How Taxes Affect Economic Behavior

By Henry J. Aaron; Joseph A. Pechman | Go to book overview
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Labor Supply

ALTHOUGH income and payroll taxes account for 75 percent of federal revenues, most economists have concluded that they cause little reduction in the supply of labor and do little harm to economic efficiency. The results of this study contradict that comforting view. Direct taxes on income and earnings significantly reduce labor supply and economic efficiency. Moreover, the replacement of the present tax structure by a rate structure that proportionally taxes income above an exempt amount would eliminate nearly all of the distortion of labor supply and more than half of the economic waste caused by tax-induced distortions.

Income taxes, in principle, can cause people to work either more or less. Taxes lower the net wage and reduce the labor supply through the compensated substitution effect. But taxes also reduce income, causing people to consume less of all normal goods, including leisure. Thus taxation of labor income can well lead to either more work effort or less. Besides the direction of change, of interest is the size of the effect. One task of this paper is to measure the effect of the existing tax system and of alternative tax systems on the supply of labor.

This paper also reports estimates of the effect of the current tax system on individual welfare. It is a common misconception to assume that a tax is not distortionary if it has little or no effect on market behavior. On the contrary, taxes affect economic efficiency through the compensated substitution effect. If the income effect and the substitution effect offset each other exactly, a tax could still leave individuals much worse off than

I am grateful to Henry Aaron, Cary Brown, Peter Diamond, and Dan Holland for helpful suggestions; to Margaret Tsang, John Hamilton, and Paul Ruud for research assistance; and to the National Science Foundation for research support.


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How Taxes Affect Economic Behavior


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