Do higher taxes discourage people from working? Answering this question requires a more realistic view of individual behavior
What would you do if all income tax rates, including your own, suddenly increased by ten or even twenty percentage points? Would you work less? Would you work more? Would you try to get another job? If this had happened at the beginning of your career, would you have chosen a different career altogether? In the face of rising income inequality, swelling public debt, and the grim prospect of prolonged fiscal austerity, the debate in the U.S. and Europe over whether to raise taxes on the wealthy has escalated with calls for policies like the Buffet Rule coming from rich and poor alike. While there are certainly ideological factors at play, much of the debate hinges on the answer to a seemingly basic economic question: to what extent does raising income taxes, particularly on the wealthy, discourage people from working? After decades of research the issue still remains largely unresolved, and the reason lies with the fundamental approach taken by economists on both sides of the debate, which does not fully account for how real people think about work and taxes.
The traditional argument, most famously captured by the Laffer curve of the Reagan era, has been that changes in tax rates significantly affect how much people work. As evidence, economists such as Edward Prescott have relied on macro-level studies that show people work more in countries with lower income taxes such as the U.S. than in countries with higher income taxes such as France. In addition to cross-country comparisons, macro studies have also examined the effects of changes in tax rates within the same country over time, such as the 1986 Tax Reform Act in the U.S., which significantly lowered tax rates for the top income brackets.
The general conclusion from these studies is that tax rates do significantly affect labor decisions, enough to make raising taxes on the wealthy a harmfully inefficient proposition. But this approach is rife with problems, including the statistical significance of such a limited sample size of countries where many other strong factors besides income taxes are involved.
More recently, the alternate hypothesis that higher taxes do not discourage people from working as much as previously thought has gained considerable traction among researchers. A number of micro-level studies by economists such as Austan Goolsbee have examined how specific groups such as corporate executives have responded historically to changes in tax rates. These studies have shown that while individuals may respond to changes in taxes by shifting income across time—by exercising stock options sooner or later, for example—people don’t fundamentally work much less if you tax them more. The problem with these studies as economists such as Peter Diamond, Emmanuel Saez, and Raj Chetty have pointed out is that they only focus on the short run. It may be difficult to change how many hours you work in the short run, but in the long run higher taxes may affect decisions such as which career to choose in the first place, whether to invest in costly education, whether to start a risky new business, or when to retire.