Wednesday, March 30, 2005

Low tax, low work?

If you repeat something often enough, especially in politics, it seems to become the truth. All the more so if it is plausible to begin with. Take the idea that if we are given tax cuts we will work harder. The so-called ginger group of Coalition MPs and its fellow travelers are pushing this idea to build their case for a cut in the top marginal rate of income tax, which is 47.5 per cent plus the Medicare levy.

The head of Parliament's economics committee, Bruce Baird, went on ABC radio shortly after the governor of the Reserve Bank complained about a shortage of skilled workers. Baird said the high top tax rate contributed to the shortage. "If we want real incentive - for people to stay in the workforce, for skilled tradespeople to work overtime - when they're hit by a 47.5 per cent tax rate, it is too high."

Australia's best-known backbencher followed up. Malcolm Turnbull said he wanted to cut the top rate so there was "nothing in the tax system which discourages people from seeking work".

Briefing the ginger group has been the Centre for Independent Studies. Its paper Tax Reform to Make Work Pay asserts that a cut in the top rate would make people "work harder to earn more".

It is a simple interpretation of human behaviour not shared by one of the founders of modern economics...

William Stanley Jevons asked rhetorically more than a century ago: "If a workman can earn ninepence an hour instead of sixpence, may he not be induced to extend his hours of labour by this increased result?"

His reply was that: "This would doubtless be the case were it not that the very fact of getting half as much more than he did before lowers the utility to him of any further addition. By the produce of the same number of hours he can satisfy his desires more completely."

What was he getting at? Any increase in pay, or a tax cut that increases pay, affects the desire to work in two diametrically opposed ways. On one hand it increases the financial reward for doing an extra hour of work, just as the centre has noted. Economists call this the "price" effect.

But on the other hand any increase in the rate of pay makes it easier for a worker to obtain his or her income target. After that it reduces the need to do an extra hour of work. Economists call this the "income" effect.

A pay increase or a tax cut makes extra work both more attractive and less necessary. It is impossible to tell on the basis of theory whether a tax cut would increase the number of hours people put in at work or cut them. Or do nothing much at all if the two effects more or less cancelled each other out.

It is also very difficult to find out in practice. Many of us are in jobs in which the hours are fixed and the pay rates don't vary much. So in 1994 four American economists decided to investigate the group of workers they thought most free to respond positively to a hike in their hourly rates of pay.

New York taxi drivers are free to vary the number of hours they work each day up to a maximum of 12 hours a shift. After paying a fixed fee for use of the cab, they keep every fare they earn. And their hourly rate of pay varies from day to day. On good days, when business is brisk, their hourly rate of pay is quite high. On bad days it can be appallingly low.

If an increase in the hourly rate did encourage workers to put in more hours, New York taxi drivers would be expected to put in the most hours on those days when their pay rate was high, knocking off earliest on those days when it was low.

A Caltech University economist, Colin Camerer, and his team examined more than 1000 taxi company documents providing data on the daily pay rates and hours of work of about 500 drivers. What they found appeared to defy common sense.

Typically on those days when business was good, New York taxi drivers knocked off the earliest. On those days when their hourly pay was at its lowest, they worked the longest. It's the opposite response to that assumed by the Centre for Independent Studies. Camerer concluded that taxi drivers were "target earners" who kept driving each day until they made a certain amount of money.

(Interestingly, he found that not all drivers behaved that way. The more experienced drivers did tend to work longer hours on those days when business was good, as assumed by the centre, but the effect was small and overwhelmed by the behaviour of the less experienced drivers.)

Singapore taxi drivers appear to behave that way as well. Yuan Chou of the University of Melbourne discovered that in 1997 when he set out to test whether Camerer had stumbled onto a purely Western phenomenon. In the latest issue of the Journal of Political Economy the economist Henry Farber revisits Camerer's study and finds no connection between the daily pay rates of New York taxi drivers and their knock-off times.

But even this is scarcely good news for those politicians and think-tankers asserting that tax cuts make people work harder. If that was true you would expect to find a very strong positive connection between pay rates and knock-off times.

After surveying studies on all types of work Farber concludes that the response of men to an increase in pay is usually "very small and not significantly different from zero".

Intriguingly, he finds that for women, particularly married women considering returning to work, the response to a pay hike or a tax cut is a good deal larger.

There are several reasons that should be the case. Married women have other demands on their time (an Australian survey finds that married women spend twice as much time on housework and child rearing as married men); they often don't need to work in order to live (having access to their husband's income); and the effective rates of tax they face on returning to work are horrific. Many make next to nothing after paying for child care.

The evidence suggests that these are the people the ginger group should be focusing on if it wants to use the tax system to get Australians to do more work. Cutting the top rate of tax might do nothing at all.

A few years ago my wife and I needed to phone our plumber. He told us he had retired early and moved up the coast.

I have a suspicion that if he had been facing a lower rate of tax he might have retired even sooner.