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.
So which side is right? The answer is neither because they both rely on the same oversimplified model of individual behavior. Both sides assume that individual labor decisions can be characterized by a straightforward trade-off between labor and leisure, at least at the aggregate level. In other words, they assume people try to find a balance between work and free time, and that an increase in tax rates tilts that balance away from work because the benefits of work—i.e. income—have been effectively reduced. This may seem like a logical framework, but this is highly unrepresentative of how most people actually think about taxes and work decisions.
Some people may indeed fit the classic labor-leisure trade-off model that economists have in mind. But some people are more like threshold earners: they work enough to make a certain level of income and then they stop. If these people are subjected to higher tax rates, they might actually work more in order to reach their preferred level of income. Some people are more like maximizers: they keep their leisure time relatively fixed and work to make as much income as possible. These people would not change their behavior in response to higher taxes because they are already doing everything they can to make as much money as possible. And finally, for many people, even among the wealthy, tax rates most likely play a very insignificant role in affecting work and career choices. At this point, it is still unclear what proportion of the population falls into which category. But given how sharply behavior differs across these types of individuals, understanding this distribution is a crucial piece of the puzzle.
We have to abandon our convenient but inaccurate models of individual behavior and try to understand how people actually make decisions in the real world. Only by doing so will we finally be able to settle on the economic facts that lie at the heart of such an important and controversial policy debate.
Read more in this column Kyle Chan: On Tuesday, A Day For Nation Building