Incentives and Income Taxes; R. Shannon

Russell Shannon Incentives and Income Taxes HERE'S an intriguing opportunity: A book club now offers two free books to any member submitting the name of a friend who wants to join. But if you submit a secondname, you will get five books! Why does the club offer more than twice as much "pay" for just twice as much product? Is the offer obliga tory or just odd?Surprisingly enough, it goes a long way toward explaining the movement to reduce income taxes. Finding a second friend to join the club could be considerably more dif ficult than finding the first. You may have to travel further, or talk longer to convince him. That makes the larger reward crucial. Russe" Shannon Is a professor In the Department of Economics, College of Industrial Management and Textile SCience,Clemson University. But what if extra effort were un necessary? What if you could con vince two friends of the benefits of membership simply by making a 15 minute phone call to each one? As it turns out, even then an additional incentive may be needed.

Examples of this fact pervade our economic lives. The need to increase incentives regularly appears when ever companies want employees for overtime work; usually they must pay workers time-and-a-half, even though the duties involved do not differ from the ordinary routine. Similarly, when you buy a box of ce real in the supermarket, you may receive along with it a coupon worth ten cents on a second box. Diverse though these examples may seem, they all have one thing in common. They all illustrate the 653 654 THE FREEMAN November fundamental economic principle of "diminishing marginal returns." Sometimes, the same principle is called the law of "increasing costs." Understanding of this principle dates back at least two centuries. In 1789 Thomas Malthus published his thoughts on population. 1 Using data provided by Benjamin Franklin and others, Malthus predicted that pop ulation growth eventually would outstrip the food supply.

That prediction is one of the rea sons economics even today is called the "dismal" science. In current dis cussions of famine in Third World countries, references to the "Mal thusian specter" are not unusual. In Aldous Huxley's famous novel Brave New World, women wear "Malthu sian belts" designed to prevent con ception and control population growth. 2 But what has Malthus to do with book clubs and income taxes? If you take time to find a friend to join a book club, you will be con fronted by a cost. The cost isn't nec essarily money-unless you ac tually take time off from your job. But you will have to give up work ing in your yard, playing a game of bridge, or watching TV. Such a sacrifice might be fairly easy to make while finding the first friend. But what about the second? Giving up one TV program or half an hour of your yard work may not mean much. But the second half hour will surely mean more; that is, the cost increases. So you will need a larger reward to compensate. The people who run the book club ob viously know this, and they have acted accordingly.

By the same token the company that sells cereal knows that a second box of their product will be less at tractive to most people than the first. The cost-or opportunity forgone will be larger. Thus, by making them a better offer on the second box, the company may entice people to buy more. ProgressiveRates of Tax All of this may seem strangely re mote from the matter of income taxes, but in fact it is not. Both our federal and our state income taxes are "progressive." That means that, as people earn larger incomes, they move into higher income tax brack ets. So more pay means they end up sending a larger share of their in come to the government. Several arguments support the progressive system, not all of them objectionable. Some people, of course, urged on by envy, merely like the idea of trying to "soak the rich." Others, however, talk in terms of peoples' ability to pay; they main tain that wealthier individuals can surely afford to shoulder a larger share of the tax burden. But what effect do rising tax rates have on the incentive to work?

Clearly, the progressive rates may 1981 INCENTIVES AND INCOME TAXES 655 generate a perverse response. Con sider, for example, a married person whose employer offers him the op portunity to do more work and earn more income. Say this employee, in exchange for ten per cent more work, could get 15 per cent more pay. Based on what we have just discussed about human inclinations, we would rea sonably expect the employer to make that kind of offer. But the increase in pay may shift the employee into a higher income tax bracket. If his taxable income were about $20,000, he could, as a result of the pay increase (and based on 1980 federal income tax rates), vault from paying 28 per cent on marginal income to paying 32 per cent. Thus the incentive to work may be so diminished that it will no longer be attractive. For someone in an even higher in come tax bracket, the adverse effect is augmented. Thus, to secure the employee's services, the employer would be forced to make an even better offer. Of course, the job might be offered to someone else but he might lack the competence. Thus the job will go unfilled and the work un done, and society will be the poorer for it.

In recent years, Congress has gra ciously refrained from raising our income tax rates. However, Social Security taxes have risen dramati cally. Simultaneously, inflation, prompted largely by the rapid growth of government spending, has shoved more and more Americans into higher and higher income tax brackets. Thus there is less and less incen tive to earn incomes that are tax able. So unless we like more leisure, we are increasingly inclined to enter the so-called "underground econ omy."3 Of course, that doesn't mean peo ple are actually burrowing beneath the soil-or looking for oil. Instead, they engage in barter or else make payments in cash, seeking thereby to escape the ever watchful eyes of the Internal Revenue Service. In one case, for example, a worker presented a bill for some repair work to a home owner for $30. When the owner started to write out a check, the worker demurred and insisted instead on receiving cash. But when the owner discovered he had only $25 in his wallet, the worker ac cepted it, gladly sacrificing the $5 rather than pay taxes on $30!

The UndergroundEconomy The phenomenal growth of such activities has become so substantial that, by some estimates, our "under ground" activity may now be the equivalent of 20 or even 30 per cent of Gross National Product. Cer tainly, this production is, in some sense, less desirable than it would be if everything were out in the open. Besides that, our government is los656 THE FREEMAN ing tax revenue which might other wise be used to build schools or shore up our national defense. If tax rates fall, American work ers will have greater incentives to produce goods and S'ervices for American consumers. Some people who are already working will leave the underground for the more effi cient open economy. Thus, income subject to taxation will grow. In fact, it's even possible that, though income tax rates fall, the in crease in taxable economic activity will be so great that tax revenues will rise. That is the thesis underly ing the now-famous Laffer curve, originated by the economist Art Laf fer.

4 The implication is that, while tax rate cuts will directly benefit in dividuals, in the end society as a whole will prosper. At first glance, you might have thought the book club's offer was ei ther totally absurd or grossly irrel evant. But it's not. It bespeaks a universal truth which underlies much of the current "supply side" economics. When you understand that additional effort often requires increasing rewards, then, along with many others, you may be eager to ride the tide of enthusiasm rising relentlessly behind the tax reduc tion program. , -FOOTNOTESIT. R. Malthus, An Essay on Population (New York: E. P. Dutton and Co., 1958). See Vol. 1, Book I, Chapter I, pp. 5-11. 2Aldous Huxley, Brave New World (NewYork: Bantam Books, 1962), p. 34. 3See Alfred L. Malabre, Jr., "Underground Economy Grows and Grows," Wall Street Jour nal, October 20,1980, p. 1; Robert M. Bleiberg, "Surfacing the Scratch," Barron's February 9, 1981, p. 7.

4See Edward Meadows,"Laffer's Curve Picks Up Speed," Fortune, Feb. 23, 1981, pp. 85-88; ''A Guide to Understanding the Supply-Siders," Business Week, December 22, 1980, pp. 76-78; Rowland Evans and Robert Novak, "What 'Sup ply Side Economics' Means to You," Reader's Digest, June 1981, pp. 118-122; "Laffer: A Steady Supply of Ideas," Newsweek, June 29, 1981, pp. 11, 13; "The Laffer (not laughter) Curve" in Richard B. McKenzie and Gordon Tullock, The New World of Economics: Explo rations into the Human Experience (Home wood, Ill: Richard D. Irwin, 1981), pp. 227 241. IDEAS ON LIBERTY The High Cost of High Tax Rates IN COMBINATION, the high rates of corporate, personal, and estate taxes have the effect of creating an all but irresistible "death wish" in the successful, small, closely held company. The owner of such a company is likely to have as his principal concern, not how he can expand and insure the continuity of the venture, but rather how he can most advan tageously sell it out, liquidate it, or cut down his share of ownership all in defense against potentially confiscatory taxes.

THE MORGAN GUARANTY SURVEY Clarence B. Carson C. S. Lewis on Compelling People to Do Good ONE of the more amiable traits which many people have is the inclination or desire to share something good with others. If good fortune befalls them, they rush to share it with their friends. If they discover a good recipe, an interesting author, a new plant, or whatever, they can hardly wait to share the information with someone. I once knew a good woman who was so given to sharing what she cooked with others that her hus band accused her of waylaying pas sersby on the road to feed them. There are pitfalls to be avoided, however, even in such good-natured sharing. Not everyone is at every moment at the right spiritual pitch to appreciate the good tidings of oth ers. Not all palates are prepared for Dr. Carson Is a specialist in American social and in tellectual history. He Is President of the Center for Individual and Family Enterprise. For further infor mation, write him at Route 1, Box 13, Wadley, Ala bama36276.