ChainWhat it assumes · how to break it
Start
The government makes income tax more progressive, for example raising the 45% additional rate paid on the highest incomes.
1
As a result, the post-tax wage for each extra hour worked by high earners falls.
marginal tax rate · net wage
marginal tax rate · net wage
Assumes: The higher rate applies to the extra income of people deciding how much to work.
But: Many high earners are salaried with fixed contracts, so their hours do not depend on the reward for each extra hour.
2
This means leisure becomes relatively cheaper, so through the substitution effect some high earners work fewer hours, retire earlier or turn down promotion.
substitution effect · income effect
substitution effect · income effect
Assumes: The substitution effect outweighs the income effect.
But: Through the income effect, some high earners work more to keep up their post-tax income, so total hours may not fall.
3
Consequently, entrepreneurs keep less of the reward from starting and expanding businesses, so fewer new firms are created and less risk is taken.
entrepreneurship · incentives
entrepreneurship · incentives
Best link to attack
Assumes: Entrepreneurs' rewards are taxed as income.
Assumes: Entrepreneurs' rewards are taxed as income.
But: Founders often take their returns as dividends or as capital gains when they sell the business, which are taxed differently from income.
4
Therefore, investment, innovation and productivity grow more slowly, so LRAS shifts right by less and long-run growth is lower.
LRAS · productivity
LRAS · productivity
Assumes: Lost investment by entrepreneurs is not replaced.
But: If the revenue funds education, infrastructure or research, the state may raise productivity by more than private investment falls.
End
Long-run economic growth may be lower as incentives to work, invest and take risks weaken.
Evaluation chain
- E1However, the effect on growth depends on how much of entrepreneurs' reward is actually caught by income tax.
- E2Because founders often take returns as dividends or as capital gains when they sell a business, a higher income tax rate leaves much of the reward untouched.
- E3As a result, the incentive to start and grow firms changes very little.
- E4So the effect on long-run growth is small, unless taxes on dividends and capital gains rise at the same time.
Another way to attack it: Lower income inequality may itself support growth by widening access to education and keeping consumption steady, since lower-income households have a higher MPC.
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Questions this answers
- Assess the impact of a more progressive income tax on long-run economic growth.
- Discuss the conflict between reducing inequality and promoting growth.
- Evaluate the view that higher taxes on top earners damage the economy.
Diagram
LRAS diagram: LRAS shifts right by less than it otherwise would, so potential output grows more slowly.
Reverse and related
Cut in the top rate → stronger incentives for work and enterprise → LRAS may grow faster, although inequality widens.