Unexpectedly Intriguing!
June 27, 2006

Greg Mankiw inspired a new tool this morning - here's his commentary, with our tool for doing the math following....

In a previous post, I expressed a preference for consumption taxation over income taxation. In a comment, Daniel Demetri (an ec 10 student this past year) asks an important question about incentives:

I'm confused as to why a consumption tax does not affect incentives while an income tax does.... People don't care about saving money--they care about spending it.

With income tax: 1 hr work --> $16 pre-tax --> $8 post-tax --> $8 of chocolate cake, video games, and Red Sox tickets.

With consumption tax: 1 hr work --> $16 pre-tax --> $8 of chocolate cake, video games, and Red Sox tickets + $8 of tax.

The amount worked and the amount spent are the same, so what's the real difference?

Daniel is exactly right, as far as he goes. If we are looking at the decision to work today in order to consume today, consumption and income taxes have similar effects. Both discourage work effort.

Consider, however, another margin of adjustment: Work today in order to save and consume in the future. Let's continue with Daniel's example of a 50 percent tax rate. Suppose that the interest rate is 7 percent, so $1 saved today becomes $2 in 10 years.

With income tax: 1 hr work --> $16 pre-tax --> $8 post-tax --> $16 of savings in 10 years --->$4 more in income taxes on the interest--> $12 of chocolate cake, video games, and Red Sox tickets.

With consumption tax: 1 hr work --> $16 pre-tax --> $32 of savings in 10 years --> $16 of chocolate cake, video games, and Red Sox tickets + $16 of tax.

So under a consumption tax, there is a greater incentive to work and save today in order to consume in the future.

You'll have to go to Mankiw's post for the formulation which begins after this point, but here's our tool for doing the math described for comparing the amount of consumption an individual might realize after a consumption tax versus that after an income tax:

Wage and Tax Information
Input Data Values
Real Wage per Hour, W ($USD)
Interest Rate, r (%)
Tax Rate, t (%)
Time for Deferred Consumption, T (years)


Consumption Amounts
Calculated Results Values
Amount of Consumption After Income Tax ($USD)
Amount of Consumption After Consumption Tax ($USD)
Difference in Consumption ($USD)
Consumption Tax Approach - Income Tax Approach
Before Tax Relative Price (for Comparison)

Mankiw comments on the math:

You can see that the consumption tax creates a constant wedge: the after-tax relative prices is 1-t times the before-tax relative price, regardless of T. However, an income tax creates a growing wedge. The larger is T, the greater is the gap between the before-tax and after-tax relative price. In other words, a consumption tax taxes current and future consumption at the same rate, whereas an income tax in effect taxes future consumption at a higher rate than current consumption.

The bottom line: Both consumption taxes and income taxes discourage work, but income taxes discourage saving as well.

Labels: ,

About Political Calculations



blog advertising
is good for you

Welcome to the blogosphere's toolchest! Here, unlike other blogs dedicated to analyzing current events, we create easy-to-use, simple tools to do the math related to them so you can get in on the action too! If you would like to learn more about these tools, or if you would like to contribute ideas to develop for this blog, please e-mail us at:

ironman at politicalcalculations.com

Thanks in advance!

Recent Posts

Applications

This year, we'll be experimenting with a number of apps to bring more of a current events focus to Political Calculations - we're test driving the app(s) below!

Most Popular Posts
Quick Index

Site Data

This site is primarily powered by:

This page is powered by Blogger. Isn't yours?

Visitors since December 6, 2004:

CSS Validation

Valid CSS!

RSS Site Feed

AddThis Feed Button

JavaScript

The tools on this site are built using JavaScript. If you would like to learn more, one of the best free resources on the web is available at W3Schools.com.

Other Cool Resources

Blog Roll

Market Links
Charities We Support
Recommended Reading
Recommended Viewing
Recently Shopped

Seeking Alpha Certified

Archives
Legal Disclaimer

Materials on this website are published by Political Calculations to provide visitors with free information and insights regarding the incentives created by the laws and policies described. However, this website is not designed for the purpose of providing legal, medical or financial advice to individuals. Visitors should not rely upon information on this website as a substitute for personal legal, medical or financial advice. While we make every effort to provide accurate website information, laws can change and inaccuracies happen despite our best efforts. If you have an individual problem, you should seek advice from a licensed professional in your state, i.e., by a competent authority with specialized knowledge who can apply it to the particular circumstances of your case.