Incentives and Income Taxes

Russell Shannon is a professor In the Department of Economics, College of Industrial Management and Textile Science, Clemson University.

Here’s an intriguing opportunity: A book club now offers two free books to any member submitting the name of a friend who wants to join. But if you submit a second name, you will get five books!

Why does the club offer more than twice as much “pay” for just twice as much product? Is the offer obligatory or just odd? Surprisingly enough, it goes a long way toward explaining the movement to reduce income taxes.

Finding a second friend to join the club could be considerably more difficult than finding the first. You may have to travel further, or talk longer to convince him. That makes the larger reward crucial.

But what if extra effort were unnecessary? What if you could convince two friends of the benefits of membership simply by making a 15-minute phone call to each one? As it turns out, even then an additional incentive may be needed.

Examples of this fact pervade our economic lives. The need to increase incentives regularly appears whenever companies want employees for overtime work; usually they must pay workers time-and-a-half, even though the duties involved do not differ from the ordinary routine. Similarly, when you buy a box of cereal in the supermarket, you may receive along with it a coupon worth ten cents on a second box.

Diverse though these examples may seem, they all have one thing in common. They all illustrate the fundamental economic principle of “diminishing marginal returns.” Sometimes, the same principle is called the law of “increasing costs.”

Understanding of this principle dates back at least two centuries. In 1789 Thomas Malthus published his thoughts on population.[1] Using data provided by Benjamin Franklin and others, Malthus predicted that population growth eventually would outstrip the food supply.

That prediction is one of the reasons economics even today is called the “dismal” science. In current discussions of famine in Third World countries, references to the “Malthusian specter” are not unusual. In Aldous Huxley’s famous novel Brave New World, women wear “Malthusian belts” designed to prevent conception and control population growth.[2] But what has Malthus to do with book clubs and income taxes?

If you take time to find a friend to join a book club, you will be confronted by a cost. The cost isn’t necessarily money—unless you actually take time off from your job. But you will have to give up working in your yard, playing a game of bridge, or watching TV.

Such a sacrifice might be fairly easy to make while finding the first friend. But what about the second? Giving up one TV program or half an hour of your yard work may not mean much. But the second half hour will surely mean more; that is, the cost increases. So you will need a larger reward to compensate. The people who run the book club obviously know this, and they have acted accordingly.

By the same token the company that sells cereal knows that a second box of their product will be less attractive to most people than the first. The cost—or opportunity forgone—will be larger. Thus, by making them a better offer on the second box, the company may entice people to buy more.

Progressive Rates of Tax

All of this may seem strangely remote from the matter of income taxes, but in fact it is not. Both our federal and our state income taxes are “progressive.” That means that, as people earn larger incomes, they move into higher income tax brackets. So more pay means they end up sending a larger share of their income to the government.

Several arguments support the progressive system, not all of them objectionable. Some people, of course, urged on by envy, merely like the idea of trying to “soak the rich.” Others, however, talk in terms of peoples’ ability to pay; they maintain that wealthier individuals can surely afford to shoulder a larger share of the tax burden. But what effect do rising tax rates have on the incentive to work?

Clearly, the progressive rates may generate a perverse response. Consider, for example, a married person whose employer offers him the opportunity to do more work and earn more income. Say this employee, in exchange for ten per cent more work, could get 15 per cent more pay. Based on what we have just discussed about human inclinations, we would reasonably expect the employer to make that kind of offer.

But the increase in pay may shift the employee into a higher income tax bracket. If his taxable income were about $20,000, he could, as a result of the pay increase (and based on 1980 federal income tax rates), vault from paying 28 per cent on marginal income to paying 32 per cent. Thus the incentive to work may be so diminished that it will no longer be attractive.

For someone in an even higher income tax bracket, the adverse effect is augmented. Thus, to secure the employee’s services, the employer would be forced to make an even better offer. Of course, the job might be offered to someone else but he might lack the competence. Thus the job will go unfilled and the work undone, and society will be the poorer for it.

In recent years, Congress has graciously refrained from raising our income tax rates. However, Social Security taxes have risen dramatically. Simultaneously, inflation, prompted largely by the rapid growth of government spending, has shoved more and more Americans into higher and higher income tax brackets.

Thus there is less and less incentive to earn incomes that are taxable. So unless we like more leisure, we are increasingly inclined to enter the so-called “underground economy.”[3]

Of course, that doesn’t mean people are actually burrowing beneath the soil—or looking for oil. Instead, they engage in barter or else make payments in cash, seeking thereby to escape the ever watchful eyes of the Internal Revenue Service.

In one case, for example, a worker presented a bill for some repair work to a home owner for $30. When the owner started to write out a check, the worker demurred and insisted instead on receiving cash. But when the owner discovered he had only $25 in his wallet, the worker accepted it, gladly sacrificing the $5 rather than pay taxes on $30!

The Underground Economy

The phenomenal growth of such activities has become so substantial that, by some estimates, our “underground” activity may now be the equivalent of 20 or even 30 per cent of Gross National Product. Certainly, this production is, in some sense, less desirable than it would be if everything were out in the open. Besides that, our government is losing tax revenue which might otherwise be used to build schools or shore up our national defense.

If tax rates fall, American workers will have greater incentives to produce goods and services for American consumers. Some people who are already working will leave the underground for the more efficient open economy. Thus, income subject to taxation will grow.

In fact, it’s even possible that, though income tax rates fall, the increase in taxable economic activity will be so great that tax revenues will rise. That is the thesis underlying the now-famous Laffer curve, originated by the economist Art Laffer.[4] The implication is that, while tax rate cuts will directly benefit individuals, in the end society as a whole will prosper.

At first glance, you might have thought the book club’s offer was either totally absurd or grossly irrelevant. But it’s not. It bespeaks a universal truth which underlies much of the current “supply side” economics. When you understand that additional effort often requires increasing rewards, then, along with many others, you may be eager to ride the tide of enthusiasm rising relentlessly behind the tax reduction program. []

1.   T. R. Malthus, An Essay on Population (New York: E. P. Dutton and Co., 1958). See Vol. 1, Book I, Chapter I, pp. 5-11.

2.   Aldous Huxley, Brave New World (New York: Bantam Books, 1962), p. 34.

3.   See Alfred L. Malabre, Jr., “Underground Economy Grows and Grows,” Wall Street Journal, October 20, 1980, p. 1; Robert M. Bleiberg, “Surfacing the Scratch,” Barron’s February 9, 1981, p. 7.

4.   See Edward Meadows, “Laffer’s Curve Picks Up Speed,” Fortune, Feb. 23, 1981, pp. 85-88; “A Guide to Understanding the Supply-Siders,” Business Week, December 22, 1980, pp. 76-78; Rowland Evans and Robert Novak, “What ‘Supply Side Economics’ Means to You,” Reader’s Digest, June 1981, pp. 118-122; “Laffer: A Steady Supply of Ideas,” Newsweek, June 29, 1981, pp. 11, 13; “The Laffer (not laughter) Curve” in Richard B. McKenzie and Gordon Tullock, The New World of Economics: Explorations into the Human Experience (Homewood, II1: Richard D. Irwin, 1981), pp. 227241.