Increasing income taxes can, as Becker argues, reduce the amount of work. But when the issue is increasing marginal income tax rates, the likelihood of a significant effect on work depends critically not only on the amount of the increase but also on where the margin is set. The Obama Administration proposes by allowing some of the Bush tax cuts to expire on schedule to increase the marginal income tax rate of persons whose taxable income exceeds $250,000 a year from 35 to 39.6 percent. The top 1 percent of American earners have household incomes in excess of about $330,000; their taxable income is less; so probably not much more than 1 percent of taxpayers would be affected by the proposed tax increase. The effect on most of these taxpayers would be small. Suppose a person earning $300,000 in taxable income pays $75,000 in taxes currently. If his marginal rate (the rate for taxable income above $250,000) rises from 35 to 39.6 percent (for simplicity I’ll round this up to 40 percent), then his total income tax bill will rise from $75,000 to $77,500 (because on the last $50,000 of his income he will pay an extra 5 percent in tax). Will this increase in his total federal income tax bill, of 3.3 percent, cause him to work less? I would like to see evidence that it would.
Because of tax avoidance opportunities, it seems that very few people pay more than about a quarter of their income in federal income tax. Suppose someone has an income of $10 million on which he currently pays $2.5 million in income tax. The Administration’s tax increase would raise his income tax by $487,500 ([$10 million - $250,000] x .05), or slightly less than 20 percent. Would that affect how hard he works? I’m skeptical.
Income tax on earned income (as distinct from capital gains and dividends, which I’ll discuss shortly) does increase the cost of work relative to leisure, which is the basis for concern that increasing income tax rates, especially marginal rates, will cause a shift from work to leisure (and, as emphasized by Becker, to nonpecuniary work such as household production). But there is another effect: by lowering disposable income, an increase in income tax may cause a person to work harder iin order to maintain his previous standard of living. The net effect on income of a higher tax is therefore uncertain.
The Administration’s tax plan would raise the capital gains tax from 15 to 23.8 percent and the tax on dividend income from 18 percent to 43.8 percent. These would be substantial increases but except for the 3.8 percent (a new Medicare tax) would merely return these tax rates to what they were in the Clinton years, the 1990s, actually a more prosperous time than the 2000s even before the financial bust of September 2008 and the ensuing general economic downturn. I don’t know what effect on work these tax increases would have, because I don’t know how direct the relation is between either capital gains and work or dividends and work.
Americans are accustomed to working hard and to achieving and maintaining a high level of expenditure on consumer goods. In addition, people who earn high incomes tend to be highly competitive and to rate themselves by their income relative to the income of peers. Because of the absence of an aristocracy and the presence of a generally philistine attitude toward culture, money is the key index to prestige and social standing in the United States and, for many Americans, to a feeling of self-worth. These features of American society lead to me to be skeptical in general about the effect on work and therefore income of increasing marginal income tax rates to the levels contempated by the Administration.
The more important question is the revenue effect of the proposed tax increases, if they are put into effect. Increasing taxes can actually reduce government revenues if the increase induces people either to work less or, more likely, to report less income, either by increasing lawful deductions (implying an added demand for services of lawyers and accountants) or by cheating. And an effective tax increase, one that reduces after-tax incomes, is hardly a recipe for promoting recovery from a severe economic slump. So I am not enthusiastic about increasing taxes now, especially since the Treasury remains able to borrow at extraordinarily low interest rates to finance the federal deficit. Nor is this just short-term borrowing; the 10-year Treasury rate as of three days ago was 1.5 percent.
The real significance of the proposed tax increases is political. Income inequality is growing in the United States and there is increased resentment at what seem the outlandish incomes of the rich and the increased frequency of crime and sharp practices by businessmen (whether that frequency actually has increased is unknown). A tax increase limited to high earners might assuage this resentment somewhat.