The Efficiency of a Tax System – the Effect on Incentives & Behavior

The Efficiency of a Tax System – the Effect on Incentives & Behavior

Income taxes can be inefficient if they alter people’s behavior. If income tax rates are high, for example, people may choose to work less than if the tax rates are low. Suppose a doctor earns $5,000 per week and the marginal tax rate for people with this income level is 70%. The marginal tax rate is the tax paid on an additional dollar of income. The government will collect $3,500 of this doctor’s weekly income and the doctor’s take-home pay will be only $1,500 per week. (Seventy percent of $5,000 is $3,500. Thirty percent of $5,000 is $1,500.) Because taxes take such a large share of the doctor’s earnings, the opportunity cost of vacation or leisure time is significantly smaller. The opportunity cost is what is sacrificed or foregone when a choice is made. At this tax rate, if the doctor spends a week on vacation, he or she only foregoes $1,500 of income. If the tax rate were 10%, however, the government would collect $500 of the surgeon’s weekly income and the surgeon’s take-home pay would be $4,500 per week. In this case, if the surgeon spends a week on vacation, he or she foregoes $4,500 of income. Thus, high marginal income tax rates provide an incentive for people to work less by reducing the opportunity cost of leisure. Working less may be an inefficient allocation of the economy’s resources. When people work less, the society produces less output. The reduced production of goods and services causes the economy to have a smaller gross domestic product (GDP) and thus a lower standard of living. The increased leisure time might increase the quality of life of the society, however. Standard of living measures the amount of goods and services consumed by an average person. Quality of life attempts to measure the fulfillment people receive. People may receive more fulfillment from having more leisure time and fewer goods and services.

Income earned from most types of personal investments is also subject to taxation. If the tax rates are high, individuals may be inclined to save less of their income for personal investments than if the tax rates are low. For example, if a person saves $10,000 and invests it in a savings account that pays 5% interest per year, then this person receives $500 of interest income each year from this personal investment. (Five percent of $10,000 is $500.) Suppose the tax system is structured so income from personal investments is taxed at a 50% marginal tax rate. Thus, the government is owed $250 annually from the $10,000 savings. The saver is left with only $250 on interest income. ($500 interest earned - $250 taxes = $250 net interest after taxes.) This rate of return may be so low that the person would rather spend it on consumption than save it for personal investments. Since savings is a major source of investment funds for the economy, this distortion may also lead to an inefficient allocation of resources. There may not be enough savings and personal investment, and thus not enough economic investment, because the structure of the tax system discourages it.