Arnold Kling

Prescott on Tax Cuts

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In this essay, I explain 2004 economics Nobel Laureate Edward Prescott's views that the Bush tax cuts were too small.


Prescott re-casts the trade-off as between "market time" and "non-market time." In addition to TV and Bon-Bons, you spend some of your non-market time producing goods and services, such as home-improvement projects, meals cooked at home, housework, and child care. Thinking of the choice in those terms, an increase in your wage rate could have a significant effect on your labor supply. The higher your wage rate, the more it makes sense for you to "outsource" household chores. If I can earn enough in six hours of work to pay for someone else to do eight hours of household chores, then I can get more hours for TV and Bon-Bons by increasing my "market time." Working six more hours but spending eight fewer hours on household chores gives me a net saving of two hours.

...The bigger the tax wedge, the more you will tend to do household chores yourself rather than outsource them. Suppose that you earn $40 an hour and it would take you 80 hours to build a deck, although a contractor could build the deck for $2400. On a pre-tax basis, it takes you only 60 hours to earn enough money to pay the contractor, so it makes sense to work more hours and pay the contractor. However, if your income and payroll tax rate together is 40 percent, then you have to work 100 hours in order to be able to take home $2400. Taking into account taxes, you are better off building the deck yourself, because your deck-building labor is tax-free.

The lower the tax wedge, the more likely it is that you will choose to use goods and services to replace household chores, increasing your market time in exchange for more true leisure time. Since many of the goods and services that we buy -- from microwavable food to lawnmowing services to wash-and-wear clothing -- are designed to save on household labor, the tax wedge is a significant economic factor.


After I wrote this essay, but before it was published, Prescott himself explained his views this way:

I would point you to the data which show that when the French and others were taxed at rates similar to Americans, they supplied roughly the same amount of labor. Other research has shown that at the aggregate level, where idiosyncratic preference differences are averaged out, people are remarkably similar across countries. Further, a recent study has shown that Germans and Americans spend the same amount of time working, but the proportion of taxable market time vs. nontaxable home work time is different. In other words, Germans work just as much, but more of their work is not captured in the taxable market.

I would add another data set for certain countries, especially Italy, and that is nontaxable market time or the underground economy. Many Italians, for example, aren't necessarily working any less than Americans -- they are simply not being taxed for some of their labor. Indeed, the Italian government increases its measured output by nearly 25% to capture the output of the underground sector. Change the tax laws and you will notice a change in behavior: These people won't start working more, they will simply engage in more taxable market labor, and will produce more per hour worked.

UPDATE: Mark Steckbeck points out


This [shift from market to non-market production] has real effects...this is not an equivalent trade off or a wash, which simply just fails to be accounted for in official national income accounts. High employment taxes reduce real output overall because output per worker--their productivity--is less given workers' reduced time engaged in a specialized skill

His point is that non-market-time labor tends to be less efficient than market-timer labor. I would add that there are other reasons for the underground economy to be relatively inefficient. Lack of access to capital, for example.

UPDATE 2: Jonah Goldberg writes,


it simply seems to me that a country which sends state goons to companies to make sure no one works overtime and which considers six weeks vacation slave-driving, has some additional anti-work policies in addition to lousy tax rates. Also, aren't French tax rates themselves a product of cultural differences?

This is a point we have discussed on this blog before, which is that just because tax rates can explain work differences (if indeed they can) does not mean that there are not cultural differences. It could be that a nation's tax code is a reflection of its culture.

For Discussion. Does Prescott's argument favor a flatter tax system or an "all holes, no cheese" tax system, which uses tax breaks to favor certain types of income?


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CATEGORIES: Supply-side Economics



TRACKBACKS (9 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/149
The author at The Liberal Order in a related article titled Gains From the Division of Labor writes:
    Arnold Kling disucsses Ed Prescott's Wall Street Journal Op Ed (subscription required) from yesterday, where Prescott argues that high employment taxes cause workers to reduce their number of hours employed in the market. This, according to Prescott, e... [Tracked on October 22, 2004 2:56 PM]
The author at The Big Picture in a related article titled Carnival of the Capitalists - October 25 2004 writes:
    Hello and welcome to this week's Carnival of the Capitalists! We have an exciting and wide ranging line up, which I have tried to categorize ((futiley, I might add) for your reading pleasure. if I missed anyone's trackback, please email it to thebigpic... [Tracked on October 25, 2004 11:48 AM]
The author at Capital Flow Watch in a related article titled Nobel Prizes in Economics 2004 writes:
    Finn Kydland and Edward Prescott were awarded the Bank of Sweden Prize in Economic Science in Memory of Alfred Nobel for 2004 for their work in "time-consistent policy and the generation of the business cycle". As is the case with... [Tracked on October 26, 2004 1:18 PM]
COMMENTS (13 to date)
Lawrance George Lux writes:

Prescott favors the flatter tax system, but he does little to differentiate between Individuals and Business organization. The only way to utilize a flatter tax system is to separate the two entities, and actually eliminate loopholes for Business. Lobbyists work hard to tie Business tax rates to Individual tax rates. An Individual tax rate of 16% being very sound, does not make it equally as valuable at a Business tax rate, whose optimum may actually be 32%. lgl

Boonton writes:

It's been argued that the corporate income tax is nothing more than a tax on the consumer because it must get passed on in the form of higher prices? If this is so, then wouldn't the corporate income tax really be the all important 'consumption tax' that some on the right have been advocating?

Lawrance George Lux writes:

Boonton,
Suggesting the corporate income tax may be a 'consumption tax' can have it's rationale, but it ignores the functional difference. The corporate tax can be fluxed, or worked; each corporation capable of adjusting prices and Profitability ratios, to get their desired production matrix of Sales. A flat Consumption tax is stratified where economies of scale and technological expertise is equally penalized. lgl

Zoran Lazarevic writes:

The whole argument assumes that taxes are useless. Of course that people will do more business if the taxes are lower. But if we drop the taxes to zero, we will lose the ability to pay for military, police, courts, legislators...

Should the criteria for setting optimal taxes be GDP? E.g. we want to maximize GDP by trading off tax percentage against the number of judges employed by the government.

The optimal tax rate will be set by our representatives if they are given proper incentives. How about giving them a deferred compensation based on GDP (or other measures of National Income)? That way, if they set suboptimal tax rates they future income based on future GDP will get reduced. If they do a good job then they will benefit too!

This scheme will align interests of our representatives and we the people and thus ensure not only optimal tax rates but a good public policy also.

Bob writes:

The corporate tax represents a blended tax on capital, labor, and consumption. Evidence suggests that the bulk is paid by consumers. It should be obvious that you can't tax a "corporation" - you have to tax people.

The corporate tax is just another convenient way for Gov to take from people who don't notice to give to people who do. What makes the corporate tax inefficient is that its costs are disguised - people don't realize they are paying it and it distorts business decisions, creating a deadweight loss. To say nothing of the many accountants and lawyers paid top dollar to avoid it.

Tom West writes:

I will admit I don't understand why many people complain about lots of different taxes and in the same breath say that if taxes are too high people will work in the underground economy, work less, etc.

It's obvious we have many smaller taxes rather than one large tax in order to make it difficult to avoid all taxes completely, and to make it less worthwhile to alter one's behaviour in order to avoid a particular tax. After all, taxes are not something we're supposed to be able to easily optimize away :-).

Secondly, I suspect few people (outside of economists :-)) could (1) assume that there is automatically extra work to be done should the incentive of lower taxes be there, (2) not take into account the removal of services that a lack of taxes would bring, and (3) assume that for a family, work for pay is equivalent to work at home in everything but the paycheck. I suspect the children involved (if even peripherally) would have some strong opinions about that.

Mcwop writes:
It's been argued that the corporate income tax is nothing more than a tax on the consumer because it must get passed on in the form of higher prices? If this is so, then wouldn't the corporate income tax really be the all important 'consumption tax' that some on the right have been advocating?

The CIT and VAT are similar, and the taxes are different. The taxes are similar in that they are paid by the consumer. The difference is that the CIT is only paid if the company earns income (in its most basic form). The VAT is paid regardless of profits, and applies to the total cosst of the good (revenues).

Ann writes:

I agree with Tom West that there's a real problem with trying to collect too many revenues from only one tax, whether it's a sales tax or income tax - if the rate gets too high, there's too much incentive to avoid it in some way.

But, I question the idea that there may not be any "extra" work to be done at a lower tax rate, as well as the idea that high taxes somehow mean that children get more of their parents' attention. As a single career mother, I am desperately short of time and would love to hire someone else to do more around the house. If I can pay someone else to do household chores, I can spend more time with my children and less time with my washing machine, dishwasher or lawn mower.

In fact, for a few years I had a full time nanny, hired legally, but the taxes just killed me. I needed her because I had to work some evenings, and because one of my children needed to be taken to therapy 4 times a week (and needed extra attention at home). The many layers of taxes, and the unbelievable bookwork, meant that I had to dip into savings to get through those years, even though I made a good income. It was worth it, since therapy is something that can't be put off, but it was a huge strain.

I used to think about how much my employer had to start with, before taxes, to get one dollar after all taxes to my nanny. First my employer paid taxes for me, then it paid me money that I paid taxes on, then I paid taxes for my nanny (social security, workers' comp., etc.) and gave what was left to her, so that she could pay taxes also. I would guess that about 75% came out in taxes, plus there was so much filing and bookwork.

There's plenty of work to be done - it's unimaginable to me, given how stressfully busy most people's lives are, that there won't be extra work to be done if taxes were brought to a level where people could get help. And by taxes, I mean not just the "useful" monetary taxes (government does at least some good with what they collect, usually) but also the ridiculous deadweight cost of people spending huge amounts of time and effort on bookkeeping. My children would benefit hugely from lower taxes and a less complicated tax system that allowed me to spend more time with them.

Ann writes:

I did some calculations related to my last post, and it's unlikely that the total tax burden equaled 75%, even with 4 levels of taxation. But it's easily over 50% and might have taken 2/3's of each dollar my employer began with, for me to get money after tax into my nanny's pocket.

Lawrance George Lux writes:

Ann,
You, and a lot of others, attempt linear progression of tax rates. It sounds good, and seems reasonable, but will end with Corporate tax rates being set at 5%, because you will pay an 8% Sales tax on your retirement income. Short lesson on taxes:

1) Taxes raise revenue to pay for Government Goods and Services. Government spends about 20% of current GDP, and total tax revenues must reflect such excessive spending.
2) Separate tax rates are set on separate economic units. There is some protest when one specific set of economic entities are picked to be the sole taxpayers (the great drawback on a Consumption tax--Consumers don't like it).
3) Reduction of the specific number of economic units to which tax rates are applied, leads to reduction of total tax revenues. A spread inclusion of economic units taxed leads to not only increased tax revenues, but less economic impact on each economic unit.
4) Tax applied only to specific elements of the economy inevitably leads to economic growth distortions--a serious impact of Our current tax structure.

There is always a tendency to decry Government efforts to collect taxes. Things could always be a lot better, and have often been a lot worse. lgl

Ann writes:

That's a very sensible basic tutorial, but I don't see how it applies all that directly to my comments. If we had a tax system with fewer distortions and exceptions, the dead-weight cost of calculating taxes (my own or those of anyone I hired) would be substantially lower. When I lived in Hong Kong, income taxes took practically no effort to calculate, whereas here they're a nightmare.

The multiple layers of taxation, and the crippling forms that go with each, discourage people from paying tax when they hire a babysitter or someone to mow their lawn. And the high additional tax rates for someone to pay someone else to help them, taxes paid out of after-tax income, also discourage many types of employment.

I was responding to an earlier post that said that there might not be more work for people, even if tax rates were lower, and that children might be better off if high tax rates prevented people from specializing and hiring help around the house, so that they could put in more hours at work. Neither of those arguments rang true to me.

Bill Fellers writes:

It's all culture. My wife is German and I've spent a bit of time there. Compared to Americans, Germans consider laziness a virtue and hard work a vice. It's culturally acceptable to by lazy and live off the labor of others. Germans seem to think that people are either born lazy or industrious. They don't choose. They are living Marx's dream: From each according to their ability, to each according to their need.

The only "fair" tax is a flat tax. All else is thievery.

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