Should the government reward effort?

Recent posts by two of the most prominent New Zealand left wing blogs (the Standard and New Z Blog) lament the fact that the wage people are paid does not necessarily relate to the effort they put into their work. As a policy solution to this inequitable result of the free market both blogs suggest that the government provides tax cuts that give the poor more.

However, no matter how sympathetic I am to the idea that effort and reward aren’t correlated in a way that most people would view as “fair”, I don’t think that adding further progressivity to the tax scale is the appropriate mechanism with which to achieve this social goal.  Furthermore, I don’t think the trade-off between production in society and the achievement of our “equity” goals is appropriately mentioned in these posts.

Starting with the issue of an equity-efficiency trade-off we have to realise that for the same level of revenue (in a static sense), a more progressive tax scale will lead to higher “marginal tax rates“.  The higher the marginal tax rate – the less incentive people have to work an additional hour.  This phenomenon is especially prevalent among secondary income earners – which have become an important part of our labour force.  There is also a case for tax-avoidance and as the tax rate rises for those on high incomes it disrupts savings incentives – influencing the accumulation of capital and thereby reducing productivity.

Furthermore, progressive taxes make “skilled” labour relatively more expensive then “unskilled” labour.  This implies that firms will move away from productive processes that use skilled labour – which likely implies that potential output in the economy will fall.

Anyway, lets ignore this trade-off for now, even without it I would prefer us to have a flat tax scale but progressive benefit payments.  Why?  It’s transperant!

One of the most important issues in a democracy is transparency.  Income taxes are levied to raise revenue for government spending, ‘welfare’ payments are made in order to increase distributional justice (which is effectively what we want to do in this case).  By keeping them separate the public is fully informed about the sort of welfare enhancing policies we have in place, and can express how it feels about them (more welfare or less).

When we mix up the tax and benefit systems, the discussion of distributional justice and efficiency becomes mixed and we end up in a situation where the party with the best rhetoric surrounding either tax cuts or helping the poor will end up taking the day.

The main cost from such a division between taxes and benefits is “churn” – however, I’m not a big proponent of churn anyways, and hopefully a flat tax scale would give sufficient administrative benefits to make up for this churn.  Note in efficiency terms both the tax and benefit schemes have a cost – as they both increase effective marginal tax rates.

This isn’t much – do you have anything a bit more convincing?

Ok ok, I have another trick up my sleeve to explain why I think benefits and not tax is the way to go here.

First, tax incidence.  Unskilled labour is easier to replace then skilled labour.  As a result, firms’ will pay unskilled workers a wage closer to their “reservation” wage in net terms, while skilled labour has the ability to gain more of a surplus.  When a tax cut is given to the poor, the firm will (over time) cut their gross wage back towards their reservation level.

As a result, tax cuts to the poor will probably have a greater impact on firm costs then they will on achieving the equity goal of giving the poor a wage that more closely matches the effort they put in.

Ultimately – I think that the tax incidence argument, in conjunction with the transparency argument, is sufficient to illustrate why our equity goals should be achieved through direct government spending instead of fiddling with the revenue generating device that is taxes.

  • Kimble

    Nice work.

    The ’employer’ has greater knowledge of an employees tax than their welfare receipts. But they still, over time, will come to learn their employees welfare status, and this would be more true if welfare payments become more common.

    I reckon that the movement towards the reservation wage because of a tax cut would be relatively quick, but I still think the movement towards the reservation wage would occur with some sort of a universal benefit scheme. It will just take a little longer. Short run vs Long run again.

  • “Nice work.”

    Thanks Kimble 🙂

    “I still think the movement towards the reservation wage would occur with some sort of a universal benefit scheme”

    Agreed. But to figure out how, we have to realise that the “reservation wage” is actually a function of benefit payments.

    If benefit payments are higher, the reservation wage will be higher – as the price of leisure is greater (given diminishing marginal utility of income) and the EMTR’s are higher. As a result, higher low income welfare will lead to higher low income income 🙂

    Of course I expect you to say that if we go back to the efficiency-equity trade-off this creates problems, as lower taxes would encourage higher labour supply while higher benefits reduce the labour supply (this could be partially over-come by making the welfare payments partially dependent on work, or at least work search). I agree, I would say the same thing 😉

    However, if the tax cuts don’t achieve equity outcomes – because all the surplus is extracted by firms, then we only have the option of achieving equity considerations through benefits.

    Asking Dr Cullen to make the tax system more progressive won’t help those who need/deserve it, and will screw up savings and labour supply incentives further up the income chain – in a couple of hours we’ll see how he did this 🙂

  • Fred

    Matt, where’s a quick calculator showing the marginal rates, in particular taking into account WFF. Some graphs would be nice 🙂

  • “Matt, where’s a quick calculator showing the marginal rates, in particular taking into account WFF”

    I’m not sure there are any calculators around working out EMTR’s – however IRD has done some work on them.

    http://www.ird.govt.nz/aboutir/reports/briefing/briefing-2005/bim-part2/bim-part2a.html

    A good graph is here:

    http://www.ird.govt.nz/resources/file/eb63c649ad71c2b/bim-figure7-large-doc.jpg

    Although it looks like the EMTR’s here are actually only MTR’s + WFF – they don’t seem to include the removal of other benefits, which would increase the EMTR’s early in the scale.

    This is on the old tax scales though – the tax cuts will shift these EMTR’s up the nominal income scale (although in real terms they should be equivalent to the situation in say 2002/03 (wild guess) if WFF has been fully integrated by then).

  • Fred

    Interesting, in fact more than interesting, if I’m reading that right. I only asked because I wondered whether friends of ours had actually worked out whether it was worth Dad working Saturday, or Mum taking on evening work. Most will be well above the $30,000 bracket below which something seems to be seriously amiss. If I read the graph correctly someone earning around 13K gets a top up to 25K with one child and around 31K with two. So to ask the obvious question. How many part timers/seasonal workers do a deal with the boss to do the minimum hours to get to the 10K bracket and then spend the rest of their time “doing something else”. Does this show up in the stats and is it significant enough to affect overall productivity.

  • “How many part timers/seasonal workers do a deal with the boss to do the minimum hours to get to the 10K bracket and then spend the rest of their time “doing something else”. Does this show up in the stats and is it significant enough to affect overall productivity”

    That is a good point. It does show up in the data – there are spikes at each income tax bracket and at areas with high EMTR’s. Patrick Nolan from NZIER has done a lot of work on this sort of stuff – he’d have more of an idea about how this functions in the New Zealand context.