Does income taxation create disincentives that impede growth?

May 15, 2013

Last week, I took part in a debate on the future of North Carolina tax reform with Jared Bernstein (if you missed it, you can watch it here). In my most recent Fiscal Fact, released today, I follow up on my conclusions from the discussion. Today, I wanted to introduce the first point of disagreement between Mr. Bernstein and I: that income taxation will not impede economic growth.

Economically speaking, income taxes are the worst types of taxes because they alter individuals' decisions to work and to invest. This is especially true for those with high graduated rates. An age-old adage notes that “when you tax something, you get less of it.” The last thing we want to do is discourage those things that add productive value to the economy.

A common counterargument to this idea is that encouraging consumption alone can push the economy forward. Consumption, though an integral part of our complex economy, is the byproduct of growth, not the driver. A recent Forbes article articulates this point much more eloquently than I: Consumer demand does not necessarily translate into increased employment. That’s because “consumers” don’t employ people. Businesses do. Since new hires are a risky and costly investment with unknown future returns, employers must rely on their expectations about the future and weigh those decision very carefully…Where do these “consumers” get their money to spend? Before we can consume, we need to produce and earn a paycheck. And paychecks have to flow to productive—that is, value-creating—behavior…Our various demands as consumers are enabled by our supply as workers/producers for others…Consumption is the goal, but it is production that is the means…Increasing consumption is a result of…growth, never the cause of it.

Higher tax liability makes it less profitable than it would be otherwise for individuals to work or businesses to expand their production. As a result, people will engage in less of these activities than they would have otherwise and the economy produces less overall.

Income taxes result in larger “deadweight loss,” a fancy term economists use to demonstrate the fact that tax revenues removed from the economy aren’t the only cost of taxation. In other words, “deadweight loss” is the loss in benefit from the reduced number of productive activities as a result of the tax. An accountant that is hired to help a business navigate and comply with the complicated tax code is one less productive laborer. Those resources could be used more effectively elsewhere.

To minimize this loss, taxes on income need to be as small and as simply structured as possible, and they need to minimize a person’s disincentive to produce. The solution here is flatter, lower income tax rates applied to a broad, neutral base.

Critics of tax reform are misunderstanding my argument entirely. I’m not selling any “snake oil” asserting that any and all tax cuts will lead to instant growth. What I am arguing, however, is that the ultimate goal of tax reform should be creating an atmosphere where business can thrive and economic growth is possible, while still generating revenue for the government to pursue its priorities. Growth won’t be instant, but a continued, consistent commitment to a system that won’t discourage the very things that will move North Carolina’s economy forward will most definitely benefit the state in the long-run.

Be sure to take a look at the full report here!

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