Arnold Kling

Taxes and Market Time

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Steven J. Davis and Magnus Henrekson write,


Regressions on rich-country samples in the mid 1990s indicate that a unit standard deviation tax rate difference of 12.8 percentage points leads to 122 fewer market work hours per adult per year, a drop of 4.9 percentage points in the employment-population ratio, and a rise in the shadow economy equal to 3.8 percent of GDP. It also leads to 10 to 30 percent lower employment and value added shares in (a) retail trade and repairs, (b) eating, drinking and lodging, and (c) a broader industry group that includes wholesale and motor trade.

...our evidence strongly suggests that labor and consumption taxes operate with powerful effect on several margins: substitution between legal and underground activity, substitution between home and market production, the mix of market production activity, and the composition of market expenditures. Prescott’s model collapses these response margins to a single choice between work and leisure.


A number of other economics blogs have pointed to this study. I first saw it referred to by Steve Antler.

For Discussion. I think of lawnmowing, child care, and fast food as industries that would be sensitive to tax rates, because if tax rates are high enough you would do those jobs yourself tax-free rather than earn taxable income to pay someone else to do them. What other industries would be most sensitive to tax rates?


Comments and Sharing


CATEGORIES: Tax Reform



COMMENTS (19 to date)
spencer writes:

Doesn't this raise a very different policy question.

Current tax policy is based on the premise that the economy is better off if we shift the tax burden from capital to labor. But maybe that is the problem, and we should be shifting the tax burden the other way-- from labor to capital.
We have been following the first policy for a quarter century without much in the way of good results, so maybe our problem is not that tax on capital is too high but that taxes on labor are too high.

We keep hearing about how the US economy does better than European economies, and their tax policy is biased much more than the US in favor of capital.

Mcwop writes:

It may affect industries with labor shortages. My wife is a nurse at an outpatient surgery office. She used to do some reserve/overtime at the old hospital she worked at, when they were short staffed. She quit doing the reserve/overtime work, because what was left over after taxes was pitiful (despite the high hourly rate paid by the hospital).

We have been following the first policy for a quarter century without much in the way of good results....

In what country are you living?

William Woodruff writes:

What other industries would be most sensitive to tax rates?

Any and every activity which requires casual labour is subject to substitution forces mentioned in the study. I strongly believe increased taxes on consumption promote a greater propensity of "off the books activity".

A "Lafer Curve" of consumption, if you will.

Lawrance George Lux writes:

There are forms of taxation other than official tax rates. Fed policy which drove down Interest rates was a taxation of the form of investment common to the Poor and Working Class. Most Excise and Sin taxes are designed to impact the Poor far greater than the Wealthy. Current allowed Tax Accounting procedures have served to allow Business Interests to cancel or eliminate Retirement packages and Group health insurance coverage, but one never sees Corporate management berift of retirement packages and Group health insurance.

Davis and Henrekson's conclusions concide with my own suspicisons, but they fail to evaluate by Regressions the impact of Excise and Sin taxes, the shift in Wealth of tax regulations, and the loss of Employment due to tax-free shift into Retail and Consumer credit by Corporate structure. lgl

Bob Knaus writes:
Which industries would be most affected by tax rates?

The examples you give (babysitting etc.) are the sort that one might do in one's spare time... not much of that left after an exhausting work week is there? Seems that these might not have enough hours attached to them to really be "industries most affected".

Based on my experience growing up lower middle class (which experience seems in short supply amongst posters on this blog) I can tell you that the industries where tax evasion is most common are those where you get paid under the table, or where you get a 1099. If your income is reported on a W-2, it's hard to get around paying taxes.

In general, W-2 work corresponds to a steady job, while 1099 and under-the-table work are more common in what others here have referred to as "casual" labor.

Perhaps counterintuitively, I believe it is W-2 work which is most affected by tax rates, since they are harder to dodge. Casual labor, on the other hand, will continue to happen regardless of the tax situation. It just goes underground if tax rates get too high.

Capt. Bob Knaus
S/V PELLUCID
www.pellucid.org

spencer writes:

December 22-- Patrick Sullivan is obviously referring to the US. Pick almost any measure of economic well being and you will find that it did better in the quarter century before 1980 than in the 25 years since 1980. About the only exception is inflation, that has been lower since 1980. If you look at the economic data you would have to conclude that the experiment of lowering taxes since 1980 has been a massive failure.

Just to cite one example our host likes to talk about is personal savings. The savings rate peaked in 1980 and has fallen almost every year since to almost zero.

How about income inequality. The Fed reserves says is has grown by about a third since 1980 as the US has probably experienced the largest income transfer upward in history -- comparable downward adjusement occured many times like after the French, Russian and Chineses revolutions.

Maybe you ought to try to look at realtity ever once in a while.

Michael writes:

Spencer, you said above that,

“How about income inequality. The Fed reserves says is has grown by about a third since 1980 as the US has probably experienced the largest income transfer upward in history -- comparable downward adjusement occured many times like after the French, Russian and Chineses revolutions.”

Let’s look at a hypothetical example that mimics what has been played out in the U.S. for the past 25 years or so. At the end, I will show you some statistics computed from actual census and CPS data between 1979 and 2000 (working on 2004 now).

Suppose my income is $10,000 today and yours is $100,000 and we live in a 10 person economy. 8 people have an income of $40,000. In this society, the income share held by the wealthiest two people is apx. 33% while the income share held by the poorest two people is apx. 12%. A standard measure of inequality is the ratio of the income share held by one group of people over another group – in this example the inequality measure is 2.8.

Suppose that after 21 years or so that the income levels (real terms) of the middle 8 people remain unchanged at 40,000. However, the rich guy is making a killing and his real income doubles over this period to $200,000. The poorest person (me) gets a college education and rather than earning $10,000 as a shelf-stocker earns $20,000 as a secretary – admittedly boring and an underutilization of my skills, but a job nonetheless. What happens to our measured inequality? In this new year, the wealthiest two people now hold apx 44% of the income in this country while the poorest two hold only 11%. The income inequality has increased in this country from 2.8 to 4.0 – stop the presses! So, while aggregate income is growing in real terms at about 1% per year, the rich are getting richer and the poor are getting poorer.


Now, let’s look at some U.S. data over the 1979-1999 period.

 Average household income in the U.S. has grown at a real rate of about 0.9% per year.

 Average (real) incomes for households at the 10% level in the income distribution rose from $7,850 in 1979 to $10,593 in 1999 – an annual rate of 1.4%

 Average (real) incomes for households at the 25% level in the income distribution rose from $17,555 in 1979 to $20,975 in 1999 – an annual rate of 0.9%

 Average (real) incomes for households at the 75% level in the income distribution rose from $53,888 in 1979 to $67,729 in 1999 – an annual rate of 1.1%

 Average (real) incomes for households at the 90% level in the income distribution rose from $77,958 in 1979 to $94,873 in 1999 – an annual rate of 0.9%

So the income gap between the richest and poorest 10% of the households grew by $14,000 while the gap between the richest and poorest 25% grew by $7,000.

So, the poor are screwed – especially since the poorest 10% in 1979 must be exactly the same 10% in 2000. I guess there is no such thing as immigration, no such thing as changing age structures, no such thing as changing family structures, etc.


Now, I think your attack on Patrick is a bit hasty and rude. Your comment above infers, as is common among people making similar claims, that there are winners and losers in every economic change and transaction – that the pie is fixed. The evidence on the U.S. points to a resounding rejection of your claim. I for one believe that an income transfer upward as you suggest has happened would be as appalling as the income transfers down you seem to celebrate in France, Russia and China.

Now, about Arnold’s question, which 90% of the time goes unanswered when people put their 3 cents in, I can only answer for myself in that I will choose not to teach the extra course over the summer that I would like to, and I will not be participating in a high school honors program for our state’s top students. Since I will be getting paid a very low NET amount, I figured I ought to spend my marginal hours doing research. Since my comparative advantage does not happen to be in research, I think many stand to lose because of this decision. However, on the bright side, my selfish decision should make it easier for me to get tenure (which I believe ought to be abolished, but that is another story for another time).

Thanks to Arnold for posing yet another thought provoking and important question.

Mcwop writes:

Spencer, my wife now earns five times what she earned nine years ago. Nine years ago her annual income was just above the poverty level. Income mobility - it happens. 100% of people at the lower end of the income ladder certainly do not experience this, but there are large numbers that do climb the ladder.

References on Income Mobility (there are lots of studies on this subject)
A 1992 Treasury Department study showed that between 1979 and 1988, 86 percent of those in the bottom income quintile moved to a higher quintile, and 35 percent in the top income quintile moved to a lower quintile

A 1996 Urban Institute study showed that large numbers of Americans move into a new income quintile, with estimates ranging from 25 percent to 40 percent in a single year. The same study found even higher mobility rates over longer periods: about 45 percent over five years and 60 percent over 9-year and 17-year periods

Secondarily, who cares what Bill Gates earns or is worth compared to me? How does that harm me - it doesn't. In fact as an owner of MSFT stock if his net worth grows, then so does mine. The same would be true even if I did not own MSFT stock. Gates' income and net worth could both double and I will not feel a thing. Unfortunately, those critical of income inequality base the criticism on the psychological effect of income inequality. In other words, if someone feels bad or envious of people with higher incomes then inequality is a bad thing.

The real problem is not inequality but poverty. These are not the same thing. After all Bill Gates earns significantly more than someone with a $100,000 annual income, but $100k is a good income. Bill Gates does not cause poverty. Poverty is caused by a different set of circumsatnces.

spencer writes:

nice hypotheticals -- but if you look at the data comparing real growth and welfare the period prior to 1980 experienced a significantly higher
of real growth and real income growth. This was my point, that the tax cuts have had little impact.

Moreover, if you look at the recent work by the Fed of Minn. that looks at life time earnings they are finding that income mobility is much lower than generally assumed. They are finding that something like 60% of lifetime earnings is determined by ones fathers income.

Moreover, I was not attacking Patrick Sullivan--
I was agreeing with him.

I presume the wife that experienced a nine fold income growth went from a low job while she, or you were in grad school to a high paying professional job. The question I am asking was the job at point one a temporary low income reflecting her temporary position as a student
and the job now reflects her lifetime earnings potential that is a reflection of the good
childhood education, etc, that she had because of her parents income

spencer writes:

December-- actually, I was in agreement with you that tax policy does discourage output. The point I made, that you ignored, is that maybe we ought to take tax policy in the other direction. Rather than raising the tax on labor and lowering the tax on capital -- current policy --we should be lowering the tax on labor and raising the tax on capital.

What evidence do we have that capital should be taxed at a lower rate than labor?

mcwop writes:

Spencer, my wife's job at point A was her full time gig. Her parents are poor filipino immigrants. She had a career in retail, but decided to go to nursing school in hopes of a better career. She paid for the school herself. The theory that income mathces that of your father ignores that may be due to education and not necessarily income. Someone from a higher income family may put more emphasis on school, but most people have access to education - if they want one.

You are right that tax cuts have had little impact on income growth. Taxes determine how much of your income you keep, but has little to do with what you get paid. But then again, I believe there should be a low flat tax on income and capital.

I do have a serious question? Were taxes really cut during the 1980's? In other words what was the total tax burden of individuals before 1980 and after. There were actually quite a few tax increases after 1980 (1986 tax reform, payroll tax increase, Clinton tax increases). You must also factor in state taxes, sales taxes etc... My hunch is that effective tax rate have been very stable over time.
http://www.truthandpolitics.org/fed-tax-burden-cbo.php

Michael writes:
but if you look at the data comparing real growth and welfare the period prior to 1980 experienced a significantly higher of real growth and real income growth. This was my point, that the tax cuts have had little impact.

While there is certainly nothing untrue about the above comment, it ahs the feel of a broken-window argument. That which is not seen in the above quote is what economic growth and real income growth would have been in the absence of the tax changes. The counterfactual is extremely difficult to test reliably given the small number of data points.


we should be lowering the tax on labor and raising the tax on capital

To achieve what ends? Higher personal income? Higher GDP growth? Higher tax revenues? Regardless, this is a normative statement. I feel like we should be lowering taxes on both labor and capital if our goal is to expand incomes and expand GDP growth (and for many other reasons).


Moreover, if you look at the recent work by the Fed of Minn. that looks at life time earnings they are finding that income mobility is much lower than generally assumed. They are finding that something like 60% of lifetime earnings is determined by ones fathers income.

Three comments here:
1. This still means that 40% of lifetime income is determined by "other" factors - certainly not an amount to scoff at. I'd also be curious to see whether they explored any nonlinearities in this relationship. In addition, income is not the same as compensation, and the non-pecuniary share of total compensation now makes up an average of 30% of total compensation in the U.S.

2. I can make unconditional data tell just about any story that I want it to. It occurs to me that the slower income mobility you are citing comes at the same time as disability, welfare, etc. programs have expanded enormously.

3. The study you cite still only represents averages. While on average 60% of a randomly selected person's earnings are due to her father's income, for some it might be 100% and for others 10%. MCWOP's and my stories are cases in point. I grew up with 8 people in a two-bedroom, 850 square foot apartment in Queens. My father supported all of us on less than $30,000. How come I was able to be upwardly mobile? Not because my father went to Harvard (he went to Queens College at night while working full-time), not because we were wealthy (our first new car came in 1985 after my oldest brother turned 19 - we crammed all 8 of us into a used Buick sedan until then), ... but because my father and mother taught us the importance of hard work, discipline and personal responsibility. Many of the families we grew up with that were more fortunate than us are no better off today than they were in the 1980s. It is not hard for me to see why. Ultimately, we are talking about real people here, not aggregated statistics.

Happy Holidays.

Bob Knaus writes:

I unsay my comment about the lack of lower middle class upbringing amongst posters on this blog. Apparently there are more of them out there than I thought.

My birth certificate doesn't have an address on it, because the woods where we lived wasn't zoned for trailers. I only went to school through 10th grade, then finished up my diploma through a mail-order course. From age 15 through 19, I was a sharecropper on my father's farm and got paid once a year.

Then I started programming on PC's, and opened a business, and hired techs, and became a network engineer. I was even a management consultant for a few years, giving advice to local governments.

Now (at age 42) I am semi-retired, living on a sailboat in the Caribbean. Hooray for income mobility!

Since it's the season for cheer, how about some other success stories?

Happy holidays to all!

Capt. Bob Knaus
S/V PELLUCID
www.pellucid.org

spencer writes:

Just to point out that I am not out of line with the others in this sample. My parents went to Berea college in Ky during the depression .
If you are not familiar with Berea,it is a very unusual school. If you can afford to go anywhere else they will not take you -- you have to work your way through. He was a school principle and she was a school teacher in rural, southern Appalalachia. I got my near PhD in economics and worked in govt and the Boston investment community and have operated my own economic consulting firm for the last 20 years and am now comfortably semi-retired.

I agree we have a great system that allows people to work their way up and make it to upper income
groups. But what I see happening is that the system is actually making this more difficult to do now. When I went to school in the 1960s a middle class kid could get through school without taking on masive debt. That is no longer true.
Moreover, it was fairly simple to get aid for grad school, and if you could not get a fellowship for grad school you did not belong there.

Now, almost everything the republicans are doing in the way of tax policy is aimmed at making our system more and more an upstairs-downstairs society and making it more and more difficult to have upward income mobility. Moreover, if you look at the data you see there was a break point about 1980 in the well being of the middle class. For example,if you look at the share of families in the 20th to 94th percentiles it fluctuated around 80% prior to 1980. After 1980 it has fallen just about every year as the share of income absorbed by the top 5% has risen from around 15% prior to 1980 to about 22% now. There has been a significant shift in the economic wellbeing of the middle class. This clear break in trend coincided with the shift in tax policy under the Reagan admin and continued since then.

I agree there is no such thing as a good tax, all taxes distort economic signals. On the other hand, there is no good evidence that the modern mixed economic system is inferior to the small
government system you dream about. For example, in the golden era of free market capitalism from the civil war to WW I US per capita real income actually grew at a slower rate than it has since WW II. Moreover, the old system was highly volatile -- for example the stock market was
in a bear market almost 50% of the time prior to ww II.

My radical proposal is to have a real, effective inheritence tax that would take in large sums -- the current inhereritance tax is essentially a voluntary tax -- and use the large sums that could be raised to lower income taxes.This would create much smaller distortions to the economic system. Morally, It would also be a superior system -- What is the difference between someone living on a trust fund and a welfare queen.

spencer writes:

December shows data for income growth since 1979.
But does not compare it to data prior to 1979. In the 20 years 1960 to 1980 real family mean income grew at a 2.4% rate. Since 1980 it has grown at a 1.5%. That is my point, there was a break in out economic wellbeing that coincided with the shift in tax policy about 1980.

Of course the shift was due to many things, but at a minimum you can not demonstrate that the lowering of tax rates since 1980 generated an improvment of US economic performance.

Michael writes:
But does not compare it to data prior to 1979. In the 20 years 1960 to 1980 real family mean income grew at a 2.4% rate. Since 1980 it has grown at a 1.5%. That is my point, there was a break in out economic wellbeing that coincided with the shift in tax policy about 1980.

Of course the shift was due to many things, but at a minimum you can not demonstrate that the lowering of tax rates since 1980 generated an improvment of US economic performance.

Have you not been reading our above posts? I make no claims that lowering taxes led to improved economic performance because it would be awfully speculative - just as your claim that it led to worse performance is. It is simply not good economics to make statements like this.

When I went to school in the 1960s a middle class kid could get through school without taking on masive debt. That is no longer true. Moreover, it was fairly simple to get aid for grad school, and if you could not get a fellowship for grad school you did not belong there.

I happen to study higher education, public higher education finance in particular. I find the above comment to be a bit misleading. Average public university tuition (in-state) is still less than $5,000 per year (higher in some states like MI and VT and much lower in others like my current home state of KY). So, even in the absence of merit aid programs, students can still get through 4 years of public college without taking on substantial amounts of debt.

Furthermore, I don't believe "the system" is making it more difficult to get to and through college, I think it's been working the other way. The popularity of low cost two year colleges has exploded, the rise of for-profit colleges has given many people opportunities to "attend" college in ways that are much more convenient than in the past, many states are refocusing their efforts on student aid programs (though likely for political reasons), the share of high school graduates going on to college is extraordinarily high, though it has dipped a bit in recent years, etc. If there is a problem, it's the problem of students not completing college once there. Some of this attrition is due to financial factors indeed, but a majority of the attrition is due to other factors such as poor academic preparation.

I happen to still believe that there are strong positive externalities to investments in higher education, contrary to many people I know. So, I do believe there is an important role for government to play in encouraging folks to get through college. However, it is abundantly clear that our higher education system is sick, and the illness is not due to a lack of governmental support. Given the competitive environment in higher education today, we are stuck in a bad equilibrium where society would be better off if all colleges changed the way they did business, but no one college has an individual incentive to change its behavior.

Now, almost everything the republicans are doing in the way of tax policy is aimmed at making our system more and more an upstairs-downstairs society and making it more and more difficult to have upward income mobility.

I find this offensive (note that I am not a Republican). Taken literally, it sounds like you are saying that republicans are increasing taxes for poor people. If I am a republican strategist and I'm looking at the fastest growing segments of the population and the fastest growing regions of the country, in order to rally support for my party I would be doing exactly the opposite of what you claim they are doing. Immigrants come here with the dream of upward mobility. The Hispanic population is growing enormously and it is clear that the republican party is aggresively courting their votes - would they really be interested in "keeping them down?" I just refuse to buy into the idea that either the Democrats or the Republicans (as a group) have subversive intentions. Do you really think George Bush doesn't want the poor to have access to health care? Do you really think John Kerry thinks that rich people and corporations are evil and do no good for the US? No, I simply don't believe this.

Michael writes:
I agree there is no such thing as a good tax, all taxes distort economic signals. On the other hand, there is no good evidence that the modern mixed economic system is inferior to the small government system you dream about.

Once again, you are making claims where the counterfactuals are impossible to substantiate. There also does not happen to be any evidence whatsoever that "modern" mixed economic systems are superior. Further, why do you mock my "dream" as if it is some sort of ludicrous desire? Is wanting more freedom an unreasonable desire? Should I mock your desire to have less? My real dream is not to have everyone be subject to small government, but for everyone to have the choice to live under small or large governments as they wish. I left NY for KY partially for the additional freedoms I enjoy down here. However, the more imposing our federal government becomes, the less freedom I have to choose the system I'd like to live under. I have no problem if NY wants to have huge inheritance taxes and a substantial welfare system and government funded schools, as long as I have the freedom to go somewhere that does not have those things.

For example, in the golden era of free market capitalism from the civil war to WW I US per capita real income actually grew at a slower rate than it has since WW II. Moreover, the old system was highly volatile -- for example the stock market was in a bear market almost 50% of the time prior to ww II.

I've never read anywhere that this was the golden era of free-market capitalism. This time has yet to come and it is doubtful it ever will.

My radical proposal is to have a real, effective inheritence tax that would take in large sums -- the current inhereritance tax is essentially a voluntary tax -- and use the large sums that could be raised to lower income taxes.This would create much smaller distortions to the economic system. Morally, It would also be a superior system -- What is the difference between someone living on a trust fund and a welfare queen.

Now we are getting into morals? If this is the case, I find the above comment morally repugnant. I'd love to see data on the share of Americans living on trust funds versus the share living off income maintenance. Now, I'm 30 years old and starting a family. You are telling me that putting money away now so that my own children and grandchildren can get a better start in life is morally inferior to ...? You are saying that my children have to start with nothing, because that's fair to everyone else that had parents that did not have the means or foresight to take care of their children? What do you suggest I do? If you are worried about savings problems in the US, which you mentioned above, wouldn't an enormous inheritance tax kill the savings incentive? Wouldn't it also encourage behavior among the really wealthy that is less desirable than the problems you hint at above? Now, I have no intention (or means) to have my children live off of my trust fund - but wouldn't this still be better for society if the money in my fund was available for entrpreneurs to access for capital than if there were no fund there at all?

Have you seen research estimating the elasticities of inheritance taxes versus income taxes (and consumption taxes)? I have not, but I suspect inheritance taxes are highly elastic due to the long-run nature of the question at hand.

Why do you prefer high inheritance taxes to a system of consumption taxes? We could exempt all families making less than $25,000 or some other threshold from paying any consumption taxes at all. This would preserve the incentives to save, produce, invest and bequest.

Happy Holidays. By the way, my name is Michael, not December.

jaime writes:
What other industries would be most sensitive to tax rates?

I am a professional engineer experienced in a very special field. In addition to my salaried job, a few years ago started consulting and I found that there is demand for this kind of short-term, occasional specialist work. The marginal income tax rate in this country (Israel) is 58% and there is an additional Social Welfare tax of 18%. Since I love consulting projects (to be a respected "etzesgebber" - advice giver - without responsability), I continued to do it. But consulting is considered by tax people as a business and I was forced employ an accountant and pay advances and so on. The worse was the constant harassment: official letters asking for all kinds of permits, for copies (they regularly lose papers and request authenticated copies), for explanations of things done six years ago, they put you in the follow-up list and investigate your activities during the last 7 years or from the unfortunate day you first put your foot in this land, they investigate your wife and baby daughters, and so on.

The economic consequence is that Israelis search for consulting in foreign countries, and second, that companies requiring short time occasional expertise are forced to maintain and employ full time (and underused) specialists or do without their services.

I mean that any tax rate, badly enforced, will damage all economic activities. In case of consulting, lecturing, etc. - it kills it.

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