Average vs. marginal tax rates

by on June 7, 2004 at 7:30 am in Economics | Permalink

Not long ago I asked whether the marginal or the average tax rate had more influence on economic behavior. Too often economists take the measured marginal rate as the true trade-offs faced by the individual.

The ever-insightful Randall Parker recently emailed me the following, in support of the point:

1) People in conventional regular jobs do not have total control over how many hours they work or their income. For lots of jobs it is all or nothing. Either you work full time or you don’t work at all. You are on a salary. What you make is what you make. The marginal tax rate for the next dollar doesn’t matter to you since you don’t have much control over whether you get a raise.
You can’t boost or lower your income much in a given year. The alternatives that would give you more control are too risky or lower in income per hour worked or unappealing in some other way.

2) People in entrepreneurial pursuits often have far less predictability of income. It is hard to work harder or less hard in a given year as a reaction to marginal tax rates because you just do not know how many of the deals you are working on will close by the end of the year or when various billables out there will generate a check in your in-box. Believe me on this one if you haven’t been in this position. It is a real situation for lots of people.

3) You can’t predict in advance what your tax burden will be. Hey, only the tax expert can figure it out. How much will you get to keep? You’ll find out when he tells you. Kinda hard to behave during the work year as if you are responding to a known marginal tax rate at any given point.

4) Customers won’t let you respond to a known marginal tax rate. Again, this is a variation on the theme of a lack of control. You make deals early in the tax year and earn income at a low marginal tax rate. Then as the year goes along you keep a smaller fraction of what you earn. What to do about it? Laze off. Take a trip. Oh wait, your customers won’t let you. Still want them to be there in January when the marginal tax rate drops again? Well, you have to work hard to service their needs in the last 6 months of one year to get the lower tax rate income of the first six months of the following year. This means you have to work at a high marginal rate to get the low marginal rate income. Thinking of your tax rate as an average then makes more sense, doesn’t it?

5) On an even longer time scale people choose their careers at the beginning in part based on what they will make. If an economy has a high marginal tax rate then that can be an incentive to choose a less demanding and lower income career path. In that scenario it may make more sense to go for high job security since you could be faced with a tax schedule where you get more after-tax income making say, $50,000 for two years in a row than making $200,000 one year and $0 the next year.
I’d expect a shift toward lower marginal tax rates to most heavily impact career choices. So the impact would gradually increase as more people managed to retrain for higher income careers.

The bottom line: If you want to encourage private economic activity, don’t focus obsessively on measured marginal tax rates. True marginal rates tend to move closely with the size of government more generally. I’ve said it before and I’ll say it again: government spending is a better measure of our fiscal burden than marginal tax rates.

My thanks again to Randall for writing. And while you are at it, read Randall’s post on how trade protectionism makes us fatter and less healthy.

Addendum: Here is a useful recent piece on what the Laffer curve was all about, by Laffer himself.

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