Personal income tax and social security contributions

Taxes on employment income and compulsory contributions to social security schemes can affect the supply of labour as a result both of their income effect - to the extent that they make employees try to compensate for their loss of after-tax earnings - and their substitution effect - to the extent that they make employees willing to sacrifice their earnings in exchange for the benefits of increased leisure. Empirical evidence tends to indicate that income tax has a negative effect that is larger for females than for males, and that it is greater for both when tax rates are progressive^[17]. The combined influence of employment income taxation and means-tested state benefits can also reduce the supply of labour as a result of the operation of the unemployment trap and the poverty traps^[18]. Taxes on employment income can also affect the demand for labour as a result of the tax wedge that is driven between he cost of labour to employers and the net payment received by employees. The magnitude of the effect upon unemployment depends upon the price flexibility in the relevant labour market, because it depends upon the extent to which employees are able to pass a tax increase on to their employers ^[19]. There is also evidence that high tax rates for low earners can increase unemployment among low-skilled employees, especially at relatively high levels of the minimum wage^[20].

The substitution effect of personal taxation may be expected to reduce the motive for saving, but the income effect may prompt an increase in savings in order to preserve a desired level of retirement income. Empirical evidence concerning the magnitude of the net effect has yielded widely differing findings but there is general agreement that the outcome is a reduction in savings^[21]. There is also some evidence to suggest that income tax may reduce human capital as a result of its effect upon the willingness of parents to spend money on their children^[22].

The above effects suggest the possibility that high marginal tax rates have negative consequences for productivity, and an OECD study has indicated that progressive income tax does, in fact, cause significant reductions in GDP per head (in addition to any effects arising from the reduced acquisition of human capital),^[23].