Taxes, Demand and the Importance Or Otherwise of Incentive Effects

The Atlantic cites a 65-year study indicating that “tax cuts don’t lead to economic growth” (h/t Tom Hickey). On closer inspection, the study finds more specifically that tax cuts on the wealthy fail to promote economic growth while exacerbating inequality. This should not be surprising to anyone cognizant of basic macroeconomic principles, but to make that point is not to downplay the value of the study. Many have made claims contrary to the findings of the study. If we consider the effects of taxes more generally, our conclusion is likely to be less sweeping. The effects of taxation vary depending on what particular tax we have in mind and the context in which that tax operates. The matter can be considered both in terms of demand effects and so-called incentive effects.

In terms of demand, most first-year economics students come to understand that, other factors remaining equal, an additional dollar of government spending is somewhat more expansionary than the same sized tax cut. This result is sometimes discussed in terms of the ‘balanced budget multiplier’. The reason for the result is that extra government spending directly adds to aggregate demand in the first round of the multiplier process. Since spending equals income, by definition, government expenditure, like any expenditure, has an immediate macroeconomic impact. A tax cut, in contrast, does not all go to spending in the first round of the multiplier process. Some of the tax cut will be saved. In the case of a tax cut for the wealthy, quite a lot of the tax cut will be saved, because the wealthy have a relatively low marginal propensity to consume.

This result does not rule out the possibility that a particular kind of tax cut could be as expansionary as some kinds of government spending. Different spending measures have different multipliers, as do different tax measures. Tax cuts – or, equivalently, additional transfer payments – that are targeted at low and middle-income households are likely to be mostly spent, adding to income. If that spending goes through channels involving relatively low leakage from the circular flow of income, then such a tax cut could have a bigger overall impact on demand than a form of government spending that, in the first instance, mainly benefited the rich. The initial impact of the government spending can never be less than that of an equivalent tax cut, and will almost always be greater, but later rounds of the multiplier process could conceivably offset this.

For growth prospects to be significantly enhanced by a tax cut, it seems clear that there would need to be a reduction in taxes relative to government spending. ‘Supply siders’, however, have often claimed, to the contrary, that tax cuts alongside government spending cuts can have a significant impact on growth due to supply-side (rather than demand-side) effects. In particular, there has often been an appeal to ‘incentive effects’. In reality, though, there is little justification for a strong claim along these lines.

One distinction relevant to the incentives issue is between endogenous and exogenous taxes. Taxes that are directly applied to income or consumption are endogenous in the sense that tax payments will rise and fall directly with the level of income. Lump sum taxes, on the other hand, are exogenous. They do not depend on the level of income.

Consider a simple head tax that required every citizen of working age to pay a certain amount, irrespective of his or her income. This is an example of an exogenous tax. Far from creating a disincentive to work or invest, such a tax would intensify the economic compulsion felt by most individuals to supply labor services or invest productively.

Taxes on wealth similarly entail an element of coercion, a coercion that increases with the level of the tax. A completely confiscatory tax on wealth would compel the wealthy to join the ranks of the working class and work for a wage.

It is perhaps worth noting, in passing, that if exogenous taxes could be said to create a disincentive to work, then by the same logic lump-sum transfers – such as a basic income scheme – would create an incentive to work. Yet, supply siders have been in the forefront of those who demand cuts to unemployment and welfare payments on the grounds that such transfers create disincentives to work.

If anything, then, exogenous taxes would seem to incentivize work, just as lump-sum transfers are likely to do the opposite, with possible exceptions, at least according to mainstream theory, at the bottom of the income scale, due to the high effective marginal tax rates faced by those moving from unemployment to employment. (Of course, the intention here is not to argue for an increase in exogenous taxes and an intensification of the economic compulsion on individuals to supply labor services. It is simply to point out that the incentive effects of taxes are often not those claimed by supply siders.)

Nor is it obvious, overall, that endogenous taxes create disincentives to work or invest. For most people, those essentially surviving from one paycheck to the next, a heavier income-tax or consumption-tax burden will increase the compulsion to supply labor services in much the same way as the introduction of an exogenous tax. The less income workers retain after paying income and consumption taxes, the more they will need to work simply to maintain their current standard of living (unless an increase in public provision of free goods and services makes up the difference).

In terms of mainstream theory, it could be said that, for the majority, the ‘income effect’ of a tax increase is likely to more than offset the ‘substitution effect’. According to the substitution effect, a tax hike makes leisure more attractive relative to work. The ‘opportunity cost’ of leisure (the forgone after-tax wage) is reduced when income taxes are increased. But, in opposition to this, the income effect says that it will now be less affordable for the individual to choose leisure. A cut in the after-tax wage will mean that individuals need to work additional hours to maintain their standard of living. For those with debt commitments or struggling to get by, the option of choosing more leisure in response to a lower after-tax wage is unlikely to be considered viable.

Of course, the notion that the typical individual is in a position to alter hours of employment at will is fanciful to begin with. Most workers take what they can get. The more desperate their circumstances, the more draconian the pay and conditions that they can be pressured into accepting.

Regarding investment, clearly subsidies and other tax breaks for investors will encourage private investment, other factors remaining equal. However, the strength of these effects will ultimately depend on the state of overall demand in the economy. If demand conditions are weak, the impetus to invest is also likely to be weak, tax breaks or no tax breaks. In this respect, tax breaks are not much different from interest-rate cuts. Whereas an act of spending adds directly to income, an investment subsidy or tax break works only indirectly as an inducement to invest. The strength of the inducement is uncertain.

In any case, once it is recognized that investment includes not just private but also public investment, there is no necessity to incentivize private investment. Even if a change in taxes happens to discourage private investment, a currency-issuing government can always take up the slack. Not only can government maintain levels of overall investment spending, but doing so is likely to maintain conditions conducive to private investment. This is likely for both supply and demand-side reasons. On the supply side, public investment in infrastructure sets a foundation for more efficient and cheaper private production and investment. As with other supply-side effects, whether the potential is realized will still be contingent on demand. On the demand side, public investment, like any form of exogenous expenditure, has a multiplier effect on income that is likely to encourage, rather than discourage, private investment.

In closing, the purpose of the present discussion has not been to claim anything definitive about the effects of taxes but simply to observe that: (i) the demand and incentive effects of taxation are far from uniform, and in many cases the incentive effects are likely to work in the opposite direction to those claimed by supply siders; (ii) notwithstanding any incentive effects, a currency-issuing government always has the fiscal capacity to maintain demand and to facilitate socially beneficial production irrespective of the preferences of private corporations or profit considerations.

Needless to say, a government in cahoots with the most powerful corporations and financiers will not use its fiscal capacity for the benefit of ordinary citizens unless ordinary citizens first become aware of this capacity and stand up as one to demand responsible application of it.

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One thought on “Taxes, Demand and the Importance Or Otherwise of Incentive Effects

  1. Speaking of taxes, no blog yet on the refreshing developments in Greece? Included in those is the creation of a new ministry tasked with cracking down on the rampant tax evasion and on other corruption.

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