Ch4. Income Tax and Corporate Tax Theory — Effects on Labor Supply and Saving

Income Tax and Labor Supply

The federal income tax is levied on earned income. Does a higher tax rate cause people to work more or less?

Substitution Effect and Income Effect

Substitution effect: When the tax rate rises, the after-tax wage falls, making leisure relatively cheaper. Workers therefore substitute leisure for labor — labor supply decreases.

Income effect: When the tax rate rises, real income falls. To maintain their target income, workers may work more — labor supply increases.

Effect	Direction	Explanation
Substitution effect	Labor decreases	Leisure becomes relatively cheaper
Income effect	Labor increases	Workers try to compensate for lost income

Net direction: Determined by the relative magnitude of the two effects.

Lower income range: income effect tends to dominate → labor may increase with higher tax
Higher income range: substitution effect tends to dominate → labor decreases

Backward-Bending Labor Supply Curve

As the after-tax wage rises:

Low-wage range: wage increase → more work (substitution effect dominates)
High-wage range: wage increase → less work (income effect dominates; income target already met)

This produces the backward-bending labor supply curve.

The Laffer Curve

Arthur Laffer’s illustration of the relationship between the tax rate and tax revenue.

Revenue
 |        *
 |      *   *
 |    *       *
 |  *           *
 | *               *
 |                   *
 +---------------------------> Tax Rate
 0%                         100%

Key insights:

Tax rate of 0% → revenue = $0
Tax rate of 100% → revenue = $0 (no one works)
There exists a revenue-maximizing tax rate somewhere in between

Policy implications:

If the current rate is to the right of the revenue-maximizing point, cutting rates can increase revenue
This was the theoretical foundation of supply-side economics (Reaganomics)

Empirical limits: The revenue-maximizing rate is difficult to identify precisely. Evidence that current US rates are on the right side of the curve is weak.

Income Tax and Saving Decisions

Two-Period Consumption Model

Effect of the income tax on the saving-consumption choice:

After-tax return on saving:

After-tax interest rate = interest rate × (1 - tax rate)

When interest income is taxed, the real return on saving declines.

Tax effects on saving:

Effect	Direction
Substitution effect	Increase current consumption (less saving) — saving becomes more costly
Income effect	Increase saving — need more saving to reach future income target

The net direction is theoretically ambiguous. Empirical studies find the tax effect on aggregate saving is small and uncertain.

Interest Income Tax and Capital Formation

Tax on interest income → possible decrease in saving → less investment capital → slower economic growth

This is the argument behind proposals for lower capital gains and interest income tax rates.

Counter-argument: Empirical evidence suggests the interest income tax has a modest effect on saving. Non-tax factors (income level, financial literacy, pension design) matter more.

Corporate Income Tax Theory

Economic Incidence of the Corporate Tax

Who actually bears the corporate income tax?

Short-run incidence: Capital is immobile in the short run → shareholders (capital owners) bear the burden.

Long-run incidence (Harberger model):

Capital is mobile across sectors in the long run
Corporate tax → lower after-tax return in the corporate sector → capital migrates to the non-corporate sector
In equilibrium, the after-tax return equalizes across all sectors
The burden falls on all capital, not just corporate shareholders

Small open economy (most relevant for the US in a global context):

Capital is internationally mobile
Corporate tax increase → capital outflows → lower domestic wages
The corporate tax burden can effectively be borne partly by workers

Efficiency Effects of the Corporate Tax

The corporate tax distorts several economic decisions:

Investment decisions:

Corporate tax → lower after-tax return on investment → less investment
Accelerated depreciation, R&D tax credits mitigate this effect

Capital structure decisions:

Interest payments are deductible; dividends are not
This favors debt financing → creates incentives for excess leverage

Payout vs. retention:

Retained earnings may be preferred over dividends for tax reasons
Affects corporate dividend policy and shareholder value

Double Taxation

Corporate profits face two layers of tax in the US:

Entity level: Federal corporate income tax (currently 21% flat rate)
Shareholder level: Dividend or capital gains tax when profits are distributed

The same income is taxed twice.

Remedies:

Remedy	Description
Dividend tax exclusion / preferential rate	Qualified dividends taxed at lower capital gains rates (0%, 15%, or 20%)
Full integration	Treat the corporation and shareholders as a single taxpayer
Corporate deduction for dividends	Allow dividends to be deducted like interest

The US partially addresses double taxation through the preferential tax rate on qualified dividends and long-term capital gains.

Effective Tax Rates

Average effective tax rate: Actual taxes paid ÷ pre-tax income Marginal effective tax rate: Effective tax rate on an additional dollar of investment income

The marginal effective tax rate drives investment decisions. It is typically lower than the statutory rate due to accelerated depreciation, tax credits, and loss carryforwards.

Frequently Tested Concepts

Labor supply effects:

Which dominates, substitution effect (labor decreases) or income effect (labor increases)?
Backward-bending supply curve explains why the net effect varies by income level

Laffer Curve:

Revenue = $0 at both 0% and 100%
A revenue-maximizing rate exists in between
Empirical application is uncertain

Corporate tax incidence:

Short run: shareholders
Long run / open economy: can shift to workers

Double taxation:

Corporate tax + dividend tax = double taxation
Qualified dividend and LTCG preferential rates partially offset this

Study Checklist

Explain the substitution effect and income effect of the income tax on labor supply
Describe the shape and policy implications of the Laffer Curve
Differentiate short-run and long-run corporate tax incidence
Explain why the US corporate tax creates a bias toward debt financing
Describe the double taxation problem and how the US partially addresses it

Laffer Curve ★★★★★ : Tax revenue is zero at both 0% and 100% rates; a revenue-maximizing rate exists in between. At rates beyond the peak, tax cuts can raise revenue — but identifying the peak empirically is difficult.

Backward-Bending Labor Supply ★★★★ : At low wages, higher wages attract more work (substitution > income). At high wages, higher wages may reduce work hours (income > substitution) — workers choose more leisure once they’ve hit their income target.

Harberger Model ★★★★ : In a two-sector closed economy, the corporate income tax burden ultimately falls on all capital, not just corporate shareholders, because capital flows between sectors until after-tax returns equalize.

Practice Quiz

Q. Describe Weber’s characteristics of bureaucracy.

①Hierarchy (chain of command), ②Formal rules (legal authority), ③Specialization (division of labor), ④Written documentation (record keeping), ⑤Impersonality (decisions based on rules, not relationships), ⑥Merit-based recruitment. Optimizes rationality, predictability, and efficiency.