Does the Tax System Decrease Organizational Productivity?
For many in the United States, tax season has come and for some it’s already passed. I think a fundamental question that our economy as a whole should always be debating is whether the tax system helps increase the productivity of employees working across America’s businesses and perhaps even government institutions.
It’s a commonly accepted principle that as taxes increase, the activity which they target is usually less attractive to those who would otherwise have performed it. In other words, taxes act as a dragging factor on anything that they are applied to. For example, if you charge a high sales tax on computers, you increase their overall price which means that you decrease their demand, so people will buy less computers. And, although this example might oversimplify things a little bit, the concept at its core is theoretically and technically sound.
Income taxes work by taking an upfront or at least a simultaneous payment from each individual’s income as they earn that income. They’re not future looking, but sometimes individuals can be taxed for past income which was not registered or which was not claimed as non-taxable income.
Also, in the United States income tax is graduated. That means that if you make more money you will be taxed more, theoretically speaking (never mind all those tax loopholes and deductions.)
The way the system is set up makes me wonder if there are individuals that will choose a lower overall income to avoid being in a tax bracket which would increase their tax responsibilities. In other words, from a human capital perspective, does it mean that some individuals with higher levels of human capital (knowledge, skills, and relevant attributes), will choose not to apply their human capital to the economy to the fullest extent so that they avoid making a small jump into a new tax bracket which will effectively reduce their take-home income?
I’ve actually heard stories in the past of individuals doing just that, where they were just on the edge of one tax bracket and on the cusp of another. I’m not a tax expert but I don’t necessarily think that this is how it works, but it would be great to get some clarification in the comments of this article if you’re up for it. My basic understanding is that the higher tax bracket is only applied to the remaining income from all the below tax brackets, not the whole income itself.
However, the point here is not necessarily about how the graduated income tax bracket system works, but really about whether individuals will choose to apply less of their skills and knowledge in fear of earning more money which is therefore taxed more.
When it comes to income taxes I’m not entirely sure that the prevailing wisdom is that you want to avoid taxation so let’s move on.
Taxes on Bonuses
Taxes on bonuses are a whole different story however. Bonuses are taxed at a much higher rate than basic income tax. In addition, taxes on bonuses do not follow a graduated system of taxes, but usually fall under a flat fee/flat tax system. In my experience, I have seen numbers as high as 50% of the bonus goes to the government as a tax on bonuses and performance incentives.
This system of taxing bonuses and performance-based incentives is something that I think is much more worthy of vigorous discussion in the various economic and human capital fields than taxes on income. So let’s break it down for analysis: Once again, if we apply the general concept of “taxes reduce the incentive to perform the activity which they tax,” we see very quickly that there is potential that bonuses, when taxed, can have the overall effect of reducing productive performance because they could reduce the activity on which they are applied – in this case hard and innovative work performance.
It’s essential that we understand the process of performance degradation based on performance taxation because sometimes it is not very intuitive. It’s not that someone will consciously make the decision not to work harder because their bonus will be taxed at a high flat rate, but that when they see the actual bonus amount deposited into their bank accounts, they may make the decision that in the future, working as hard as they have worked to earn that small bonus is not necessarily worth their time. This is a very key point to understand because it describes a feedback loop in the decision-making process of evaluating whether a performance incentive is worth the effort that it would require.
Let me explain it once again using a fictitious example: Let’s say that I got a new job where I will be eligible for a quarterly bonus of 10% of my base pay. During the first quarter I meet and exceed my goals, and consequently I’m awarded the bonus which I receive at the end of the quarter. Let’s say that I had to work very hard in order to meet my goals for that quarter, but was still excited at the potential of a bonus that will equate to 10% – I mean 10% is a lot, right? Then, I actually see how much the bonus was (feedback loop,) and because of government taxation it is less than half of the total amount before taxes.
In my mind at that point, I would most likely be performing a conscious and sometimes sub-conscious re-evaluation of whether that bonus was worth the incredible amount of hard work that I put in to get it. The fact that that I’m re-evaluating my bonus worth is simply because I was faced with the reality that the amount of money that I took home was a lot less than the amount of money that I earned and that I imagined taking home in my mind. From that point on, every quarter I will (at least subconsciously) re-evaluate whether the bonus is worth the effort. Over time that constant re-evaluation may result in the eventual conclusion that the bonus is no longer worth my effort, especially that most organizations including the fictitious one that I work for, are constantly increasing the goals that I have to meet in order to earn that same bonus without increasing the amount of the bonus itself.
Thus, the taxation on my bonus likely contributed to my eventual decline in performance and the decline of overall organizational productivity.
I understand that this topic is exceedingly complex, and that there are 1 million factors that play into whether an employee chooses to be productive or not, but we cannot understand the comprehensive system of employee productivity and organizational productivity without trying to isolate some independent systems and processes for us to evaluate. Tax and performance is such a system that must be isolated, on paper, in order for us to understand the relationship between the two, and although I’m not familiar with empirical evidence that suggests one way or another whether taxes on bonuses and performance decrease productivity (send me some in the comments if you know of any,) I think it’s worth the discussion within corporate America and within government institutions.
Photo by John-Morgan