James d. Gwartney

ELEMENT 2.6
People produce more when they can keep more of what they earn.

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€75 if they earn an additional €100. But, if the marginal tax rate rose to 40 percent, then the
taxpayer would get to keep only €60 out of a €100 increase in earnings.
There are three reasons why high marginal tax rates will reduce output and income.
First, high marginal tax rates discourage work effort and reduce the productivity of labor.
When marginal tax rates soar to 55 or 60 percent, individuals get to keep less than half of their
additional earnings. When people are not allowed to keep much of what they earn, they tend
not to earn very much. Some, perhaps people with working spouses, will drop out of the labor
force. Others will simply work fewer hours, retire earlier, or take jobs with longer vacations or
a more preferred location. Still others will be more particular about accepting jobs when
unemployed, refuse to move to take a job or to gain a pay raise, or forget about pursuing that
promising but risky business venture. High tax rates can even drive a nation’s most productive
citizens to countries where taxes are lower. Such movements will reduce the size and
productivity of the available labor supply, causing output to decline.
Video:
Portugal Hopes to become a Pensioner's Paradise with Zero Tax Offer
Of course, most people will not immediately quit work, or even work less diligently, in
response to an increase in the marginal tax rate. A person who has spent years training for a
particular occupation will probably continue working—and working hard—especially if that
person is in the peak earning years of life. But many younger people who have not already
made costly investments in specialized training will be discouraged from doing so by high
marginal tax rates. Thus, some of the negative effects of high tax rates on work effort will be
felt in the form of reduced productivity for many years in the future.
High tax rates will also cause some people to shift to activities in which they are less
productive because they do not have to pay taxes on them. For example, high taxes will drive
up the costs of skilled painters, perhaps leading you to paint your own house, even though you
lack the skill to do it efficiently. Without high tax rates, the professional painter would do the
job at a cost you could afford, and you could spend your time doing work for which you are

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better suited. Waste and economic inefficiency result from these tax-distorted incentives.
Second, high marginal tax rates will reduce both the level and efficiency of capital
formation. High tax rates repel foreign investment
(?)
 and cause domestic investors to search
for investment projects abroad where both taxes and production costs are lower than at home.
This reduces investment and the availability of productive equipment, which provides the fuel
for economic growth. Domestic investors will also turn to projects that shelter current income
from taxation, and away from projects with a higher rate of return
(?)
 but fewer tax-avoidance
benefits. These tax shelters enable people to gain personally from projects that do not enhance
the value of resources. Again, scarce capital is wasted, and resources are channeled away from
their most productive uses.
Third, high marginal tax rates encourage individuals to consume tax-deductible
(?)
goods in place of nondeductible goods, even though the nondeductible goods may be more
desirable. When purchases are tax-deductible, individuals who purchase them do not bear their
full cost, because the expenditure reduces the taxes they would otherwise pay. When marginal
tax rates are high, tax-deductible expenditures become relatively cheap.
The sales of the British-made luxury car Rolls-Royce in the 1970s provide a vivid
illustration of this point. During this era, the marginal income tax rates in the United Kingdom
were as high as 98 percent on large incomes. A business owner paying that tax rate could buy a
car as a tax-deductible business expense, so why not buy an exotic, more expensive car? The
purchase would reduce the owner’s profit by the car’s price—say £100,000—but the owner
would have received only £2,000 of his or her profit anyway, because the 98 percent marginal
tax rate would have reduced the £100,000 to £2,000. In effect, the government was paying 98
percent of the car’s costs (through lost tax revenue). When the United Kingdom cut the top
marginal tax rate to 70 percent, the sales of Rolls-Royces plummeted. After the rate reduction,
the £100,000 car now cost the business owner not £2,000 but £30,000. The lower marginal
rates made it much more expensive for wealthy Brits to purchase Rolls-Royces, and they
responded by reducing their purchases.
High marginal rates artificially reduce the personal cost, but not the cost to society, of
items that are tax-deductible or that can be taken as a business expense. Predictably, taxpayers
confronting high marginal tax rates will spend more money on such tax-deductible items as

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plush offices, Hawaiian business conferences, business entertainment, and a company-provided
automobile. Because such tax-deductible expenditures reduce their taxes, people will often buy
goods they would not buy if they were paying the full cost. Waste and inefficiency are
byproducts of high marginal tax rates and the perverse incentives they generate.
Reductions in tax rates, particularly high rates, can usually increase the incentive to
earn and improve the efficiency of resource use. The government of Georgia made radical
changes to tax legislation from 2005 to 2008. The 21 different tax rates that were applied in
2004 were reduced to 6 in 2005. From 2009, aggregated taxes (income tax and social tax
together) were reduced by abolishing social tax and implementing a single personal income
(?)
tax rate. The marginal income tax was reduced from 32 percent to 20 percent.
The disincentive effects discussed above have caused many economists to advocate for
what is called a “flat tax,” under which the marginal tax rate is the same for all income levels
above a certain minimum. The untaxed minimum, if high enough, can still mean that actual
taxes paid as a percentage of income increase as families get wealthier. Many post-communist
governments have been leaders in moving to flat taxes, including Russia, Georgia, Slovakia,
and Serbia. As predicted, there is research showing that such policy causes a decrease in the
share of economic activity that happens “off the books” in what is called the shadow or
underground economy.
In contrast, large tax increases can exert a disastrous impact on the economy. United
States tax policy during the Great Depression illustrates this point. Seeking to reduce the
federal budget deficit in 1932, the Republican Hoover administration and the Democratic
Congress passed the largest peacetime tax rate increase in the history of the United States. The
lowest marginal tax rate on personal income was raised from 1.5 percent to 4 percent. At the
top of the income scale, the highest marginal tax rate was raised from 25 percent to 63 percent.
Essentially, personal income tax rates were more than doubled in one year! This huge tax
increase reduced the after-tax income of households and the incentive to earn, consume, save,
and invest. The results were catastrophic. In 1932, real output fell by 13 percent, the largest
single-year decline during the Great Depression era. Unemployment rose from 15.9 percent in
1931 to 23.6 percent in 1932.
Just four years later, the Roosevelt administration increased taxes again, pushing the

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top marginal rate to 79 percent in 1936. Thus, during the latter half of the 1930s, high earners
were permitted to keep only 21 cents of each additional dollar they earned. (Note: It is
interesting to contrast the words of candidate Roosevelt presented at the top of this element
with the tax policy followed during his presidency.) Several other factors, including a huge
contraction in the money supply and a large increase in tariff rates, contributed to both the
severity and length of the Great Depression. But it is also clear that the tax increases of both
the Hoover and Roosevelt administrations played a major role in this tragic chapter of
American history.
The disincentive effects of high marginal tax rates are not just an issue for those with
high earnings. Many people with relatively low incomes also confront high implicit marginal
tax rates, the combination of additional taxes plus the loss of benefits from income-tested
transfer programs. For example, suppose that an individual’s income increases from €20,000
to €30,000 and, as a result, income and payroll taxes take 30 percent of the additional
earnings. Further, because of this increase in income, the individual loses €5,000 in benefits
from existing social programs. He or she would confront an implicit marginal tax rate of 80
percent! Thirty percent would come in the form of a higher tax bill and an additional 50
percent in the form of lost transfer benefits.
People in this position who earn an additional €10,000 get to keep only 20 percent of
it. Obviously, this will substantially reduce their incentive to earn and make it more difficult to
move up the income ladder. We will return to this issue in Part 3, Element 8, when examining
the impact of transfer programs on the poverty rate.
In summary, economic analysis indicates that high tax rates, including implicit rates
reflecting the loss of transfer benefits, will reduce productive activity, impede both
employment and investment, and promote wasteful use of resources. They are an obstacle to
prosperity and the growth of income. Moreover, large tax rate increases during a period of
economic weakness can exert a disastrous impact on the economy.