Policy implications

Suppose that government wished to encourage individuals to work for longer hours. How might this be done? One method operates by shifting upwards the schedule of additional utility gained from extra hours of paid employment. Suppose that workers currently pay tax on additional labour income. If the tax rate were to be reduced with other things remaining constant, this would have the effect of shifting this function upwards. Note also that if high income levels are taxed at high marginal rates, reductions of these marginal rates will shift the curve upwards and tend to make it fall less steeply from left to right. In either case, the individual will choose to work more hours. The reason for this is that the terms of the trade-off between utility from work-income and utility from leisure have altered; a lower tax rate has increased the attractiveness of work relative to leisure.

This analysis can only be suggestive of the possible effects of changing tax rates. There are very many other effects that one would need to consider before any confidence could be placed in one’s predictions. In addition to inducing existing workers to work longer hours, lower tax rates may also encourage more people to participate in the labour market. Some individuals may choose not to work when tax rates are high, but may choose to do so when tax rate are lower. The effect of tax rates on the incentive to work, and on the choice of hours, has been at the heart of tax reform programmes in the 1980s and 1990s, and has been an important factor contributing to reductions of marginal tax rates in a large number of countries.