How income tax causes unemployment

One of our members stated in a discussion group that “Progressive income tax” causes unemployment at the bottom end and is avoided at the top. This produced the following response...

In all honesty, I don’t know how you can say that progressive income tax causes unemployment at the bottom.

We have discussed the matter many times on this website, but the reply given was a concise summary of the argument and is re-stated here.

Have you come across something called, confusingly, the “incidence” of a tax? It is the individual or body on which the tax ultimately falls, as opposed to the one that is nominally responsible for paying it.

In the case of taxes such as Income Tax and National Insurance, the incidence is on the employer, not on the employee, and the employer in turn will try to pass it back to the customer in the form of higher prices. If he cannot do that, his profitability will be lower and the incidence will then fall on his landlord.

This is because people regard as their wages that which is actually available to spend ie their take home pay, or more precisely, what they can buy with their take home pay. When the alternative is some kind of benefit, that sets the floor to take home pay. To leave employees with any particular level of take home pay, the employer incurs a gross labour cost around 70% higher. The exact figure depends on the circumstances of the employee.

The result is that employers are reluctant to employ unskilled labour, as the value they can add is less than the gross cost incurred in employing them. They will either not provide the service, or replace the workers by machines.

You may have noticed the spread of self-scanning machines in supermarkets. The technology behind this is very expensive and the supermarkets would not even be thinking about introducing it if what I have just said were not the case.

Minimum wages also come into the equation, but here again, there is an interaction with tax. Because tax thresholds are set below the level of the minimum wage, if the thresholds were higher, then the minimum wage could be reduced without reducing minimum take home pay. Sales taxes also have an effect. The real purchasing power of the minimum wage is reduced by, for example, VAT; this too has to be built into the minimum wage figure to achieve a minimum acceptable real wage. Absurdly, VAT costs also have to be built into into welfare payments to achieve an acceptable standard of living for those on government benefits. In the latter case, this gives rise to “churning” as public money is given out with one hand and taken back with the other.

Taxes on both wages and on goods and services lead to unemployment which hits, primarily, unskilled labour. The first task is to raise both tax thresholds and to cut VAT substantially to limit the damage.