Tax Cuts Do Not Increase Labor Supply

A central tenet of U.S. “conservative” and Republican economic policy since at least the election of Reagan in 1980 is that tax cuts cause people to work more and longer hours. This is part of the so-called “supply side economics”.  The implication is that the longer hours and more labor supply will then raise the dollars of taxes collected despite the rates being lower, the so-called Laffer Curve effect.

The argument is overly simplistic and fallacious on it’s face. The theoretical support is the one-liner theory idea that “people respond to incentives, take-home money is an incentive to work, and therefore increased take-home pay causes people to work more”. It’s just a version of the retailer’s “cut the price and make it up on volume” logic.  And as such it is dependent on the elasticity of the responses – remember when the response is inelastic, as in “I have to work to live”, the volume won’t be made up.  Despite their being no strong empirical evidence of tax cuts helping raise more tax dollars or motivate widespread increased labor supply at least in the range of real-world tax rates, the concept persists – another Zombie Economics idea.

Dillow adds more to the evidence pile:

Taxes and labour supply: more evidence

Do tax cuts boost labour supply and hence tax revenues? Here’s some evidence that they don’t. Pierre Cahuc and Stephane Carcillo report on an experiment* in France:

The detaxation of overtime hours introduced in October 2007 was intended to allow individuals in France to work more so as to earn more. The evaluation conducted in this article indicates that the detaxation of overtime hours has not, in fact, had any significant impact on hours worked…
Detaxation is a measure costly for the public purse, without any ascertained impact on hours worked.

We can put this alongside the evidence we have for footballers and New York cabbies, which suggests that we are on the positive side of the Laffer curve, where tax cuts do not increase revenues. It’s also consistent with the – very tentative – evidence we have from UK tax receipts this year, which suggests that the introduction of the 50p tax rate has not (yet) reduced revenues.
Now, this is not to deny that Laffer curves exist. No doubt, there is a point at which higher taxes would be counter-productive and tax cuts would pay for themselves. And I’ll concede that it’s possible that the 50p tax rate will, eventually, have adverse effects.
But where is the hard evidence that, at tax rates around current levels, there are such effects? Do the glibertarians  have anything more than prejudice, half a theory, and the post hoc ergo propter hoc fallacy?

Readers and students should note: There is no conflict between these claims and the Keynesian macro-economic policy assertion that tax cuts can stimulate the economy.  The Keynesian policy mechanism works differently.  It asserts that tax  cuts work to widen the budget deficit.  The households spend part of the tax cut while the government continues to maintain it’s other spending. Therefore Aggregate Demand, total spending, in the economy increases. As the spending is received by firms who then pay for labor & resources in the circular flow, the increased spending has a multiplied effect.  The Laffer curve concept is different. It asserts a direct greater willingess-to-work labor supply response.

Why Do People Work?

Why do people work?  At first it seems an easy question – to get money or earn income is the answer that comes quickly to mind.  Indeed, mainstream neo-classical micro economic theory answers the question this way and uses it to build a model where people (households) make decisions about how much to work (called “labor supply”) as a function of the real wage offered.  There’s a counterpart model where business firms decide how many workers to hire based on the real wage and it’s called “marginal productivity theory”.  It results in a “labor demand” curve. Like moths drawn to lights, when economists are given a “supply” curve and a “demand” curve we must see where they intersect, label that equilibrium, and say all’s well, the market solves everything. We then proceed to use our equilibrium result as block in building an even larger theory or model.  And, in fact, that happens with labor demand and supply.  It becomes a critical part of some mainstream (mostly Classical based) macroeconomic theories.

Unfortunately, this little example also shows economists behaving badly, or at least illogically and unscientifically.  Let’s go back to the beginning.  It’s a huge assumption and leap of faith (or ideology) to go from the casual observation that most people prefer (or need) to get paid for their work to assuming, as mainstream theory does, that money is the only reason people work.  An even greater leap is the assumption that there is a quantitative relationship between real wage rate and the amount of work people are willing to offer.  The mainstream economists assume that work is necessarily a negative, disutility-creating experience. But that is not a logic inference from the observation that people like to or insist on getting paid for work.  It is entirely plausible that people find work a necessary, fulfilling part of life – after all many people are observed to continue working even when they don’t need it financially. If may be that people want balanced lives – a mix of work, leisure, and hygiene.  It may be a mix of these factors. Indeed, research in management and psychology fields suggests it is.

But economists persist in the simplified theory. Unfortunately this leads to misunderstandings and bad models when the economists tackle larger problems like unemployment. Bill Mitchell notes:

The simplest version is that labour supply in the mainstream model (and complex versions don’t add anything anyway) says that households equate the marginal disutility of work (the slope of the labour supply function) with the real wage (indicating the opportunity cost of leisure) to determine their utility maximising labour supply.

So in English, it is assumed that workers hate work and but like leisure (non-work). They will only go to work to get an income and the higher the real wage the more work they will supply because for each hour of labour supplied their prospective income is higher. Again, this conception is arbitrary and not consistent with countless empirical studies which show the total labour supply is more or less invariant to movements in the real wage.

Other more complex variations of the mainstream model depict labour supply functions with both non-zero real wage elasticities and, consistent with recent real business cycle analysis, sensitivity to the real interest rate. All ridiculous. Ignore them!

In the mainstream model, labour market clearing – that is when all firms who want to hire someone can find a worker to hire and all workers who want to work can find sufficient work – requires that the real wage equals the marginal product of labour. The real wage will change to ensure that this is maintained at all times thus providing the classical model with continuous full employment. So anything that prevents this from happening (government regulations) will create unemployment.

If a worker is “unemployed” then it must mean they desire a real wage that is excessive in relation to their productivity. The other way the mainstream characterise this is that the worker values leisure greater than income (work).

Macroeconomists, thinking they have firmly built a macro theory on some “micro foundations”, assume that involuntary unemployment (the kind where you want a job but can’t find a job) simply doesn’t exist unless people are insisting on getting paid too much.  It’s absurb, but that has become the foundation of not only macro theory, but micro theories of distribution of income, and modern policy.