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Desirable Incentive Effects of Income Taxation III

Summary:
This is the third post in a series. I will discuss advantages of income taxation different from the obvious advantage that taking from people with high income hurts them less than taking from people with low income. Here again, I will assume that, in equilibrium, income tax is returned to the people who pay it as a lump sum. I do this to focus on the incentive effects of income taxation. The first two posts are here and here. In standard models, these effects are undesirable and amount to a deadweight loss which is second order in the tax rate. However, the standard models rely on standard assumptions which are completely implausible. They are used, because it is guessed that the policy implications don’t depend on the absurd assumptions.

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This is the third post in a series. I will discuss advantages of income taxation different from the obvious advantage that taking from people with high income hurts them less than taking from people with low income. Here again, I will assume that, in equilibrium, income tax is returned to the people who pay it as a lump sum. I do this to focus on the incentive effects of income taxation.

The first two posts are here and here.

In standard models, these effects are undesirable and amount to a deadweight loss which is second order in the tax rate. However, the standard models rely on standard assumptions which are completely implausible. They are used, because it is guessed that the policy implications don’t depend on the absurd assumptions. The policy implications always, in fact, follow from the assumptions.

In this post, for the third and last time, I will relax the assumption that people are 100% purely selfish and care only about their own consumption and leisure. Instead I will assume that people maximize the sum of their pleasure from consumption and leisure plus a constant far less than one times other people’s pleasure from consumption and leisure.

In this post, I will assume that all people have the same wealth and ability so all have the same income. This rules out egalitarian benefits from income taxation and the interaction of partial altruism and inequality which was the focus of the first two posts.

In the first two posts I assumed that there is perfect competition and that all people are self employed, that they produce goods with labor alone . I noted that both of those extreme assumptions rules out beneficial incentive effects of income taxation. In this post, I will back up that claim. This is fairly obvious so the post will be brief.

First it is clear that the combination of imperfect competition and partial altruism implies beneficial incentive effects of income taxation.

A profit seeking monopolist will charge a markup on marginal cost implying demand sales and production below the level that maximizes the sum of consumer and producer surplus. A perfectly altruistic monopolist will charge marginal cost maximizing the sum of consumer and producer surplus (which is equivalent to maximizing total welfare from consumption and leisure given the assumption of a perfect equality and therefore a representative agent). A partially altruistic monopolist will chose a price between marginal cost and the profit maximizing price.

An income tax whose revenues are rebated lump sum reduces the advantage of pre-tax profits, but does not reduce the contribution of the monopolist’s production to consumer plus producer surplus. So the income tax will cause lower optimal markups and bring the equilibrium towards the perfect competition equilibrium.

I don’t see any reason to restate this argument with equations and algebra. Imperfect competition creates a difference between maximizing profit and maximizing the contribution to social welfare. Iif people care (even a little) about their contribution to social welfare, reducing incentives to maximize profit increases the relative weight they put on social welfare. This is a first order benefit of income taxation.

Similarly, employer-employee interactions can create beneficial effects of income taxation if the employers are partially altruistic. If the employer is a monopsonist, the logic is identical to the logic above.

More generally, if there is involuntary unemployment for any reason, a partially altruistic employer will hire people partly to gain their marginal product and partly to help them. Altruism will cause higher employment. As always, weakening the profit motive means that the un-weakened altruistic motive will have a larger effect.

In particular, there are a large number of plausible efficiency wage models in which firms do not pay the lowest wage they can pay and still hire workers to fill vacancies. In these models there is a profit maximizing wage and deviations from that wage have second order effects on profits. In these models even a very weak altruistic motive can have a large effect on wages. As always, income taxation weakens the standard economic motives but does not weaken altruistic motives. Other things equal it causes employers to pay higher wages. This increase in wages does not lower demand for labor, because it is voluntary – employers prefer to pay higher wages so the higher wages do not discourage them from hiring.

I consider the assumption of partial altruism to be obviously more realistic than the assumption of perfect selfishness. However, I want to address other issues. So, from now on, I will assume that people are selfish.

Before moving on, I should mention one efficiency wage argument which sounds very much like the assumption of partial altruism, but which is quite different. One model of efficiency wages, which has extremely strong support both from hard data and from interviews with employers, is the morale model. The argument is that in employment relationships there is a partial gift exchange – employers pay more than the minimum they have to pay to fill vacancies and workers work harder than the minimum to avoid being fired. Importantly, the workers are assumed to care about whether they are fairly treated and this is separate from their desire for consumption and leisure. Also, obviously, it is not altruism.

Similarly, it is plausible that employers just don’t want workers to feel unfairly treated and to be angry with them. This is a motive different from the concern that angry workers will not work as hard or as well. Especially in a small firm, the proprietor just doesn’t want to work around people who are angry with him or her. The fear of others’ anger and the desire for their gratitude is not true altruism. However, it works just as well and implies the same beneficial effects of income taxation.

Robert Waldmann
Robert J. Waldmann is a Professor of Economics at Univeristy of Rome “Tor Vergata” and received his PhD in Economics from Harvard University. Robert runs his personal blog and is an active contributor to Angrybear.

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