Incentive Effects of Higher Wages

By James Kwak

My Atlantic column this week is on a familiar theme: why don’t Barack Obama and Democrats provide an clear alternative vision to the Romney-Ryan state of nature, instead of slowly stumbling along in the Republicans’ wake? But it also brings up a question that I haven’t seen before.

The theoretical argument against higher tax rates is that it reduces the incentive to work because it changes the terms of the tradeoff between labor and leisure. That is, higher taxes reduce your effective returns from labor, while your returns from leisure remain constant, so you will substitute leisure for labor.

In the long term, however, real wages tend to go up; even in the past three decades, which have generally been bad for labor (and good for capital), they’ve gone up by about 11 percent. If tax rates remain constant, that should increase the effective returns to labor, causing people to substitute labor for leisure (i.e., work more). Put another way, you could increase tax rates and keep the tradeoff between labor and leisure constant.

I generally don’t buy these pure theoretical arguments, but my point is that if you believe that higher taxes reduce labor supply through the substitution effect, then you should acknowledge that the effect of higher taxes could be swamped by growth in real wages.

24 thoughts on “Incentive Effects of Higher Wages

  1. Higher wages also means an increase in concentrated effort to perform better and better, such as that professed by the athletes making up the New England Patriots football club, as well as some government nerd toiling daily in a small cube with a lucky window seat.

  2. If you haven’t seen discussion of the income v. substitution effect, then you haven’t read very widely in the econ literature. For instance;

    When the government cuts a marginal tax rate, and that’s all it does, that cut has two effects in opposite directions: a substitution effect and an income effect.

    The substitution effect is to make leisure more expensive. If you’re facing a 35% marginal tax rate (MTR), for example, and the rate is cut by 20% to 28%, your “price” of leisure rises by (72 – 65)/65, or 10.8%. When the price of a normal good rises (and leisure is a normal good), you buy less of it. So people work harder.

    The income effect is to make you buy more leisure. The cut in marginal tax rates increases your real income and therefore you demand more leisure. That is, you work less.

    I could easily find a dozen more examples.

  3. NORMAL minded and healthy people want to lead interesting and productive lives. A lot of what makes life interesting and productive is living in a civilization where there are a lot of interesting and productive people doing cool stuff like figuring out how to capture some of the energy from lightening bolts :-)

    Taxation in USA does NOTHING to make that possible for the greatest number of citizens in the country!

    Of course for people like Paddy, all he wants is his booze and the algorithm that allows him to steal from grandma…

  4. It is always “refreshing” to be reminded by the upper class that they face a trade-off between labor and leisure. Their existing property holdings return sufficient unearned income that they don’t in fact need to work to earn the means of survival. The fallacy is that most of humanity has no such trade-off available. The trade-off is between labor and starvation and the regressive sales, fuel, and property taxes guarantee that true leisure without property to produce unearned rents lead to homlessness and starvation.

  5. The questions posed presupposes the existence of an ability to apply intellectual honesty in Politics. The absence of which is precisely what makes Politics, Politics.

  6. And you can either eat dinner and relax a while, or have supper and then walk a mile. The choice is yours. It’s more than likely you will be in the majority, and be wrong about it all, at the wrong time. But that alright by me, cause i’m just an observer of the lines of life.

  7. @martyheyman : you beat me to it. That theo-er-hypthothetical argument by Mr. Sullivan has no relevance for the vast majority of people.

  8. Why waste any time whatsoever on these theoretical arguments when we have iron-clad empirical evidence that a 39.6% top marginal rate has no negative effect whatsoever on economic growth? The notion that a few hundred dollars a month in extra taxes for someone actually making $1 million a year (or $83,000 per month) would cause some kind of relaxation in work efforts is absurd.

  9. Exactly, @ urban legend.

    And also, the leisure argument is basically absurd. IF you’re working as an employee, as opposed to self-employed, hours of work (tour of duty) are basically set, and there isn’t a lot of leeway in a general sense.

  10. long ago, james heckman taught me labor econ. on day 1, he gave the 3 standard reasons why firms might benefit from unions and/or higher wage employees.
    1) higher wages attract better workers;
    2) higher wages lower turnover;
    3) higher wages encourage firms to save on labor, especially by investing in technology.

  11. Love your screename, Thasswhatimtalkinbout…….Just wish I had been able to take the course you reference in your post, which I totally agree with.

    I would just add that higher wages lifts all boats. Higher wages are what breeds vitality into the economy, and gets things churning, as opposed to low wages where people have a hard time just affording the basics, food, rent, car, electric and home heating, gasoline, medical needs, etc. No room in this scenario for discretionary spending to any great degree.

  12. Some great work on the motivation of intrinsic vs. extrinsic motivation has been done by Decci and Ryan (U. of Rochester). Intrinsic motivation comes from autonomy, relatedness and competence (mastery) and appears to have much greater effect particularly on creative individuals (the “job creators”?). Extrinsic motivation in some settings appears to depress motivation. Greed is not really a great motivator – extrinsic motivators (money) are probably more powerful for those at near subsistance levels.

  13. Really? you made that argument in public? There has not been upward pressure on wages. It has been downward. I suppose it matters what segment of the economy you are in but your quick argument didnt make the distinction. Also, it appears your argument for the benefits of wage inflation do not consider the price inflation that is associated with it, as well as the fact that taxation is a percentage; and a progressive percentage at that.

    Then there is the fact that the lower half doesn’t even pay some taxes at all. So, higher wages will mean some folks will finally start to pay taxes. Which is a dam good argument not to go above a certain wage for folks on the cusp. No, I just cannot make any sense of your argument as a broad sweeping statement.

    Of course the detriment to savers and those on fixed income of all this inflation is not even considered in your dialogue.

  14. ‘IF you’re working as an employee, as opposed to self-employed, hours of work (tour of duty) are basically set, and there isn’t a lot of leeway in a general sense.’

    Never heard of working ‘overtime’?

  15. PAtty, as one who actually worked OVERTIME< as opposed to someone working OVERTIME on an un-read blog, I guess I can say I heard of it, in fact, reality, and larger checks. You miss everything when you obfuscate the message, my lad.

  16. everybody trying to get over on each other

    no one feels better than doing nothin’ and gettin’ a whole lot of someone else’s sumptin’

  17. We have a natural experiment to fall back on – the Bush tax cuts. With those, you should be able to point to specific industries and show hours worked per worker going up. 5 minutes of google shows that to be untrue.

    Click to access art1full.pdf

    People work what they are going to work, and they modulate their spending habits based on their income. Most workers cannot ‘buy leisure’ time in significant quantities. They can outsource some of their home tasks – lawn care, home cleaning, cooking, but they cannot buy vacation time. An increase in taxes from 35% to 40% reduces marginal after tax income by 8% (60/65). Take the average cost of those outsourced tasks to be $25. Someone would have to go from it being more valuable for them to work that hour and pay someone for the task, to doing the task themselves. So their hourly wage would be around $26 – or $50k – nowhere near the top tax bracket. Look at someone making $75/hr, still well below the top tax bracket, but consider their marginal rate going from 35% to 40%. The marginal income change is $3.75/hr. So equivalently their task now ‘costs’ $29/hr. A significant one-time change, but if someone’s lawn care (2 hour physically demanding task) bill goes from $50 to $60, and they make $75/hr, suddenly they’re going to start mowing their lawn themselves?

    What I would like to see is one example of a person who upon the Bush tax cuts taking effect started working more. One.

  18. Who said anything about the Bush tax cuts and working more. Its about relief from bad tax policy’s, and just when does one decide to work less, because they are being taxed more. If your job is not physically demanding, then you should have no problem paying more in taxes. If you lift someones else’s garbage for a few pennies over minimum wage all day, you should prolly get a tax break. But that’s not what making money is all about, so it gets drowned out in the name of growth and jobs, or taxes and spending cuts.

  19. Do everyone a favor and forget all this theory crap. Just look at the facts.
    Trickle Down Theory…One Last Time…Hopefully!!!

    They are at it again. Cut the taxes on the richest of the rich and the corporations and they will spend their riches creating new jobs, and the resulting wealth will trickle down to the rest of us.

    A quick review is in order here. Jack Kemp, then a Congressman had lunch with Arther Laffer, then an economist. The story is that Laffer drew a curve on a napkin to promote the theory that tax cuts for the rich produce economic growth and new jobs. That curve will forever be know as the Laffer Curve. Of course, the joke here is unintended.

    So here is your assignment. Take a look at corporate profits. They are high as they have ever been. Corporations are sitting on record amounts of cash and have been doing so for a number of years now. (Update: Business Week, Oct. 15, 2012, “Corporations are Sitting on $1.7 TRILLION in cash.”)

    The 1% now have more money than they have ever had and their share of the wealth of the country is staggering. (Update: that is now 40% of ALL the wealth in the country.)

    So where are all the new jobs that should have been trickling down to us since, oh say, the Bush tax cuts?????????????

    Even Mitt says that 23 million Americans are unemployed or under-employed, and nothing much has changed for five years now. Record numbers of people have been unemployed for over a year now.

    And yet there are still fools in Washington trying to sell us the Laffer Curve!! It is indeed a Laugh Curve, but the results ain’t funny. Tell them to stop trying to fool you. It ain’t pretty!!

  20. Not that I don’t mind you wasting your breath, but for some 5 years we have known full well that the trickle down program started with the Reagan administration was not for the children, but for the others. It’s the very well planned program which keeps on giving.

  21. Simon has been a hero of mine for some time now, but I don’t know James well enough to make that judgement in his case. What I do know from reading the series of comments that follow rants here is that there are more than a few people who comment that remind me of what James Fallows once said of Ross Perot, e.g., “There is a wire that is supposed to go from A to B, but it doesn’t get there!” “Not that I don’t mind you wasting your breath……………”is a perfect example.

  22. Trickle down works fine. There are plenty of out of work limo drivers and masseaurs who will tell you how it benefitted them for two decades. This whole problem is caused by a greedy middle class that thinks you should be able to feed a family of four with a high school education working as an assistant manager at a movie theater. They felt they DESERVED a better life style than they earned and ran up debt and bought what they wanted anyway. Then when it comes time to pay the money back they defaulted and screwed the people who were dumb enough and greedy enough to loan them the money.

    These corporations are sitting on the cash becase the risk reward ratio is simply not there. We could raise wages across the board and all that would happen is the price of all goods and services would raise accordingly.

    The problem is STILL middle class america wants too high a standard of living for too little work.

    Employers are on the hook for healthcare, workers comp, unemploymeny, fica, osha requirements , eeoc restrictions, sexual harrasment liabilities, epa liabilities etc, So why have another potential lawsuit on their hands by hiring more people who have skewed sense of entitlment when they can simply sit in the cash and wait it out.

    If you want us back in the game then lower your price. No different than a coffemaker.

    You need us more than we need you. If you try and take it with taxes we will simply invest where the ROI is more favorable. You already accused us of rape so we may as well do what we want.

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