Effect of taxes on work and leisure

We previously discussed the effect of changes in income on spending habits. Let's now consider how taxes affect the decision to work.

Given a particular income constraint, there is a maximum level of achievable utility that each individual will pursue (by definition).

That is, U = U(I), where I = income.

I = earnings + wealth - net taxes

Rather than including "return on savings" as a portion of income, we are considering lifetime income and consumption. At any consumption decision, the individual will redetermine whether to reallocate savings to consumption.

Wages are limited by time. An individual only has so many hours a week, so many weeks per year, and has an expecation of so many years per lifetime. Depending the relative value of leisure and consumption, an individual will determine how much to work:

U = U (I, L) = U (E(1-L) + W - T, L) where E is maximum future earnings, L is the fraction of available time spent on leisure, W is wealth, and T is net taxes.

A lump sum increase or decrease in T has the same effect as increasing or decreasing W. An individual becomes less likely to work. (Exception: If an individual can use W to increase E, for example by going to school, then increasing W may increase time spent working.)

If T = tE(1 - L), where t is an income tax rate, then decreasing t has the same effect as increasing E. An individual becomes more likely to work.

So which is better in a time of recession? When demand for labor is down, should we increase supply or decrease it? It seems to me that increasing the supply of labor will offset the apparent increase in earnings by decreasing equilibrium wages through tax cuts or subsidy. A one-time subsidy will increase wages but be offset by required tax increases whether now or later.

I conclude then that in the exception is the rule. Our government action should be centered around enabling individuals to increase or maintain E by avoiding starvation, exposure, disease and death and pursuing educational opportunities and job training. Unemployment benefits, national health insurance, and subsidized tuition serve this purpose and should be pursued.