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.