Sunday, October 26, 2008

My Personal Work Incentives

Here is a question that you may have been thinking about: How do the different candidates' tax plans affect Greg Mankiw's incentive to work?

Okay, you probably haven't been thinking about this. But I have, because, after all, I am Greg Mankiw. And if you are here reading my blog, maybe you have some interest in the random thoughts running through my brain. So bear with me.

Let me start with my personal situation: I am a pretty lucky guy. I have a comfortable, upper middle class life style that includes one house, two cars, three kids, a wife, and a dog. I am fortunate enough that I don't have trouble keeping that going. I am also fortunate enough that I don't crave much more than I already have. I don't particularly want to own multiple houses or drive a Ferrari or wear Armani suits. You might say that I am close to being sated.

On a regular basis, I am offered opportunities to make some extra money. It could be giving a talk, writing an article, editing a journal, and so on. What incentive is there to put forward that extra work effort?

To a large extent, the beneficiaries of that extra effort are my kids. My lifestyle is, as a first approximation, invariant to my income. But if I make an extra few dollars today, I will leave more to my kids when I move on. I won't leave them enough so they can lead lives of leisure, but perhaps I will leave them enough so they won't have to struggle too much to afford a downpayment on their houses or to send their own kids to college.

Now back to the McCain and Obama tax plans. Here is a neat summary from the Wall Street Journal:

Let me try to put each tax plan into a single number. Let's suppose Greg Mankiw takes on an incremental job today and earns a dollar. How much, as a result, will he leave his kids in T years?

The answer depends on four tax rates. First, I pay the combined income and payroll tax on the dollar earned. Second, I pay the corporate tax rate while the money is invested in a firm. Third, I pay the dividend and capital gains rate as I receive that return. And fourth, I pay the estate tax when I leave what has accumulated to my kids.

Let t1 be the combined income and payroll tax rate, t2 be the corporate tax rate, t3 be the dividend and capital gains tax rate, and t4 be the estate tax rate. And let r be the before-tax rate of return on corporate capital. Then one dollar I earn today will yield my kids:


For my illustrative calculations, let me take r to be 10 percent and my remaining life expectancy T to be 35 years.

If there were no taxes, so t1=t2=t3=t4=0, then $1 earned today would yield my kids $28. That is simply the miracle of compounding.

Under the McCain plan, t1=.35, t2=.25, t3=.15, and t4=.15. In this case, a dollar earned today yields my kids $4.81. That is, even under the low-tax McCain plan, my incentive to work is cut by 83 percent compared to the situation without taxes.

Under the Obama plan, t1=.43, t2=.35, t3=.2, and t4=.45. In this case, a dollar earned today yields my kids $1.85. That is, Obama's proposed tax hikes reduce my incentive to work by 62 percent compared to the McCain plan and by 93 percent compared to the no-tax scenario. In a sense, putting the various pieces of the tax system together, I would be facing a marginal tax rate of 93 percent.

The bottom line: If you are one of those people out there trying to induce me to do some work for you, there is a good chance I will turn you down. And the likelihood will go up after President Obama puts his tax plan in place. I expect to spend more time playing with my kids. They will be poorer when they grow up, but perhaps they will have a few more happy memories.