EFFECTS ON WORK EFFORT

⦁ EFFECTS ON WORK EFFORT

The effects of labor supply on economic growth are twofold. An increase in population results in an increase in output; but unless output rises at the same percent age rate as population, per capita income will fall. Population growth, therefore, may depress rather than increase per capita output. This outcome, of course, was the dismal fate which Thomas Malthus predicted some 175 years ago. Even though economic development in the industrial countries has managed to combine rising per capita income with rising population, the Malthusian specter still darkens the prospects of economic development in the less developed countries. However this may be, fiscal instruments are not a major factor in population policy. Personal exemptions under the income tax, although related to family size, are hardly sufficient to enter into family planning, and expenditure programs for birth control are hardly within the realm of fiscal economics. Fiscal policy, however, enters the picture via effects on labor input with a given population. Changes in labor input-whether in hours worked or labor force participation-are positively related to the level of both total and per capita output. Tax Effects We begin with the effects of taxation on labor supply. Income Tax The effects of the income tax on work effort are by no means obvious. The tax generates an "income effect" which is favorable to working more, so as to recoup lost income. But it also generates a substitution effect which works in the opposite direction. Since the reward for surrendering leisure is reduced, people will tend to work less. The net result depends on which of these two effects is stronger. As shown in Figure 17-1, the wage rate prior to tax equals OA/OB and the worker may choose positions on the opportunity locus AB. He or she selects C, the point of tangency, with indifference curve i' and hours worked equal to DB. As a tax at wage rate AE/AO is imposed, the opportunity locus swivels down to EB and the taxpayer moves to F on indifference curve i". Leisure is increased and work has fallen by DG. Suppose, however, that the slope of the lower indifference curve is as shown by i"*. In that case, the worker moves to H, with work rising and leisure falling by /D. 3 The former case reflects an upward slope in the labor supply schedule, whereas the latter reflects a backward-sloping schedule. If the labor supply schedule is upward-sloping, as most textbooks draw it, the negative substitution effect outweighs the positive income effect and work effort is reduced. Yet seen in the historical perspective, it is evident that rising wage rates have been accompanied by reduced hours of work, i.e., a substantial part of the gains from productivity growth has been directed into increased leisure. Although this does not prove that the short-run supply schedule of labor is backward-sloping (in which case taxation would raise rather than lower the amount of labor supplied), it should not be readily assumed that an income tax must reduce effort. Even though we all seem to know someone who has been discouraged by taxation and has worked less, most of us seem to respond by working more.