Karl Smith notes that our intuition suggests higher taxes don’t discourage work. They encourage it. “Taxes make me poorer,” says Smith. “When people are poorer they ‘need’ to work more to pay for the things they want. Therefore, taxes should make me work harder.”
In economics lingo, this is called “the income effect,” and it’s balanced by the “substitution effect,” which holds that “since I am getting less money for each hour I work, I should work fewer hours.” The question is, which is stronger. Smith thinks the income effect is stronger. But he’s not thinking about it like a Republican.
I recently spent some time listening closely to Republican rhetoric on taxes, and it’s important to realize that when they talk about the way in which even minor tax hikes will destroy the economy, they’re not talking about you and me. They’re talking about the rich. “You can’t tax the people we expect to invest in the economy and create jobs,” explains John Boehner. “Class warfare may be clever politics, but it is terrible economics,” Paul Ryan warns. “To stimulate GDP growth, a tax cut has to cut the marginal tax rates upon which the decision-makers in the economy base their decisions to work and, above all, to invest,” argues the Club for Growth’s Louis Woodhill.
Smith’s intuition might hold for people who are working to make ends meet. But it doesn’t hold for millionaires. Higher taxes might make them poorer, but not in a way that forces them to work harder. It’s not like they can’t gas up the car if their marginal rate rises to 39 percent.
Republicans argue — and there’s some evidence to back them up — that the rich are more sensitive to tax rates than the middle class or the poor. Now, you may not think this sensitivity matters very much. But if you believe that the rich are “the people we expect to invest in the economy and create jobs” and “the decision-makers in the economy,” then it could matter quite a lot. And a lot of Republicans do believe this. It’s why they worry much less about extending unemployment benefits than about protecting the rich from tax increases. Both policies make people poorer. But future economic growth doesn’t depend on the poor. It depends on the rich.
The problem is that there’s not much evidence backing this view. Intuitively, the fact that money matters less at the top also suggests that getting more of it matters less. Once you’re making money in order to win a status competition, the important thing is that you’re making more money than the next guy, not that your tax rate is 35 percent rather than 39 percent. More broadly, there’s very little empirical evidence that somewhat higher taxes on the rich have coincided with slower growth or innovation. The tech boom of the 1990s, for instance, happened amidst higher tax rates than anything currently on the table, and yet that was a period of extraordinary innovation and productivity, as this graph I posted earlier today shows:
I don’t think this graph suggests that higher taxes persuade the rich and the productive to work harder and be more innovative. But I do think it suggests that slight changes in marginal tax rates aren’t the prime driver of their behavior one way or the other.