Argument: Progressive taxes disincentivize hard work and productivity
Friedrich A. Hayek. "Taxation and Redistribution". The Constitution of Liberty. 1960 - 6. It is sometimes contended that proportional taxation is as arbitrary a principle as progressive taxation and that, apart from an apparently greater mathematical neatness, it has little to recommend it. There are, however, other strong arguments in its favor besides the one we have already mentioned-i.e., that it provides a uniform principle on which people paying different amounts are likely to agree. There also is still much to be said for the old argument that, since almost all economic activity benefits from the basic services of government, these services form a more or less constant ingredient of all we consume and enjoy and that, therefore, a person who commands more of the resources of society will also gain proportionately more from what the government has contributed.
More important is the observation that proportional taxation leaves the relations between the net remunerations of different kinds of work unchanged. This is not quite the same as the old maxim, "No tax is a good tax unless it leaves individuals in the same relative position as it finds them. It concerns the effect, not on the relations between individual incomes, but on the relations between the net remunerations for particular services performed, and it is this which is the economically relevant factor. It also does not, as might be said of the old maxim, beg the issue by simply postulating that the proportional size of the different incomes should be left unchanged.
There may be a difference of opinion as to whether the relation between two incomes remains the same when they are reduced by the same amount or in the same proportion. There can be no doubt, however, whether or not the net remunerations for two services which before taxation were equal still stand in the same relation after taxes have been deducted. And this is where the effects of progressive taxation are significantly different from those of proportional taxation. The use that will be made of particular resources depends on the net reward for services, and, if the resources are to be used efficiently, it is important that taxation leave the relative recompenses that will be received for particular services as the market determines them. Progressive taxation alters this relation substantially by making net remuneration for a particular service dependent upon the other earnings of the individual over a certain period, usually a year. If, before taxation, a surgeon gets as much for an operation as an architect for planning a house, or a salesman gets as much for selling ten cars as a photographer for taking forty portraits, the same relation will still hold if proportional taxes are deducted from their receipts. But with progressive taxation of incomes this relation may be greatly changed. Not only may services which before taxation receive the same remuneration bring very different rewards; but a man who receives a relatively large payment for a service may in the end be left with less than another who receives a smaller payment.
This means that progressive taxation necessarily offends against what is probably the only universally recognized principle of economic justice, that of “equal pay for equal work”. If what each of two lawyers will be allowed to retain from his fees for conducting exactly the same kind of case as the, other depends on his other earnings during the year-they will, in fact, often derive very different gains from similar efforts. A man who has worked very hard, or for some reason is in greater demand, may receive a much smaller reward for further effort than one who has been idle or less lucky. Indeed, the more the consumers value a man's services, the less worthwhile will it be for him to exert himself further.
This effect on incentive, in the usual sense of the term, though important and frequently stressed, is by no means the most harmful effect of progressive taxation. Even here the objection is not so much that people may, as a result, not work as hard as they otherwise would, as it is that the change in the net remunerations for different activities will often divert their energies to activities where they are less useful than they might be. The fact that with progressive taxation the net remuneration for any service will vary with the time rate at which the earning accrues thus becomes a source not only of injustice but also of a misdirection of resources.
There is no need to dwell here on the familiar and insoluble difficulties which progressive taxation creates in all instances where effort (or outlay) and reward are not approximately coincident in time, i.e., where effort is expended in expectation of a distant and uncertain result-in short, in all instances where human effort takes the form of a long and risky investment. No practicable scheme of averaging incomes can do justice to the author or inventor, the artist or actor, who reaps the rewards of perhaps decades of effort in a few years. Nor should it be necessary to elaborate further on the effects of steeply progressive taxation on the willingness to undertake risky capital investments. It is obvious that such taxation discriminates against those risky ventures which are worthwhile only because, in case of success, they will bring a return big enough to compensate for the great risk of total loss. It is more than likely that what truth there is in the alleged "exhaustion of investment opportunities" is due largely to a fiscal policy which effectively eliminates a wide range of ventures that private capital might profitably undertaken
We must pass rapidly over these harmful effects on incentive and on investment, 'not because they are unimportant but because they are on the whole well enough known. We shall devote our limited space, then to other effects which are less understood but at least equally important. Of these, one which perhaps still deserves emphasis is the frequent restriction or reduction of the division of labor. This effect is particularly noticeable where professional work is not organized on business lines and much of the outlay that in fact would tend to increase a man's productivity is not counted as part of the cost. The tendency to "do it yourself" comes to produce the most absurd results when, for instance, a man who wishes to devote himself to more productive activities may have to earn in an hour twenty or even forty times as much in order to be able to pay another whose time is less valuable for an hour's services.
"Flat Tax: What Would It Do For Ireland?". Business and Finance Magazine. 5 May 2005 - From an Irish perspective, perhaps the most important benefits of a flat tax arise from the elimination of the penalty on human capital investment. By removing the negative effect of the progressive tax brackets creep, flat tax stimulates significant increases in productivity-adjusted labour supply. The results are not just higher rates of return to education, training and labour.
A recent study of a revenue-neutral flat tax proposal for the US (Ventura, 1999) shows that, due to the positive effects on individual incentives to invest in productivityenhancing learning and greater hours of labour supply, a flat tax system yields up to a 9% increase in the aggregate efficiencyadjusted labour force.
In the Irish case, this is equivalent to adding over 180,000 workers with an average productivity without incurring additional social and welfare costs of actually increasing Ireland's population. The more productive the segment of population, the higher are the increases.
Recalling that the high-earners become the most important source of tax revenue under the flat rate system, this implies that our tax revenue can increase by 4.2% to 11%, depending on the specifics of the reform. Another study (Gentry and Hubbard, 2004) shows that a similar effect applies for the entrepreneurs who experience significant added incentives to increase their productivity.
Christian Keuschnigg 1 and Søren Bo Nielsen. "Progressive Taxation, Moral Hazard, and Entrepreneurship". Journal of Public Economic Theory. 5 Jul 2004 - This paper considers the general equilibrium and welfare effects of a linear progressive income tax with entrepreneurship and moral hazard. A competitive intermediation sector diversifies risk associated with entrepreneurial activity, but full risk consolidation is prevented by moral hazard. Since effort is not observable, risk bearing of entrepreneurs is required for incentive reasons. The extent of risk consolidation is endogenously explained. We find that a nonredistributive tax is neutral. A progressive tax always impairs entrepreneurship while the effect on welfare can be positive or zero, depending on the specification of moral hazard. Some results may also depend on the concrete formulation of preferences.