Effects of Labor Taxation

It is taught in Eco 101 classes that taxes drive a wedge between the suppliers and producers and thereby prevents the most efficient allocation of resources, reduces the total surplus and causes a deadweight loss. By this calculation, a tax on labor will both reduce the amount of labor supplied and the amount of labor demanded, as the wages falls and the cost of labor rises. Consequently, unemployment rises and the economic growth gets affected.

But reality would seem to indicate a more complex set of outcomes. It has been found historically that high marginal income tax rates have subsisted with low unemployment and high economic growth. This variation in outcomes can be traced back to the varying response by different categories of labor to taxation. It is self evident that the relatively poorer people have limited options even if the wages fall, while the more well off have more options. Irrespective of the wages, the poor have to work as many hours as they always do, because they only earn just about enough to make ends meet. In other words, the lower and lower middle class are therefore price takers, or they exhibit inelasticity in supply when faced with changing wages.

In contrast, the more well off have more options when faced with a fall in wages, due to taxation. They can do less overtime, the second earning member can even leave the job, the elderly can retire earlier, or they can give up their second job. In other words, the labor supply is elastic among the well off classes, when faced with falling wages. But when it comes to the very richest, their incomes are so high, that the dent made by the tax on their incomes is so small and the marginal benefit accrued by every additional unit of work done is so high despite the taxes, that they exhibit inelasticity in labor supply when faced with fall in wages.

From the aforementioned analysis, we can draw a few conclusions
1. The distortionary effects of labor taxation are less likely to be manifested among the poorer classes. The deadweight losses increases as the income levels go up, but starts falling with the very richest. An inverted U curve relationship seems to exist between income groups and deadweight loss of taxation.
2. The developing countries, with greater proportion of lower income people and wage labor, will experience less distortions with labor taxes. In contrast, the developed countries, with more well off citizens, are likely to experience economic distortions due to high taxes on labor.
3. Among different occupations too, those highly specialized jobs with limited market (both supply and demand) will experience less deadweight loss due to any labor tax. However, in case of the more commonplace jobs, which have greater flexibility in both supply and demand, labor taxes cause significant deadweight losses.
4. Flexible labor markets are likely to suffer higher deadweight losses and hence experience more distortions than the more rigid labor markets. This is another reason why labor taxes are likely to cause greater econommic distortions in developed countries than developing countries.

However, in the real world, due to the interaction of certain other factors (whose identity and extent of influence is uncertain and difficult to predict) and the presence of certain specific circumstances, the outcomes could be different.