Monday, November 27, 2006

How distortionary are taxes?

An ec 10 student emails me a question about taxes:

Dear Professor Mankiw,

I'm a freshman taking Ec10. Prior to taking Ec10, I had no experience or interest in economics and was convinced that I wanted to be a doctor and to major in neurobiology. Now, Ec10 is easily my favorite and most intriguing course, and taking it, in combination with my reading Freakonomics, has definitely caused me to rethink my interests, goals, and life in general. Thank you for teaching this course.

However, my intrigue in Ec10 has led me to question some of the principles of economics. The first regards the idea that high income taxes distort work incentives. In theory, this makes sense, but I feel that in practice, the idea doesn't apply well, especially to the income tax. Do the distortion of work incentives and the deadweight loss really have enough of an impact to be seriously considered while forming tax policy? The reason I think that high income taxes don't significantly distort work incentives in practice is that most people probably aren't thinking about how much of their income is taxed unless it's April 15. Most people probably believe that working more means more money and don't consider how much they're taxed unless they have to physically write the check (e.g. with property and excise taxes).

[name withheld]

The key issue is the elasticity of labor supply. Some economists do believe, as you suggest, that this elasticity is small and, as a result, that taxes aren't very distortionary. Others believe that the elasticity is larger. Economist Ed Prescott has suggested that the main reason Europeans work less than Americans is the higher tax rates they face.

Think of it this way. Imagine that you are a painter deciding whether to accept another painting job this weekend. I am willing to pay you $500 for the work. It is possible that you would do the job for $500 but not for $300 (the amount you would keep after paying payroll taxes, federal income taxes, and state income taxes)? If you think that all workers make such decisions without regard to remuneration, then the assumption of inelastic labor supply is correct. In this case, taxes are not distortionary. But if some people respond to incentives and would do the job for $500 but not for $300, then that response is what makes taxes distortionary.

There are other margins to consider besides the tradeoff between work and leisure. Another is market production vs home production. To continue with our painting example, imagine that you have a choice between taking the job and staying at home to rake your leaves and fix your car. As a painter, your comparative advantage is likely painting, and it might make sense to hire a lawn service and a car mechanic to fill your other needs. But if the tax rate on your painting income is too high, you might pass on the extra job and spend your time on your tasks at home.

Finally, there is the issue of career choice. An article in today's NY Times mentioned a Harvard PhD in economics who left an academic job for a better-paying one in private equity. Based on the article, he seemed a bit wistful about leaving an academic job behind. At a higher tax rate on his new higher income, might he have stayed with the perks of the ivory tower? Perhaps. But, based on market prices, his talents are more productively applied in private equity, where he is filling the important role of allocating the economy's capital stock. If he gave up that job because of a higher tax rate, the loss to the overall economy would be measured by the deadweight loss.

On a related note: I am delighted to hear that you are reevaluating your career goals and considering a switch into economics, That is what the first year of college is all about. But I think we can agree that this important decision should ideally be based on comparative advantage and personal preferences, and not marginal tax rates.