Income tax (idea)

Here's how income tax works from an economist's perspective. In the labor market, like any market, you're selling a product: toil and trouble. The price of labor is the wage, and the quantity of labor is the number of hours worked per week.

Looking at labor in this light, it has supply and demand just like any other good or service. If the wage goes up, people will increasingly want to work, and firms will want to employ less: likewise, if the wage goes down, people will supply less, and firms will demand more. For a skilled job, the supply and demand of labor might look like this:

$/hr
  |       D         S
  |        \       /
10|         \     /
  |          \   /
  |           \ /
9 |            X
  |           / \
  |          /   \
8 |         /     \
  |___________________
               40     hours

In this case, equilibrium is reached at X, which is $9 an hour, 40 hours a week. If the wage increases, there will be more hours offered than the employers want (unemployment): likewise, if the wage goes down, employers won't be able to get enough people to work in that field.

Now, what happens if you add a 25% income tax? To the employee, it means that their actual wage is going to decrease, so they'll want to work less. The supply of labor decreases, and the new graph looks like this:

$/hr
  |       D  S(tax) S
  |        \ /     /
10|         O     /
  |        / \   /
  |       /   \ /
9 |      /     X
  |     /     / \
  |    /     /   \
8 |   /     Y     \
  |___________________
           36  40     hours

In this case, O represents what the employer pays: $10 an hour for 36 hours a week. The Y represents what the employee receives: $8 an hour for 36 hours a week. So the firm pays an extra dollar an hour, the employee makes a dollar less, and the total number of hours decreases. That extra $2 an hour is the tax, which goes to the government: economists treat it as a deadweight loss of productivity. Everyone appears to be losing.

Well, not so fast. This is a pretty conservative way of viewing income tax, and you have to keep in mind that depending on how the government is spending the tax fund, the employee and the company will probably get back at least some portion of that two dollar investment as infrastructure or health care or national defense or what have you. Still, if you're priding your society on efficiency, income tax looks like a good way to throw a spanner in the works.