A Model of Income Taxes and its Effects on Economic Efficiency

Income taxes are one of the most common forms of taxation throughout the world.  In this paper, I attempt to construct a simple model of income tax and I try to examine how raising income taxes affects the economy.  I try to show a firm a link as possible between this form of taxation and a suboptimal economic structure that includes higher prices, less consumption, reduced employment, slower commerce, and reduced efficiency.

To do so, I am going to look at what happens when we increase incomes taxes in one sector of the economy while holding them constant throughout other sectors.  Then income taxes are raised in each sector iteratively, till they have been raised in every sector of the economy.  To keep the economic model understandable, some simplifying assumptions are made:

  • Service oriented economy
  • Only resource is labor; ignoring other resources such as raw materials and land
  • No corporations; only individual service providers
  • Tax revenue leaves the system and government spending is not modeled
  • Individuals work a fixed number of hours each week.  They cannot work more or fewer hours based on demand for their services.  They only have the choice of being a service provider in the economy or not.  By holding this variable constant, some of the analysis is simplified.

I am going to begin with raising income taxes on one illustrative sector of the economy to examine the side effects.  I begin with an example that is fresh in my mind, of using a personal trainer for exercise advice.

I think this niche of the economy is a good illustrative example because it is service oriented and does not require the input of raw materials other than labor and because each PT is an independent practice without the complexity of dealing with corporate tax code and what it does to incentives.  As our economy is increasingly service oriented, I think this model is an increasingly good approximation of the real economy.

In the first step, income taxes on all personal trainers (PTs) are raised.  The taxes on the rest of the economy stay the same so the cost of all other services remains the same.  Therefore the basket of services that PTs may wish to purchase should stay the same price.  However, as the after tax income of a PT will decrease, he or she will need to raise prices in order to buy the same basket of goods as we are making the assumption that the PT cannot work more hours.

Some expected results of higher prices on the PT services:

  • As the cost of a personal trainers increases, consumption of this service decreases.
    • Thus fewer people will be employed as personal trainers.
    • Consumers reduce the number of hours they use the service, making do with less advice from a personal trainer.  This reduces their total utility.
    • Consumers may turn to substitutes as the service becomes more expensive.  For example, they may turn to online videos or self-help books instead of talking to a personal trainer.
    • The complete basket of services now including personal trainers will increase in cost.

Suppose that incomes taxes were than raised on the next sector of the economy.  Once again we would expect that:

  • prices for service 2 would increase
  • consumption of this service would decrease, thereby decreasing the number of people working in this sector
  • consumers use imperfect substitutes for service 2 with reduced utility

On aggregate after taxes are raised in all sectors of the economy we would expect:

  • Higher prices in all sectors of the economy
  • Consumption of all services decrease
  • Employment in the formal economy decreases
  • As people try to avoid the high prices on the market due to taxes they might:
    • Reduce consumption of services and decrease their total utility
    • Improvise substitutes.  That is try to replicate the service on their own.  (Ie: provide their own exercise advice rather than turning to an expert.  Cleaning their own things instead of turning to a specialist.)  The problem is that this means that the benefits of economic specialization and comparative advantage are lost.
    • Barter their services with others.  Thereby losing the efficiencies obtained from having an efficient market and a good medium of exchange.
    • Higher income taxes promote the formation of an underground market to avoid the income taxes associated with reporting taxable income.
      • This means that participants in the market have reduced legal rights and protections.
      • Government ends up with less revenue than expected from a given level of taxation.
      • Rule of law is undermined.

The net result of income taxes according to this model is reduced connectivity among individuals in the network.  People tend to be more self-reliant and independent as income taxes discourage commerce.  This represents a regression as phenomena strongly associated with the productivity increases in modern economies such as labor specialization and comparative advantages among producers are discouraged.

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Congestion Fees and Economic Efficiency

Can increasing taxes make the economy function more
efficiently?  In this article, I provide an example where a well-designed tax
actually increases economic output.  Further, the tax can provide the
revenue needed by government to provide essential services that private
entities cannot.  Congestion fees serve as an illustrative example, but similar
cases can be made for taxes on any finite resource such as fossil fuel,
electricity or land.

Congestion pricing involves charging a fee to use a roadway
or parking.  These charges result in more efficient utilization of the roadways
than a situation without taxes.  These efficiencies translate to better
performance throughout the economy and sometimes in surprising places quite
distant to transportation from zoning to healthcare.

Fees for roadway access reflect the fact that each roadway
can only carry a certain number of vehicles per hour safely.  When a vehicle
occupies some of this limited space, he or she is preventing another from
occupying that parking space or capacity on a bridge or tunnel.  This reflects
the reality that there is limited space, especially at certain bottlenecks in
the transportation infrastructure and it is not possible to simply add more
lanes.  In a downtown area for example, it might not be possible to add more
lanes without tearing down historic structures or demolishing sidewalks and

One of the goals of congestion pricing would be to ensure
optimal traffic velocity and minimize the chance of traffic jams.  A simple
philosophy to start with when designing a pricing scheme would be to begin with
the assumption that a highway, no matter how many cars manage to squeeze onto
it, is of no use to anybody if the average velocity is below 5 mph.  Extending
this idea, if traffic velocities drop significantly below a roadway’s
target-speed, then the outcome is suboptimal.  Logically, it would be sensible
to raise fees for the time periods when traffic slows below the speed the
roadway was designed for.

By pricing roadway access to ensure traffic moves reliably
and at the speed the roadway was designed for, we ensure that the space is
utilized most effectively.  The fees encourage car-pooling which could cut the
costs per passenger for parking and tolls.  This encourages buses which can
make more efficient use of limited roadway space and do not occupy parking
space.  This encourages taxis which do not require parking on both ends.

Congestion taxes mean that light users of roadways do not
have to subsidize heavy users.  In the past this had to be the case, since
tracking a vehicle’s usage of the roads was difficult and hence roads were
considered a public good.  Only limited-access highways with clear traffic
patterns and limited entrances and exits, could track drivers carefully enough
to charge tolls.  Now however, improving technology allows usage of the roads
to be tracked even in densely populated urban areas.

Congestion pricing would make roadways much more like other
utilities like electricity or water.  A user does not expect to pay the same
regardless of how much electricity or water was consumed.  With electricity,
peak and off-peak rates are quite different.  Fees that accounts for amount and
timing of roadway usage would make roadways much more like other utilities.

Demand shifting that occurs as a result of congestion
pricing can result in more efficient use of the roadways.  Higher fees to use
one route over another can be informative and encourage users to travel on less
busy corridors.  Trucks and heavy traffic might be encouraged to make
deliveries at night time when taxes are much lower.  Thru traffic might be
encouraged to go around downtown areas instead of through them if congestion
fees indicated that it is better to take the longer route during busy periods.
These changes in behavior result in more traffic being moved on the same
roadways.  This is especially important when the budget or space constraints do
not permit the expansion of transport capacity by traditional means.

Fewer gridlocks scenarios, and traffic that is more
predictable and moves faster that result from congestion taxes directly
increase economic output in the following ways:

  • Reduced variance in the delivery times
  • Businesses productivity increases as fewer employees show up late to work and commute times are more predictable
  • Fuel consumption will decrease as vehicles spend less time stuck in traffic
  • Air pollution is reduced which should improve quality of life and reduce medical costs

Accurate pricing of transport network capacity can improve outcomes in surprising places:

  • Railways would be more viable as they would not have the unfair disadvantage of not having free subsidized access to railway track that vehicles have on the roadways
  • Local businesses and local food producers may benefit because of their proximity to end users
  • New development and zoning might occur only where the transportation network has excess capacity as reflected by lower congestion fees
  • Unnecessary construction of additional highways and bridges to nowhere may be avoided if current congestion prices indicate that the expected traffic would not support the construction and maintenance costs
  • Less stressful commutes should increase productivity and reduce medical costs

One of the problems with consumption taxes as described
above is if they prove too effective at deterring a behavior such as driving in
areas.  People might choose to telecommute to work most days rather than drive
to the office.  This type of price elasticity would result in much less revenue
than might be predicted.  This response to high taxes could result in what
amounts to a ban on a particular behavior which might not be the desired
outcome.  For example, high congestion fees might make long-distance travel
cost prohibitive for many people which is probably not one of the intended
consequences of the policy.  This depends however on if municipalities choose to
maximize revenue or charge fees geared at ensuring high traffic velocity.

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The Burden of Payroll Taxes on Employment and the Economy


In this post, I make the case that the high unemployment,
one of the biggest problems facing governments, is something that can best be
addressed through the tax code.  In this article I make the argument that the
current federal tax code, composed of various payroll and personal income
taxes, discourages companies from hiring workers.  This result has many unintended
and detrimental consequences to the national competitiveness.  Some of these
consequences include higher unemployment, unfavorable foreign exchange flows,
movement of work offshore and greater capital expenditures by companies with a
reduced ability to adapt to changes in the global economy. 

The Problem


Why did income tax arise?  In the United States, most rate
hikes occurred during wartime as it was probably the fastest way to generate
revenue quickly, but not necessarily the best way to generate tax revenue.  The
problem with taxes, of course, is that once in place, they are difficult to get
rid of.  Politicians get used to having the revenue that comes from the taxes
and the public gets used to the benefits that are paid for by income taxes. 
Income taxes are also popular because unlike most forms of taxation are
progressive rather than regressive.   And since the economy arranges itself in
such a way as there are fewer supervisors than workers.  So inherently progressive
taxes are popular and have momentum.

Capital Investments vs. Hiring

Taxes on employment, weather direct as in FICA taxes or
indirect as in personal income taxes, reduce total employment.  As these
increase the cost of labor, this shifts the balance toward more capital investments
and fewer employees.  For example, if a company were to have a choice between
hiring more workers to ramp up production or to purchasing a machine to do the
same task taxes on employment decrease the probability of the former and
increase the probability of the later.

Loss of Flexibility

Employment taxes greatly diminish national competitiveness
as they reduce companies’ abilities to adapt to changing economic conditions. 

First, equipment for automating processes typically cannot
be returned to the vendor as easily as a worker can be to the unemployed pool. 
Thus a company which needs to cut production as market conditions change might
find that their capital investment is losing value to depreciation and
amortization while idle.  A human worker on the other hand can be laid-off and
the employer no longer has to pay wages.  

Second, flexibility in processes is also lost when using specialized
equipment.  While a human worker can usually be retasked to a different role with
some training, machinery can only be used for the tasks this is assigned. 
Hence, when a company makes an investment in capital equipment, they are committing
themselves to that production process for many years.  By not forcing companies
to invest in automation equipment to avoid the high taxes on hired hands, we are
not forcing companies to lock in production levels and production processes
years in advance.

Labor Intensive Work Moves Offshore

Another trend caused by high income taxes is the movement of
labor intensive industries offshore as companies move to locations where they
have lower labor costs.  This trend is exacerbated by the fact that weaker
environmental and labor regulations are typically found along with lower labor
costs.  One way to avoid a race to the bottom would be to encourage better
labor standards worldwide rather than considering these as a set of separate
national problems.

Competitive Headwinds to High-Skill Industries

Even non-labor intensive companies face the headwinds
imposed by higher labor costs and reduced labor flexibility that are a result
of these poorly designed taxes.  A company doing skilled work might find that
even though labor might be an insignificant expense for them, all the other
services they need from construction, to manufacturing, environmental compliance,
to legal and accounting services, to parts from suppliers all cost more, so
on-shore work does not make sense.  Hence, even the types of work that economists
say advanced industrialized countries should be focusing on might not stay because
the overall costs of doing business are too high. 

Loss of Workers and Retirees

In the same way that companies choose to move offshore to
combat higher costs, individuals do as well.  Such trends are becoming visible
with high-skill workers who might choose to work in a lower tax location
because the same salary goes much further.  Likewise, the lower costs of living
overseas attract retirees who take with them their skills, roles in the
community, savings and pensions.

Effects on Hiring Patterns

Regressive taxes such as FICA and the need to pay fixed
benefits per worker, encourage businesses to hire fewer workers and to work
each one for more hours than they might otherwise.  Longer hours likely mean
worse working conditions, higher stress, absenteeism and increased healthcare
expenses.  From the community level perspective, since these employees also
serve other roles such as being parents and voters, and reduced performance in these
functions can be quite detrimental.  Imagine how much better local governments
might run if their constituents had enough time to see what their elected representatives
were doing or where they tax dollars are being spent.  Insurance costs would
likely benefit and quality of life measures might also see improvements.

Unfavorable Forex Changes

Additionally, most of the above problems impact a country’s Forex
reserves negatively.  The loss of retirees to lower cost locations means that
their pensions will leave the country whereas the contributions were mostly
made by employees when they worked in the country.  The loss of manufacturing means
that the country will have to import more manufactured goods and there are fewer
exports, which is unfavorable from a balance of trade perspective.  There is
less employment allowing fewer people to afford the imported goods.  The increased
need for capital equipment has negative Forex consequences as well, since a significant
part of the equipment likely needs to be imported.


By reducing or eliminating FICA and income taxes that
penalizing the hiring of workers on-shore, we can help avoid the detrimental
consequences to the economy described above.  In many cases, by cutting taxes
to make conducting business easier, we can accomplish what more spending
cannot.  Rather than increasing our spending in R&D or education, we could
increase the effectiveness of existing spending by allowing companies and new
startups to leverage on-shore manufacturing and leverage synergies.  This would
prevent the problem we have had where new technologies are developed here
because of investments in academic and defense research, but commercialization
and large scale manufacturing moves offshore because the costs of labor are too
high.  This makes future academia/industry partnerships more difficult as these
processes become separated geographically as the industry matures, negating the
earlier investments. 


The evolution of the tax code in response to short-term revenue
demands has resulted in a system that has many unintended consequences to the
economy.  By fixing these aspects of the tax code, we can avoid these harmful side-effects
and improve the employment situation. 

This would however require the government to find
alternative sources of revenue, but I am saving my ideas on how this might be
accomplished for a future posting.  I plan to present the perspective that imposing
taxes on certain behaviors can actually make the economy run more smoothly as
compared to an economy without any taxes.

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