Stefan Karlsson recently wrote an interesting piece for Mises.org on the substitution and income effects of taxation. (See also the blog thread.) He denies the relevance of income effects of taxes on economic efficiency and argues instead that the substitution effects of marginal tax rates reduce economic efficiency by shifting us towards less work and more leisure at the margin. While his reasoning is sound, it ignores a tried solution to this problem of taxing labor without affecting labor supply.
Supply Side Economists emphasize these issues in arguing for lower marginal tax rates, and refer to John F Kennedy as one who put this into action. However, it is the case that Supply Side economics was implemented by none other than Josef Stalin in the Soviet Union- Yes, Ronald Reagan and Joseph Stalin were both avowed Supply Siders.
Stalin set high infra-marginal tax rates on labor (Olson 2000 P120). This means that Stalin set effective tax rates on the standard work week for soviet labor at very high levels. Stalin set effective tax rates on marginal income at very low levels, so that workers kept nearly all of their ‘overtime pay’ (Olson 2000 p123). What does this look like?
Stalin set taxes to try to collect the value of the area above the supply of labor curve, up to the point where people would work less at the margin. This made the income from a normal work week (infra-marginal income) too low for workers to live on. Not only did workers refrain from reducing their labor supply at the margin, they seem to have increased this supply, if possible. Stalin explicitly paid incentive pay to make workers produce more. This increased supply, as Karlsson pointed out, reduces leisure- so there is a real cost to workers. But his argument that substitution effects matter to taxation is rendered ineffective by this approach where taxes are paid mostly off the margin.
There are other costs involved here. First of all, taxes off the margin affect the returns on developing labor skills. Taxing taxed people according to their ability, but for his needs. This meant that he could reap great revenues given the existing abilities of workers, but discouraged any future efforts at developing such abilities in the future.
Olson (2000) also points out that the bureaucracy of Stalinist Russia evolved into a set of narrow special interest groups that reduced the productive efficiency of the Stalinist system, even in terms of serving political elites. Tax and spend redistribution states spur competition over money income. This is fundamentally different from normal entrepreneurial behavior. Competition over customers in capitalism means producing goods that actually serve to satisfy consumer demand. Competition over distribution burns up resources that could be used to produce goods, but are instead used to produce transfers (Tullock 1967).
Society can operate according to the principles of voluntary trade and respect for property rights or through coercive transfers and the violation of property rights. Western welfare states do in fact cause problems with the allocation of resources by taxing labor at the margin, but this is a special case where politicians ignore the logic of marginal value theory. Even when politicians recognize the importance of the margin and set tax rates in a way that serves their interests better, waste and economic inefficiency will follow. This is the nature of political competition.
Of course, Stalin’s tax system was a part of a brutal tyranny that deprived millions of freedom, and even their lives, so the avoidance of marginal losses in labor markets is no justification for such a system anyway. But the fact of the matter is that Western Democratic Welfare states could adopt Stalinist infra-marginal tax rates to eliminate the substitution effects that Karlsson worries about. Substitution effects are indeed something to worry about. So are the wastes of political competition and the erosion of individual liberty.
Olson, Mancur (2000) Power and Prosperity
Tullock, Gordon (1967) The Welfare Effects of Tariffs, Monopoly, and Theft