need to look at the history of labor in both Europe and the United States. In the 1970s, both Europe and the United States were working at pretty much the same amount. Yes, there were fluctuations with the number of hours put in on both sides, but as Prescott pointed out “when the French and others were taxed at rates similar to Americans, they supplied roughly the same amount of labor.”. What changed? What caused Americans to provide much more labor than their European counterparts? The answer is tax rates. Tax rates in Europe have spiked since the 1970s, and as they’ve gone up the amount of labor done by Europeans has decreased. Because American tax rates are lower, more and more Americans see the opportunity cost of working an extra few hours decrease. They can not only make, but also keep more money than their European counterparts.

Even I have experienced this phenomenon, though in a slightly more humorous manner. Several years ago, my older sister Angel began a breakfast business in our kitchen. From 7:30-9:30 AM, she would make eggs for anyone who wanted them, but, much like a restaurant, you needed to pay for your food. After a few days, my oldest brother William decided to get in on the lucrative trade my sister had started, so he began collecting “taxes” on my sister’s eggs. His reasoning behind the legality of such actions was that he “owned” the kitchen, and therefore if my sister were to make eggs, she needed to pay him for the use of his “land”. My sister was too young to realize that my brother had no legal hold over the kitchen, so she agreed to the proposed “taxes”. At first, William took a small portion of my sister’s business earnings, but as the money kept rolling in, he began taking even more. Soon, he was taking in almost half of my sister’s profits. As his “taxes” increased, my sister began making fewer and fewer eggs. Eventually, it got to a point where my sister was about to completely close shop, but right before she did, William decided to reduce the amount of her earnings he took (the tax rate) dramatically, which caused Angel to get back into the business. As William’s “tax rate” decreased, Angel’s productivity rose because she could now keep more of her money.

This revelation, that lower tax rates leads to larger labor supply, shows that we should be examining tax rates, and trying to find ways in which we can lower them. Prescott specifically advocated for repealing the 1993 tax rate increases, and re-establishing the tax rates from the 1986 Tax Reform Act, saying that “these lower rates would increase the labor supply, output would grow and tax revenues would increase”.  The overall economic concept Prescott examined is that of the direct relationship between opportunity cost and tax rates. The higher the tax rate, the higher the opportunity cost of working more hours will increase. If more of your money is taken away, you won’t want to earn extra knowing that that too will be taken away. The lower the tax rate, the lower the opportunity cost of working more hours will decrease. If you get to keep more of the money you earn, you’ll work more.

Prescott’s analysis was impeccable. Whenever I watch the news, I constantly see indebted college students or members of lower-income families saying that all their problems would go away if taxes were increased on the middle-class and the richest members of our society. It’s time for us to move beyond such ridiculous ideas. What many people fail to realize is that “the rich” is a temporary class, consisting mostly of people who simply have a good year, and will never again be as successful. In addition, the rich families often consist of two wage-earners, and as Prescott examined, if you increase the tax rate you are going to force one of those wage-earners out of their job because the opportunity cost of working will have increased. Tax rates do have an important impact in the labor supply of markets, and this is where the benefits of Trump’s proposed tax plan would come into effect. His plan includes many facets, but the most important deals with tax rates. His plan cuts income tax rates, lowering the top rate to 35 percent. Furthermore, this plan decreases the corporate tax rate from 35 percent to 20 percent. Europe has indirectly shown us that lower tax rates increases the labor supply, which leads to long term economic growth. Trump’s plan would benefit the economy, and put more money in the hands of Americans.

Jobs are an incredibly important aspect of any country, and incentivizing workers to do more work has become one of the major points of focus for many individuals. Economists, policy makers, and companies have been trying to figure out how to increase workers incentives for decades, and the answer has been waiting around since 1986. Europe has shown us that raising tax rates lowers labor supply. If we return to the lower tax rates of the 1986 Tax Reform Act, if we lower tax rates-as President Trump’s tax plan would do-then we can increase the labor supply, increase output, and increase tax revenue. It’s a win-win situation for everyone. ESR

This is Peter Wolf’s first contribution to Enter Stage Right. © 2017 Peter Wolf





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