Sunday, October 10, 2010

Greg Mankiw forgets about the income effect

Professor Mankiw says he can afford higher taxes.  For that I give him credit.  But he also says that higher income taxes might keep him from writing his New York Times column.   He then implies that higher taxes will generally keep people from working.

This is the substitution effect--because leisure becomes relatively cheaper, people consume more of it.  But higher taxes also reduce after-tax income (obviously), so in order to maintain living standards, one might decide to work more in the face of higher taxes.  This is called the income effect.  I can speak for my household--our after-tax income is more than sufficient for our "needs," but if we were taxed more, we might have to work more to satisfy these "needs."

It is an empirical question as to whether within certain ranges of tax rates, raising taxes increases or reduces effort.  Theory gives us an ambiguous answer.  (h/t Mark Thoma).


Richard H. Serlin said...

I constantly have to remind people of this, so thanks for helping.

But it's not just an empirical question. There's also an empirical answer. This has been studied greatly.

It turns out that people upper middle class and higher -- like Mankiw -- tend to work harder when you increase their taxes.

Over the very long run there are many things at work, but note that people 100 years ago had a small fraction of the take home pay of people today. By Mankiw's intentional misleading that should mean that they worked a fraction as much, but in fact they worked MORE.

Here is the summation of the empirical literature from a top expert in this area, MIT economist Jonathan Gruber, “Changes in tax rates appear to have relatively modest effects on total gross income; the total amount of income actually generated through work or savings does not respond in a sizable way to taxation”, (“Public Finance and Public Policy”, 2nd edition, 2007, page 734)

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