Question:
Critically discuss when taxation may be an Incentive or Disincentive to the work effort.
Modern economies of world taxation are one of the regulatory instruments applied by the national governments in order to shape up the national economic activity and bring stability all over. The implementation of tax has important justification in terms of social, political and economic activities taking place within and outside any nation. Taxation of broader term refers to the levy or charges made and mandatorily collected by the government under the jurisdiction of law. Hence taxation is a phenomenon backed by legal codes and that require legitimacy from both end [1], government and taxpayer common people. Impact of taxation on national economy as a whole is huge because it influences almost everything starting from production, consumption, savings, investment, allocation of resources and also distribution and redistribution of resources.
It also substantially influences the decision as well as ultimate work effort people contribute through income manipulation. The importance of work effort is undeniable in any country as the summation of these lead to shape up the total domestic production of the nation and higher the work effort, higher is the production and greater is the economic growth of the country [2]. Thus it becomes important to assess how the taxation impacts the work effort by creating incentive or disincentive to work for the people.
This report is to bring forth the concept of taxatio1n and the underlying importance it has upon the national economic and social health. It focuses to assess, analyze and conclude if imposition of tax promotes or hinders work effort of people.
What Is Taxation:
Taxation on a broader note refers to process of imposing and collecting taxes which is in important form of financial charges levied mandatorily by an authority mostly national and local government of any nation. Taxation is operative under legal framework of the nation following laws and the tax payers also falls under its jurisdiction. This indicates that if anyone disobeys and differs from following the law through resistance or evasion then the authority in concern can take legal action against them. Broadly, taxation can take place directly or indirectly based on whether that mode of tax collection is direct is indirect [3]. Tax can be implemented on any goods, services, property and even on income. Taxes on different components have exerts influences on service-holder, workers, sellers, buyers and citizens in different way.
Types of taxes:
Taxes are of different types based on the item is imposed upon. It can range from being income, form of social security contribution, goods & services, property, payroll or workforce and other taxes[4]. Moreover, taxes can be levied upon imports of the goods by a nation, which is called tariff. Based on application of tax, it can be direct which refers to money collection directly and indirect taxes in form of labor.
The compulsory and coercive collection of money in form of taxation is treated differently from other modes and form of payment for example in market exchanges where no obligations are imposed under taxation with no direct links with goods and services. Taxation acts as compelling act forced as threat from implicit or explicit sources. There is legal difference between taxation and extortions as government is the institutional body to implement taxes over any private bodies. Over the period of time and jurisdiction, tax systems has evolved[5]. In the modern time, tax is applied on physical assets, specific events and transaction in sales. What should be the mode, type and structure of tax policies are major concern of modern politics that imposes much challenge on the national government.
Motivation behind taxation:
Basic intention behind taxation is to earn revenue for government. It acts as one of the biggest internal source of government expenditure consolidating the fund that government maintains to incur expenditure. Moreover, taxing policies and collection plays pivotal role in social, economic and political aspects of ay nation. It is biggest tool applied by the government in order to maintain fiscal position, fight deficits, and gravitate towards budget surplus situation. Taxes on income and goods services has implication on national and per capita income that further determine the overall economic environment operating through social backdrop. Taxation has greatest impact on social redistribution of wealth from rich to poor and act as biggest instrument of bridging the gap of inequality. Taxation can be regressive, proportional and progressive which corresponds to rates of tax falling on the tax payers While tax imposition favors the government or authoritative bodies through preparing funds for its expenditure, the taxation create social problems too that can led to chronic economic and even political turmoil. Excessive taxation drains out income and resources making transfer or redistribution of money and resources within people and government affecting the overall lifestyle of people.
Work Effort:
Though scientific explanation suggests work as act of displacement due to application of force on object, in general terms work also referred to action undertaken by human. The work effort is the amount of physical and mental contribution human make in any job, work or task specified or assigned to him. There are certainly various motivating factors driving the amount of work effort contributed by people. The factors range from personal motivation, need, desire to responsibilities that create compulsion to work. However, there are some economic incentives as well that determines the work effort. For example income. It is evident that people work to earn money so that they cans satisfy their needs. If incentives are given in terms of additional pay, people would like to work more. Higher income possibilities motivate people to work more whereas lower income creates dissatisfaction that affects their work effort[6]. Even if incentives are provided whether one puts more effort in work or not depends on psychological factors and perception regarding standard of living and life. One of the important elements to be operative behind the direction of work effort on receipt of incentive or disincentives depend on elasticity of income. Moreover, taxation is also an important component that influences income and that further affects the work effort.
Relation Between Work Effort And Taxation:
The relation between taxation and work effort takes place through the manipulation of income. Taxation has direct income on income. Taxes like income tax and other goods and services tax reduces the disposable income. The impact of the taxation on work effort decision implements through two channels, monetary and psychological aspects [7]. In monetary terms, imposition of tax and its increase reduces the income. This reduces the capability of the taxpayers to spend on the necessaries, which again has greater implication on consumption, which falls too. This influences the efficiency and productivity that the labors exert. Ability to work as a result gets hampered lowering down the work effort. This is the general case mostly for poor people who have lesser income normally and taxation falls heavier on them. Rich people on the other hand receive less effects of taxation on efficiency and ability to work.
In terms of psychological factors, higher the taxation lesser is the motivation to earn more as more o fit will go out as tax payment from the income earner. This is common among rich strata of people compared to poor people who are more burdened psychologically for the taxation and consequent reduction in disposable income[8]. The psychological factor imposes tax as burden on the mind of the taxpayers. Generally taxation and fall in income produces disincentive effect on the willingness to work as same hours of work now pays off less income or the additional income is not enjoyed as it goes to government as tax. It is again psychological factor that let the tax payers decided upon whether they want to maintain existing living standard If they decide to do so, even the larger taxation cannot curb their willingness to work more to put extra effort in order to earn more and make up the loss of taxing. Thus, taxation has seemingly boosting effect on work effort [9].
The influence of taxation on the working ability is not always adverse or negative as some taxation are done in order to improve efficiency. For example, taxing cigarettes has positive impact on health protection of the people that further facilitates greater efficiency at work. Taxation has direct and universal impact on saving rate for all strata of people irrespective of their income level. Poor people have higher tendency to save. In presence of progressive taxation, as the income rises, people pay out more tax and thus rate of savings fall severely. This reduction in savings creates more incentive for poor people to work more to compensate the deficit caused from taxation. Fir rich people on the other hand, excessive taxation hampers savings and investment as a whole. Lower investment is symbolic of lower economic growth. Thus it can be concluded that taxation have disincentive effect more on the ability of the workers affecting the work effort through impact on income and savings.
Income plays driving role in the decision regarding putting work effort and actually working up to the level set. How much people react and respond towards consumption and saving decisions for fall in income after taxation are determined by the income elasticity of demand. This further determines the work effort people are willing to give. The elasticity varies between individuals of different income level and psychological mindsets. Inelastic income demand induces more work effort of the tax payers so that he can consume the things anyway he wants to irrespective of fall in income due to tax imposed. This happens because changes of income have lesser impact on his consumption demand and to mitigate his demand, he contributes to put more work effort. Thus, taxation plays role of an incentive to propel work effort. Taxation and progressive tax rates will hamper the taxpayers who have elastic income demand. The reduction in income due to tax affects the savings and consumption substantially and it acts as disincentive toward work effort of people[10].
Figure 1; Labor Supply after Tax Imposition
(Source: Author)
Figure 2; Labor Supply after Tax Imposition
(Source: Author)
The identification of whether tax induces incentive or disincentive in the work effort are done evidently through analysis of income effect and substitution effect of changes in post tax income level. There is greater implication of tax imposition in labor supply decision in the labor market. Tax on income makes individual receive lower wage than before. Lower wage cuts back the supply of labor. Two things can happen out of this. Firstly, the workers can increase the hours of work in order to keep earning certain level of income. It is known as income effect, which allows the taxpayers to compensate for the deductions from income. Secondly, the workers will become de-motivated to work and will opt for more leisure in substitution of labor[11]. This would reduce the work hour due to the disincentive in form of lower return from work. Whether imposition of tax creates incentive or disincentive among workers regarding putting more effort or supply labor that depends on which effects between income and substitution effect dominates. If substitution effect dominates then more leisure and less work laborers will put effort in the post-tax scenario, Stronger income effect increases work effort and Reduces Leisure Even If Taxing Takes Place.
Empirical Evidence:
Implication of taxation on economic growth is huge. Growth takes place through the work effort people exert, savings and investment. Taxation has direct impact on all of these making it more crucial for economic health of any nation. Taxation is biggest instrument for any government to meet national and public demands and fund for them through collection of revenues. The rate of tax varies from proportional to progressive rate implied upon personal annual income and goods and services. The amount of tax rates numerically varies among nations too depending upon the national economic situation like fiscal position, any social issues or even political turmoil. Developed nations generally tend to have lo higher income level compared to developing nations who mostly has lower per capita income. Hence, application of higher rate of tax on developing economies will induce more work effort as people need more income to sustain standard of living or reach a standard level of consumption and savings[12]. On the other hand higher income of the developed nation immune them form greater tax rates that never hinders their general lifestyle in terms of savings and consumption. Hence taxation imposes disincentives on the people to work and provoke them to curb labor supply.
From the empirical study, it has been fund that countries like USA, Australia, Canada, Germany, Italy and few other European nations, which are also termed as developed nation, have mostly tax rates ranging from 0-10% at max whereas developing nations have tax rates much higher ranging from 15-30%[13]. Countries like China, Hong Kong, India, and Argentina etc are the developing countries that encounter higher tax rates pertaining to greater fiscal burden on government in form of public expenditure, subsidies etc. Some countries impose tax on both income an dividend earnings which is called double taxation[14]. This drains out the disposable income of the people even more Overall it can be seen that disincentive to work due to taxation is higher in the developed economies than developing ones who has to put much hard work to earn livelihood and maintain decent standard of living.
Conclusion:
The discussion broadly takes us to the insight of taxation and its crucial role in the work effort. The main factor that connects these two ends is income which plays pivotal role in determining the effort put by people or amount of work is to be done. Many other factors drive the decision of work effort like needs, social status, psychological mind set and so on. An imposed tax not only reduces the disposable income people earn but also imposes mental and financial burden on the tax payer that seems to motivate him to work more and some de-motivate. Taxes are applicable on broad array of goods, services and even of different types of income. Even though taxing is good for a nation as it recovers the deficit of budget faced by government allowing it to procure enough sources of expenditure, excessive taxation can lead to frustration of people through receipt of much lower income even after working much. This can create disincentive for them to produce more or work decently. On the other hand it also has been seen from the analysis that how income elasticity of demand and urge of sustaining standard of living boost people to work more and harder even when various taxes cause deduction from income. The impact of taxation on work effort varies even between countries whether developed or developing and income level of people, poor or rich. Conclusion seems to differ pertaining to situations specific condition.
References:
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Dackehag, Margareta, and A. Hansson. “Taxation of income and economic growth: An empirical analysis of 25 rich OECD countries.” Journal of Economic Development 21.1 (2012): 93-118.
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