What Actually Happens to the Economy When Our Taxes Go Up

A shadow of a voter is seen on a poster of Uncle Sam - Source: Filippo Monteforte/AFP/Getty Images

A shadow of a voter is seen on a poster of Uncle Sam – Source: Filippo Monteforte/AFP/Getty Images

Taxes — everybody loves to hate them. But there’s a special blend of venom and spite for those who want to raise them by tacking on additional costs  to a gallon of gasoline, a six pack, or even simply just taking a bigger cut of your paycheck every week. Taxes are no fun, but they are one of the realities of the modern world.

People tend to view taxation in a variety of ways. Some people adopt the view of Supreme Court Justice Oliver Wendell Holmes Jr., when he famously said that, “taxes are what we pay for civilized society.” That tends to make sense for a lot of people, who then blithely accept that there’s little hope of worming their way out of paying Uncle Sam. But there are those on the other end of the spectrum who actually view taxation as a form of theft.

“The Constitution doesn’t permit the feds to steal your money. But steal, the feds do,” writes former judge of the Superior Court of New Jersey, and senior judicial analyst at Fox News Channel Andrew Napolitano (or Judge Napolitano, as he is commonly known), in an article for Reason.

“Just as we don’t have the power to take our neighbor’s property and distribute it against his will, we lack the ability to give that power to the government,” he continues. “Just as you lack the moral and legal ability to take my property, you cannot authorize the government to do so.”

Clearly, taxes are a touchy subject, and people get fired up about them. Especially when talk among legislators involves raising them.

What exactly happens when our taxes go up? Obviously, we have less money to spend, as more of it is going to the government. And the traditional argument is that that slows down the economy.

Is that necessarily the case? Slate’s Jordan Weissman explained in a recent article that there are essentially two competing schools of thought as to what happens in the wake of a tax increase, and both seem to make at least some sense when you think about it.

“On one side, you have the so-called substitution effect, the idea that people work less when the IRS snatches more of their paycheck, because each hour of labor suddenly earns them less money,” Weissman writes. “On the other side, you have the ‘income effect’—the idea that when taxes go up, some people might actually work harder and longer in order to maintain their standard of living.”

As for which prevails in the end, Weissman dug up a report from the Congressional Budget Office that says in practice, the substitution effect — the one where people end up working less — comes out on top. But by just a little bit. With that in mind, we can say that yes, higher taxes do have an effect on productivity, and can lead to economic stagnation. It’s a close call, however.

“The extent to which workers respond to changes in their after-tax wages, and hence tax rates, can affect the supply of labor, total output, and other aspects of the economy,” write Robert McClelland and Shannon Mok of the Congressional Budget Office. “Workers can change the amount that they work in three ways: they can decide to work or not, they can adjust the number of hours they work, and they can alter the intensity of their work for a given number of hours at work.”

Again, when we see taxes go up, and workers keeping less of what they earn as a result, they tend to become frustrated or discouraged, and pare down their spending.

Now, this is for individual earners, of course. As far as corporate tax rates, we’ve already had a chance to see what happens. At the state level, a National Bureau of Economic Research study shows that tax cuts don’t lead to increased economic advantages, but that tax increases can indeed stunt growth.

At both the individual and state level for businesses, tax increases do appear to be marginally harmful. While the debate is sure to rage on in Congress and local legislatures forever, the real decision regarding tax increases lies with balancing the need for additional revenue with the potential loss of productivity.

Follow Sam on Twitter @Sliceofginger

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