Labour Supply Incentives and the Taxation of Family Income

Abstract

Taxing family income Richard Blundell and Ian Walker Will lower marginal rates of income tax increase incentives to work? The traditional theoretical argument ignores the fact that many individuals are members of households with more than one potential participant in paid employment. The theory of optimal income tax is utilized to argue that the tax system should discriminate between individuals in the same household if their labour supply responses are different. Empirically, the response of labour supply to changes in after-tax wages is largest for secondary workers (particularly married women). Hence, the largest beneficial incentive effect is obtained if such individuals face lower tax rates. Since these individuals typically have below average pre-tax earnings, this suggests a simple way to implement our proposal: establish a progressive income tax with individual earnings as the basis of assessment. This might have additional advantages of fairness but its primary purpose would be to ensure that low-earning but highly responsive individuals face low marginal tax rates while high-earning but relatively unresponsive individuals face higher marginal tax rates. Contrary to popular wisdom, a flat-rate tax system would be less favourable for work incentives. We illustrate this theoretical argument using an empirical model of labour supply embedded in a micro computer programme capable of simulating alternative tax systems.