LM1 – TAX IS SUFFICIENT (CONTINUED)

Behavioral Responses to Rate Changes

LO: Differentiate between the income effect and the substitution effect.

In the case of an income tax, the incremental revenue generated by a rate

increase depends on whether (and to what extent) the increase affects the
aggregate amount of income subject to tax. Specifically, the increment
depends on the ways that individuals modify their economic behavior in
response to higher tax rates.

Income Effect

An increase in income tax rates might induce people to engage in more

income-producing activities.
A = 300,000 TR= 10% Annual tax = 30,000 DI = 270,000
Increase TR=20% Annual tax new = 60,000 DI = 240,000
Job #2 = 100,000 Tax = 20,000 DI=80,000+240,000=320,000

Substitution Effect

An increase in tax rate might have the inverse effect: where the taxpayer, instead of
working for longer hours or looking for a second job, might decide to devote more
time to leisure rather than on income-producing activity. Such a reaction makes
sense if the after-tax value of an hour of additional labor is now worth less than an
additional hour of leisure.

A=200000 AT=40,000

The probability of a substitution effect varies across taxpayers. The degree of

personal control that individuals exercise over their careers determines the extent
to which they can replace an hour of work with an hour of relaxation.
Consequently, the substitution effect is more potent for self-employed persons than
for salaried employees with rigid 9 A.M. to 5 P.M. schedules. The financial
flexibility necessary to curtail work effort is more characteristic of a family’s
secondary wage earner than of the primary wage earner. Finally, ambitious career-
oriented people who are highly motivated by nonmonetary incentives such as
prestige and power may be impervious to the substitution effect.

Whether an income tax will goad a person to extra effort or whether it will be a
disincentive to work depends on that person’s economic circumstances.
Theoretically, the income effect is most powerful for lower income taxpayers who
may already be at a subsistence standard of living and do not have the luxury of
choosing leisure over labor. The substitution effect becomes stronger as an
individual’s disposable income rises and the financial significance of each
additional peso declines.
From a macroeconomic viewpoint, these contradictory behavioral reactions have
important tax policy implications. Conventional wisdom suggests that governments
needing more revenue should increase the tax rate on people with the highest
incomes. But if the tax rate climbs too high, the substitution effect may become so
strong that the projected revenues never materialize as more and more people are
discouraged from working because the after-tax return on their labor is too small.

Supply-Side Economics

The decrease in the highest income tax rates should ultimately result in an increase
in government revenues. The logic underlying this theory is that a rate cut
increases the value of income-generating activities (work and investment) relative
to the value of non-income generating activities (leisure and consumption).
Accordingly, people who benefit directly from the rate reduction will invest their
tax windfall in new commercial ventures rather than simply spend it. This influx of
private capital will stimulate economic growth and job creation. An expanding
economy will result in prosperity across the board so that everyone, regardless of
income level, indirectly benefits from the tax rate reduction. People will earn more
income for the government to tax, and revenues attributable to this enlarged tax
base will swell.