Business 21C - Published by UTS Business

Governments need to consider more than after-tax wages when thinking about tax policy, says Professor Michael Keane. They also need to think about the value of work today for the individuals’ human capital tomorrow, and how it interacts with lifetime earnings and their propensity to work.

‘The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest amount of hissing.’

So said King Louis XIV’s finance minister some 400 years ago. As former Prime Minister Rudd’s experience with the mining industry demonstrates, that art has not changed.

In taxation, as in other areas of life, art combines with science. When reassessing how Australians should be taxed, the government asked economists to look at the system as a whole, and as part of that, we developed a breakthrough theory that looks at how people make choices regarding their work preferences in relation to the taxation rate.

In general, economists have assumed that if you tax people more on their income, they will work less. Conservative politics has always claimed that high taxation levels result in a lower work ethic, as people are less interested in giving up leisure time if they receive fewer rewards for doing so.

The science of taxation has therefore focused on maximising both taxation revenues and labour efficiency – finding the top of the revenue curve, where a marginal increase in taxation rates does not cause a drop in aggregate tax revenues as productivity drops off because people work less. This is known as the ‘shrinking pie’ problem: increase tax rates past a certain level and the whole pie – GDP – will fall, which means, in essence, that total tax revenues fall.

This point will be affected by labour-supply elasticities – how radically people change their behaviour in response to changes in their after-tax income. If people are very sensitive to changes in after-tax wages, an increase in tax will cause them to work a lot less. If they are not very sensitive to changes, an increase in tax will have little or no impact.

In contrast to most ideas in economics, this one has generated a clear consensus: labour-supply elasticities are very small. In the words of Seaz, Slemrod and Giertz, published in 1999: ‘…the profession has settled on a value for this elasticity close to zero … This implies that the efficiency cost of taxing labour income … is bound to be low’. Tax away, in other words, and it will have little effect on the size of the pie.

There are a few exceptions to this rule. Married women, for instance, value their time more highly than others, as do single mothers and low-skilled men, but in general, economists have thought that people don’t clock off just because they receive a little less in their pay packets. It’s ironic, then, that on one of the few occasions economists have managed to agree, they are wrong.

In my view, most of the existing labour-supply literature suffers from fundamental flaws that make it a poor guide for setting tax policy. The key problem is that the literature treats the wage as the value of time. But people are more complicated than this. What’s more, they make their decisions about whether they should work today by taking into account its impact on the rest of their lives.

Whether I choose to go to work today or not is determined not only by how much I need the wages I will get in return, but also by that choice’s impact on my wages – my value to the workforce – tomorrow. Working today gives me experience and contacts that make me a more valuable employee tomorrow. Work today is an investment in the value of my human capital tomorrow. So an individual’s value of time is more than just his or her after-tax wages. Rather, it is his or her after-tax wages plus the lost opportunity to invest in his or her future.

This idea is familiar from unemployment theory – long-term unemployed find it much more difficult to get jobs than short-term unemployed, because their human capital is valued that much lower. In recent decades, governments have undertaken numerous back-to-work schemes to help long-term unemployed solve this problem; however, to date, the idea has been foreign to taxation theory.

Incorporating it into taxation theory has a number of immediate consequences. First of all, over the long term, increasing taxation permanently has a much larger effect on the individual’s propensity to work. If you increase taxes over individuals’ lifetimes, their return on investment in their future is lowered significantly, so they will be much less likely to decide to work today in order to increase their value tomorrow. Having said that, temporary tax changes are unlikely to have as great an impact, as they really affect only the current wage, not the wage over an individual’s working life.

These factors have a real impact on how governments should think about tax and welfare policies. What economists call the ‘welfare cost’ of income taxation is likely to be much higher than previously thought, because they have ignored how taxes alter incentives to acquire human capital. What’s more, because they have mismeasured the value of work for the value of the individual’s human capital, they have underestimated how long-term changes in taxes can reduce labour supply.

The idea speaks to many facets of taxation and welfare policy, including the cost of child care and preschool and its impact on single mothers, and policies such as working families’ tax credits, as introduced in the UK.

This article is an edited version of a technical paper written for Australia’s Future Tax System report for the Rudd Government.

You can also leave a response, or trackback from your own site.