In this essay, I’m going to explore the effect of taxation on work effort. I’m going to be focusing on income tax, this is a tax levied directly on personal income. Furthermore, I will be looking at indirect taxation, this is a tax that is charged to producers of goods or services and paid indirectly by the consumer. In particular, I’m going to focus on income taxation and VAT. I am going to use examples from Nielsen, BBC and The National Bureau of Economic Research. Furthermore, I will be using theories particularly from the lecture slides, as well as from Macroeconomics by Stephen D. Williamson. I must add that when I refer to increased work effort I am referring to both participation rates and or productivity rates, unless otherwise stated.
To begin, I’m going to look at the effect of an increase in income taxation on work effort. Income tax tends, for the most part, to be progressive. The entirety of this argument assumes that the labour supply curve is upward sloping. There are varying views from researchers on the true effects of an increase in income taxation on work effort. An increase in income tax can lead to individuals working shorter or longer schedules. This is dependent on whether the income effect is greater than the substitution effect or vice versa.
I will first explore the substitution effect. An increase in income taxation means that workers will keep a smaller proportion of their gross income. Suppose an individual earns £30,000 per annum. At a flat income tax rate of 10%, the individual is left with £27,000 of disposable income. If the income tax rate is increased to 20%, the individual has £24,000 disposable income. The worker is in a position where the opportunity cost of leisure has decreased, because taking time away from work is now less costly. This will cause individuals to consume more leisure, which in turn will discourage work effort.
On the other hand, we have the income effect. Under the assumption that leisure is a normal good (a good which is consumed more as income rises), an increase in taxation and thus a reduction in wages will lead to a fall in the consumption of leisure and thus an increased work effort. An increased level of taxation will mean that an individual will have to work harder and or longer to earn the same amount of disposable income they would have earnt under a lower income tax rate. Thus individuals will be spurred on to work harder and or longer, leading to an increased work effort.
Whilst these two effects co-exist, it’s the net effect that dictates whether the increase in taxation leads to a fall or increase in work effort. If the individual’s substitution effect is stronger than the income effect, it holds that the individual will endeavour in more leisure and less work, resulting in a reduction in work effort due to the imposition of the tax. The flipside is also true, if income effect outweighs substitution effect, work effort will increase.
A more resolute point about work effort and income taxation is one that cites the era of Reaganomics and the Kemp-Roth tax cut. The Laffer curve as well as supply side economics inspired the large tax cuts in the USA in 1981. It was believed that the US economy was performing to the right of the optimum taxation rate on the Laffer curve. For this reason, the income tax rate was at a level that was so high that it discouraged individuals to work, leading to below optimum government revenue from income taxation. Work effort among a number of other critical economic indicators benefitted from a tax cut which saw a 23% cut in individual rates over three years. In the years after this cut, the US saw 14 million new jobs as well as an increase in incomes by 22%. Furthermore, GDP grew by over 3.5% and government revenue from taxation increased. The indicators above show collectively that there was a larger work effort, this is especially reinforced by the increase in GDP that was seen. However due to the large influx of new jobs, it is questionable whether individual work effort increased or whether total participation increased however all in all work effort was encouraged.
Now I am going to begin looking at the effects of indirect taxation on work effort. There are also varying views for the effect of indirect taxation on work effort. I am going to approach this part by referring to VAT. VAT refers to a value added tax which is a tax which is placed on a product when value is added to that said product at any stage in the supply chain. The goods that VAT affects range from luxuries such as sweets and video games to necessities such as road fuel and bottled water. An increase in VAT would lead to an increase in the cost of certain goods. This would in turn lead to an increase in the shopping bills of individuals. For this reason, it is my contention that an increase in VAT will in fact lead to an increased work effort, due to the fact that individuals will work harder and or longer to be able to afford keep up with the rising cost of living. I must also stress that the effects of an increase in VAT will have a larger effect on poorer individuals, and therefore the work effort increase will be skewed towards those from lower socio-economic backgrounds. This is due to the fact that VAT is a regressive form of taxation.
This is further backed up by looking at a study undertaken by The National Bureau of Economic Research. The said study saw that an increase in gasoline tax saw a decrease in pollution, lowered fall consumption and individuals working at a more socially optimal level. One of the examples as to why the gasoline tax would encourage work effort was because it would reduce the hours spent leisure driving. Despite the effects being small, this only looked at a tax levied on gasoline. Taxation effecting a number of goods would have significantly greater effects.
However, by looking at the theory of Ricardian Equivalence and Friedman’s Permanent Income Hypothesis it is arguable that work effort may not be swayed by a changed in VAT at all. Ricardian Equivalence is the idea that individuals anticipate the future, so a tax increase in the present will mean a tax decrease in the future. Friedman’s Permanent Income Hypothesis is the idea that consumers spread out their consumption over their lifetime in an attempt to consumption smooth, and a temporary increase in income will have little effect to no effect on consumer behaviour. By using the above two theories, it is arguable that an increase in taxation in the present will be met by a decrease in taxation in the future and consumers will predict this. Therefore, in time of increased VAT, consumers will use either saved money or borrow money to finance their said level of optimum consumption, meaning that the increase in VAT is unlikely to have a direct effect on work effort. I must add that the theory of Ricardian Equivalence has been heavily criticised due to its unrealistic assumptions.
Moreover, an increase in VAT leads to an increase in the cost of leisure activities. In 2011, Festival tickets were sold early to avoid tickets being subject to price increases due to VAT being increase from 17.5% to 20%. An increase in the price of leisure activities increases their opportunity cost, and could lead to consumers reducing the amount of time they devote to leisure and subsequently increasing their work effort.
On the other hand, it is possible that prices won’t increase by a significant amount and consumers will be largely unaffected by a rise in VAT. The first point I would like to explore is the idea that some businesses can and did (as stated by the British Retail Consortium), with reference to the 2011 rise in VAT, absorb the rise in costs and not pass it over to consumers. This was the case in more saturated and price competitive industries. Such action would see consumers largely unaffected and will mean that the rise in VAT will have no impact on work effort at all.
In addition to the point above, Nielsen released a report in 2016 that looked at the most influential factors when it comes to British shoppers choosing where to buy groceries. The two most influential factors were product availability and convenient location. Nielsen is a very robust source and for that reason it is valid to say that an increase in price may not effect consumer’s habits or even affect their behaviour in any way, making it fair to suggest that again an increase in prices may not change work effort. This is purely because consumers may not be price sensitive and therefore a change in prices may not affect them or directly influence their working habits.
To conclude, I have presented a number of points both in favour of increased taxation changing work effort and against increased taxation changing work effort or having no effect at all. From a theoretical standpoint, and by referring to the income and substitution effect as well as looking at Ricardian Equivalence, it is unclear whether increased taxation has a clear cut effect on the level of work effort and the actuality of the issue remains unsolved. By citing real life evidence, however, the actuality becomes clearer. By looking at the Kemp-Roth tax cut and the study undertaken around gasoline taxes effect on work effort, taxation that makes working more lucrative and undertaking leisure activities costlier tends to encourage work effort.