Included in President Joe Biden’s recently released budget proposal are several tax increases, among them an increase to the top marginal income tax rate. While the rate change, from 37 percent to 39.6 percent for income above $400,000 for single filers and $450,000 for married filers, appears minor, it nevertheless provides opportunity to explain why progressive marginal tax rates can be particularly harmful to the economy.
Advocates typically express support for progressive income taxes couched in the language of “asking the rich to pay their fair share” and “equity.”
It is fair for high income to be taxed at a steeper rate, supporters say, because the wealthy can afford to pay it. Moreover, taxing high income levels at a higher rate helps to equalize after-tax income. Combined with a welfare state that redistributes the income from rich to poor, progressives view this as a means to bring about greater income equality.
But what if progressive taxes served as an especially harmful disincentive to work and productivity, and as a result would harm the poor more than help?
Poverty is reduced through increased productivity, and in no other way. When productivity, and the resulting economic growth is stunted, it is the poor who are harmed disproportionately.
With the guidance of a sound analytical framework provided by marginal analysis, we can understand why progressive taxes are extraordinarily problematic for productivity gains.
Let’s take the example of Alex. For simplicity’s sake we’ll say he has a weekly income of $1,000. At a flat tax rate of 25 percent, his take home pay will be $750. Naturally, Alex will use this $750 to satisfy his highest-ranking goals that can be achieved with that amount of money, such as rent, groceries, and other vital utilities.
On the flip side to that coin, assuming a 40-hour work week, Alex will have 128 hours of leisure time per week. Just like his salary, Alex will use these 128 hours of leisure time to satisfy his most urgently ranked goals for leisure, such as sleep, time with family, exercise, and the like.
Now say Alex has an opportunity to work another 10 hours and earn another $250 of income. If the tax rate on that additional income was also 25 percent, Alex could take home an additional $187.50 after taxes.
Sticking with our analysis based on marginal utility, we know that Alex will use that additional money to satisfy lower-ranking goals that can be achieved with money, ends not already satisfied with his original $750 paycheck.
But he will also have to give up ten hours of leisure, and with each of those additional ten hours he forgoes, he will be giving up the satisfaction of a more-urgent goal he could have accomplished with his leisure time. The first additional hour of leisure he forgoes may not be that important to him, but giving up, say, the eighth, ninth, and tenth additional hours of leisure time will cause him to forgo an activity quite valuable to him.
But even with that consideration, to Alex, the goals he can satisfy with the additional $187.50 may still be more valuable than what he could have done with those additional 10 hours of leisure.
But what if the additional income fell into a higher tax bracket on the progressive income tax structure? Perhaps the tax rate applied on Alex’s extra hours was 75 percent. In other words, the additional $250 of income was taxed at a rate of 75 percent, leaving him just $62.50 in exchange for his extra ten hours of work.
Alex may not find the $62.50 more valuable to him than what he must give up by foregoing another ten hours of leisure time – recall that he must do without more and more valuable goals, the more leisure time he forgoes.
Additionally, in this scenario, we can say that the “price” to Alex of the additional 10 hours of leisure is reduced to only $62.50 due to the tax (he would only be forgoing $62.50 in order to enjoy 10 additional hours of leisure). At such a low “price,” Alex will tend to consume more leisure.
This effect is especially likely given that the additional potential income would be used to satisfy progressively lower-ranking ends, while additional leisure time he would need to forego would have been dedicated to increasingly valuable ends.
From this example, we can see that “progressive” tax rates are especially discouraging to people deciding whether to attain higher income through more work or higher salaries, because the additional income may be taxed at such a high rate that the worker decides it is not worth giving up additional leisure time.
Using marginal analysis, we discover that the additional – or marginal – amount of money Alex earns through working more hours will be devoted toward satisfying less-urgent desires. Meanwhile, each additional – or marginal – hour of leisure he must forego requires him to miss out on increasingly important goals he wishes to accomplish with his leisure time.
In sum, “progressive” taxes impose a particularly strong disincentive for more productive work. Depriving the economy of greater productivity curtails the alleviation of poverty, and as a result disproportionately harms the poor.