Sunday, October 10, 2010

Greg Mankiw forgets about the income effect

Professor Mankiw says he can afford higher taxes.  For that I give him credit.  But he also says that higher income taxes might keep him from writing his New York Times column.   He then implies that higher taxes will generally keep people from working.

This is the substitution effect--because leisure becomes relatively cheaper, people consume more of it.  But higher taxes also reduce after-tax income (obviously), so in order to maintain living standards, one might decide to work more in the face of higher taxes.  This is called the income effect.  I can speak for my household--our after-tax income is more than sufficient for our "needs," but if we were taxed more, we might have to work more to satisfy these "needs."

It is an empirical question as to whether within certain ranges of tax rates, raising taxes increases or reduces effort.  Theory gives us an ambiguous answer.  (h/t Mark Thoma).