In Tax Policy, the “Income Effect” Cancels Itself Out

January 15, 2014

We recently criticized a Congressional Research Service (CRS) report that argued taxes have minimal effects on economic growth. The empirical methods used in this report are not rigorous and it is unsurprising that those methods yielded no fruitful results.

I’m concerned more with issues I see in their reasoning. Econometrics is tricky, and economics can often be quite simple. The CRS made perfectly valid economic reasoning and applied it to taxes, and then forgot that the same reasoning applies to the spending that taxes enable.

The CRS posits two main microeconomic effects of taxes. The first is a “substitution effect” – that people respond to taxes by diverting their time and energy away from the activity that is taxed. For example, taxes on wage income make people less interested in working long hours. The second is an “income effect” – that taxes make people poorer, causing them to work harder in order to maintain their lifestyle. These effects run in opposite directions. The CRS reasons that they offset each other, making the effect of taxes small and indeterminate.

We agree with the CRS that both of these effects exist on an individual level. What the CRS forgets, though, is that taxes enable the government to spend. Most federal spending in the United States is transfer payments – that is, the transfer of money from one party to another. It makes one person poorer in order to make another person richer. The income effect should apply to both of these individuals – not just the individual made poorer. If making people poorer causes them to work more, then enriching them should cause them to work less.

In this way, the income effect approximately cancels itself out over the total population, applying negatively to some individuals and positively to others. The CRS's one-sided accounting of the income effect should be treated with skepticism.

However, we agree with the CRS that the substitution effect exists; it is, in fact, the main reason that taxes have an effect on the economy.

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