I had the following conversation with an associate in my law firm. He's a reasonably bright kid, but always looking to start a debate with the wacky liberal partner. This time, his bait of choice was taxes. "If you raise taxes," he said, "people will lose their incentive to work." "If you take more of what people earn, they won't work as hard, they won't innovate, they won't create the new jobs that keep the economy going."
I answered, "so you don't want a raise? Great. I'll make sure you don't get one this year."
He suddenly looked very confused.
This was going to take some explaining. So I explained. Like this.
Assume, as a starting point, that we are going to use easy numbers so I can do the math in my head.
Now assume that people make $10,000 or less pay no income tax. So, on the first $10,000, you are at your highest possible point of motivation. That actually makes sense, since you've got to eat.
Next, assume that the next $10,000 get taxed at 5%. Now remember, these are brackets, so if you earn $20,000 your second year, you pay $0 on the first $10,000, and $500 on the second $10,000. Theoretically, you would be far more lackluster than in your first year. But you're not. Why? Because you think far less about the $500 than about adding a roof over your head to the food on your table.
Okay. Year three. The next $20,000 get taxed at 10%. Still in brackets, so you have exactly the same high motivation for the first $10,000, the same motivation for the next $10,000, but how are you going to feel about the additional $20k? Well, on an income of $40,000, your total tax bill will be $2500. So, would you rather have $37,500 in your pocket, or $10,000 tax free? Yes, that's what I thought.
Okay, let's get things moving, shall we? Say the next $40,000 get taxed at 15%. So if you make $80,000 per year, you pay $8500 in taxes and take home $71,500. Now you're living large. You've got a house, some food, a car, and perhaps you can even afford to buy some delicious popcorn to support my son's Cub Scout pack.
Okay, now it's about to get interesting. Assume, for the sake of this discussion, that you are right now making $80,000 per year. You're up for a raise. You are expected to work the same number of hours in the same sort of work next year as this year. However, with an additional year of experience we think it is of greater value.
So, assume that the next $40,000 are taxed at 20%, okay? You are telling me that you will be less motivated to do the exact same amount of work if you hit a higher tax bracket. Right? Okay, assume a $5,000 raise. You pay:
* $0 on the first $10,000
* $500 on the next $10,000
* $2,000 on the next $20,000
* $6,000 on the next $40,000
* $1,000 on the next $5,000
This year, before a raise, you would bring home $71,500.
Next year, with a raise, you would bring home $74,500, for doing exactly the same amount of work, but you say you would not work as hard or be as motivated, because on the last $5,000, even though you're making more than you ever have before, your taxes went up. Right?
Well, it turns out that he wanted the raise after all.
And perhaps he even learned something.
Perhaps.