If we take a cut in income tax, it could also have an effect on the supply side of the economy.
- Lower income tax rates may encourage people to work longer. Overtime is more worthwhile if you get to keep more of your income. This is the substitution effect – work is more attractive with lower tax rates.
- However, there is also the income effect. With lower tax rates (and effectively higher wages), it is easier to get your target income by working fewer hours. Therefore, tax cuts may not increase labour supply because people don’t need to work more, if work is more highly paid.
There is much debate about the extent to which tax cuts increase productivity and economic growth. If marginal tax rates are very high e.g. 80%, cutting tax rates is likely to have some increase in labour supply and productivity. But, with tax rates of 20 or 30%, cutting income tax rates is no guarantee of increasing productivity and growth.