The visible hand in economics

Income tax and tax incidence

Posted on: October 25, 2007

There seems to be a significant debate between the left and right wing blogs about whether New Zealand is over-taxed or not. However, there is one thing that both sides agree on, if taxes are cut by $1,000, this gives people $1,000 more to spend. This is the point I’m going to discuss.

Households receive a net wage, which is their gross wage – income tax. The household requires a certain net wage before it will enter the labour market (say the benefit + the opportunity cost of leisure time), and may also require a premium to choose one firm before another firm (when labour supply is restricted).

Now the gross wage + non-labour costs (which we will assume are exogenous, even though they aren’t really :) ) is the cost to the firm of hiring that employee. If taxes fall, the net wage the household receives would be higher. However, the relationship between employers and employees determines the gross wage. If the employer knows that taxes will fall, they can reduce their employees gross wage and leave their net wage the same (I know that firms often can’t do this because of labour laws and wage stickiness, however in a dynamic sense they could just reduce the rate at which they increase an employees wage). Ultimately, the division of the tax depends on the relative bargaining power of the different agents.

If there were ‘many’ firms and ‘many’ employees, the incidence of tax would depend on the relative elasticities of demand and supply for labour. Often labour demand is assumed to be relatively elastic while labour supply is highly inelastic. In this case most of the tax is borne by the employee and so a cut in taxes will mainly benefit them.

However, if we have a high rate of unemployment, labour supply will become relatively more elastic, which implies that some of the burden shifts onto employers.

If we have a monopoly firm and many (homogeneous) low-skilled employees (flat labour supply curve) the tax burden will be fully taken up by the firm. This is because the monopoly will only want to pay enough to get the employees to work, and so the net wage will be set at the reservation level. If you cut taxes you cut the gross wage required to get this net wage. Note: This result would not hold with asymmetric information (worker effort) or heterogeneous agents (as a higher net wage would then be required to intice more workers – labour supply would be upward sloping).

Ultimately, where the burden of income tax falls is a difficult issue, and depends on the specifics of the labour and goods markets. However, it is not clear cut that if my taxes are cut I would end up with that much extra money. As a result, we have to realise that a cut in income taxes will result in a reduction in firm costs as well as an increase in consumers spending power.

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16 Responses to "Income tax and tax incidence"

So what you are saying is that cutting income taxes is more likley to have a net zero impact on inflation? Increased spending, but decreased costs?

How would that work with Working For Families*? Where the employer doesnt have the knowledge of the benefit payment?

Would that increase spending power (and demand) and keep costs the same?

* It would be very interesting to see the number of Exculsive Brethren that are eligble for WFF payments. They have large families dont they? Wouldnt it be funny if WFF funded EBs political campaigns!

Comparing working for families and tax cuts is difficult.

It is true that firms can’t tell whether you have kids in the first place, and so won’t have full information on your reservation level. But on the otherside, working for families is supposed to increase the supply of labour, by providing tax credits up to a point where the family could have a secondary earner. Ultimately, working for families should make the supply of labour more responsive to shifts in demand, as someone with children has a higher opportunity cost of time than someone without children.

As a result, working for families changes the elasticity of supply, while tax cuts give a straight increase in the supply of labour (for a given cost to the firm).

I wouldn’t go as far as saying that cutting income taxes has no affect on inflation. I would say that cutting taxes will definitely increase inflation, even though it lowers firm costs and increases the supply of labour (thereby reducing wage pressures). If there was a corresponding cut in government spending along with tax cuts, then this would have a downward impact on inflationary pressures

So tax cuts are going to be inflationary whenever they come from a surplus? Meaning when tax cuts are most justified they are most harmful inflation wise.

Another argument for not letting a surplus grow to absurd levels, I suppose.

Well the justification for a surplus comes from the idea that we have a business cycle. A government should run surpluses when the economy is booming, and then run deficits when the economy is crapping out, leaving a balanced budget over time.

I’d say that people on the left and the right can take something out of the description I gave above.

Left: Tax cuts won’t actually give workers as much money as national is saying
Right: Tax cuts may not necessarily be as inflationary as some people thought.

Ultimately I don’t care to much, I just like talking about economics.

Sure, do you think the benefit of running a surplus can change at large levels?

Is there a prudent level of surplus? If you cannot cut tax when the surplus is THIS high, when can you ever do it?

If you believed that the economy was growing far enough above its natural rate then a large surplus would be justified.

There are two ways Micheal Cullen can explain this:
1) Something structural has changed in our economy, so that the natural rate of growth has risen and these surpluses will need to be put back into the economy
2) Our economy is well above its natural rate, and we need to save as growth is likely to collapse at some point

If he takes the first route he might be able to justify tax cuts, although cutting them when capacity pressures are this intense may still be a bit irresponsible (it depends on how the tax cut influences labour supply or cuts business costs). However, if he believes the second thing then the only fiscally responsible thing to do is keep hold of the huge surpluses.

Ultimately, I think he believes the second thing but will be forced to say that the first thing has happen in order to cut taxes and win the election.

I agree that if he does believe the second thing there is no way he would ever say it, as it would come across as “we have been lucky and dont deserve this growth”. Calling it a windfall would offend everyone.

Tax cuts could be prudent, even if we are currently exceeding the natural rate, if policies were in place to remove bottlenecks in produciton and increase the natural rate. Agree?

Perhaps this is what Howard and Costello were trying to do in Australia (after many years of tax cuts and continuing surpluses, despite increasing federal budgets) with their Work Choice legislation.

In a sense, tax cuts can help ‘remove bottlenecks’ by increasing labour supply. However, with New Zealands participation rate at 68.8% I think that the labour supply response to lower taxes will be minimal.

Furthermore, if we think that the incidence of tax is such that it reduces the cost of labour, and if labour and capital are complements (which is not a given, but not impractical), tax cuts may lead to greater businesses investment. However, business investment takes time to increase productive capacity, and as a result short term inflation may still become entrenched. Also it would be easy to make the opposite argument, where tax cuts retard investment.

Ultimately, whether you want to cut taxes or not, it would be good to put in place policies that will increase the natural rate (although any equity tradeoffs would have to be taken into consideration). I doubt that tax cuts would provide much of a supply side response, and as a result, we have to accept that they would be inflationary. However, if our economy is now at a higher natural rate of growth, this money should be put back into the system, just not now when unemployment is at a record low and firms are heavily capacity constrained.

What about a reduction in GST, withholding tax, or the business tax rate*? Same impact?

*Without an offsetting increase in the cost of Labour, ie kiwisaver.

Quarterly inflation is down below 2%, surely now would be the time for tax cuts? (Or more precisely, last year WOULD have been the time for tax cuts.)

“What about a reduction in GST, withholding tax, or the business tax rate*? Same impact?”

GST is equivalent to a cut in a flat tax rate. The benefit will again depend on the tax incidence, however this time the household is the consumer. Withholding tax is just like income tax.

Now, business tax is on net profit so it is a little different. If a firm has its business tax cut, then it has extra profit avaliable, however since it was choosing labour etc to maximise profit in the first place it shouldn’t make any difference to what they do. In the longer term it would allow further entry into markets which would increase competition and reduce price pressures I guess. But it seems silly putting the business tax rate below the top personal tax rate, as it allows people to avoid tax. That should be the constraint on it.

Annual inflation is 1.8% yes. But the only reason it is in the target band is because the government introduced a whole lot of subsidies which knocked down the price level. As we care about the rate of price growth, these subsidies should be ignored. When we ignore them annual growth is around 2.1%. Now, part of the reason this is ‘so low’ is the large increase in the exchange rate which has reduced tradable inflation. Once this is taken into account, along with the intense margin pressures that some firms are facing, underlying inflationary pressure is above 3% (just look at non-tradeable inflation growth and take off the effect of the subsidies).

Last year would have been a better time for tax cuts, at least a shifting of the tax thresholds to account for fiscal drag. However, cutting taxes now is probably not a good call. Didn’t National say that they would cut taxes, but that they wouldn’t come into effect until 2009. That is a better idea, as capacity pressures will be lower by then, however announcing them now will simply lead to people increasing borrowing (as they expect their lifelong income to be higher). If this is the case, the inflationary impact of this announcement depends on the degree with which people are liquidity constrained.

“However, there is one thing that both sides agree on, if taxes are cut by $1,000, this gives people $1,000 more to spend.”

I’m a bit late commenting to this post but I don’t particularly agree with this.

While some people likely would just spend this extra money on shoes and plasma tvs and others would save the extra money, I think there’s a third group of people who are currently spending beyond their means with large mortgages or overdrafts that are slowly increasing. If these people continue to spend the same amount, but can actually afford it now, what sort of affect do you think this would have?

petermcc, your third group would presumably ‘save’ the entire $1,000 by paying back debt. Now this is a very important point, as if people have been borrowing in the belief that they will receive tax cuts, then any tax cut would be fully saved and would not lead to inflation. This argument is discuss here:

http://www.infometrics.co.nz/article.asp?id=4323

In this post on tax incidence I was simply trying to dispel the myth that if taxes get cut the full benefit goes to labour. The sentence you quoted was the sort of thing I was trying to dispel.

BTW, these threads are never dead, if you want to reply about something I’ll try to write back to you as soon as possible :)

It doesn’t even have to be a concious ‘i’m going to get tax cuts soon so I can afford to spend more now’, it can just simply be not earning enough money to pay the bills.

“i’m going to get tax cuts soon so I can afford to spend more now’, it can just simply be not earning enough money to pay the bills”

That would be true as long as people are living at an income that provides them less than a ‘subsistence’ existence. With the range of benefits offered by government this should not be the case for even the majority of the poor. Remember that politicians use statistics to lie – generally most of the households that earn under $17,600 (the bottom 20%) are students, or businessmen/farmers who are putting their money in a trust.

[…] moons ago we discussed tax incidence – I think it is time to run with this again, taking for granted some of the assumptions about the […]

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