Personal income tax is one of the ways that governments raise revenue to finance their activities whilst providing public services. Personal income tax is usually varied. It depends on the nation within which the individual is located and the existing monetary and fiscal policies. Many economies alter personal income tax to regulate other parts of the economy. Significant success has been achieved through this form of regulation. Taxation of any form affects not only the economy as a whole but also individuals who are being taxed. These effects can be direct and/or indirect. Some of the areas that alteration of personal income tax affects include the personal effort of employees in a nation, the amount of personal savings in the economy, and risk-taking activities. There is plenty of empirical evidence to support the effects of alteration of income tax on the above areas, with different researchers holding different views on the same issue. This paper uses the existing empirical evidence to support the effects that any increase in the rate of personal income tax has on personal savings, risk taking, and work effort.
Personal Income Tax
Personal income tax is a term that is applied to tax that is levied to the salaries and wages of individuals who work within a given geographical or financial system. This income tax is often expressed as a rate, with individuals being charged a certain proportion of their income as tax. An example of income tax is the 30% that is payable to the UK government for all revenues that individuals make (Freebairn 2012). This tax is paid to the authorities. Individuals pay this proportion on all investment income that they make in combination with their total earnings.
The increase in the rate of income tax rates is necessitated by the prevailing economic conditions in a country. The effects of income tax rates on personal saving behaviours, risk-taking activities, and work effort in a population are either intentional or coincidental. Irrespective of the nature of the effects on the above areas, it is given that alteration in the rate of personal income tax affects them. The nature of these effects is the focus of this paper. Empirical evidence to support the interrelationship between the actors and the rate of income stems from the existing studies on personal income tax and the above factors.
Effect on the Supply of Work Effort
Personal income tax has effects on a number of personal choices, including savings, labour, and marriage (Warren 2014). Any variation in the rate of personal income tax affects the supply of work effort, which is otherwise known as labour. When the supply of work effort is reduced, the economy is affected in a number of ways. These ways include the depreciation of the economy that is usually associated with poor output. The labour market is one of the areas of the economy that are affected by changes in rate of personal income tax. Changes in personal income tax affect the trade-off between labour and leisure.
One relationship between the income tax rate and the supply of work effort is the income and substitution type of effects (Freebairn 2012). Negative effects of income tax rates are exemplified by the substitution effect that is always negative, with the effect being the reduction in hours that employees work (Yongzhi & Cohen 2011). On the other hand, the income may have negative or positive effects on the available returns (Freebairn 2012). The positive side in the form of income effects include improvement in the work output of individuals. Personal income tax makes individuals work more, with the motivation being to increase the overall income. The combined effect of substitution can be considered an empirical matter (Yongzhi & Cohen 2011).
The relationship between personal income rates and the supply of work effort varies depending on different circumstances that individuals may go through. An example of a variation between the income tax rate and labour is the number of hours that an individual works and how these hours are determined. According to Freebairn (2012), people who work for fixed hours experience effects that are different from those whose hours of work are freely determined. The variation in the hours that the individuals work are affected partly by their sex, with Yongzhi and Cohen (2011) stating that most of the male working population is relatively insensitive to personal income tax. The observation is that most of this population works on a full-time basis (Yongzhi & Cohen 2011). The population of working married women is more susceptible to variation of working hours since it is more responsive (Freebairn 2012).
The available empirical evidence shows that increasing personal income tax rates reduces, and in some instances increases, the supply of work efforts. The effect of increased tax rates include discouragement in the population where it (the population) is unable to cope with the amount of income tax. The result of this situation is that most individuals have to ensure that they work extra hard to achieve the same revenues that they posted after taxation. The net effect is the reduction of the number of employees in formal employment and a reduction in the labour output for these individuals (Yongzhi & Cohen 2011).
Increased personal income tax rates may also have a resultant negative effect over the availability of labour in an economy. The empirical evidence that is available to support this claim shows that employees who are subjected to a high personal income tax rate are encouraged to work towards retaining their previous targets and to increase the amount of money that is taken home at the end of the month. The relationship between the rate of income tax and availability of labour can also relate indirectly to the net effects that the taxation has over the other areas of the economy such as the marriage institution (Freebairn 2012). Increased experiential evidence suggests that marriage is affected directly by the available income tax rate. These effects apply to the overall labour output.
Effects on Personal Savings
Public finance is concerned with personal savings that individuals perform. The composition of and/or amount of savings that individuals carry out is significantly affected by the taxation that these individuals go through. The overall effect of interest rate variation on personal saving can be considered ambiguous, with these effects being either positive or negative. The substitution effects are quite evident in the determination of the effects of personal income tax variations on personal savings. One major effect of variation in the personal income interest rates is the finance that is available for future events and activities. Increase in the rate of personal income tax may result in reduced savings due to the interest that is levied on these savings (Freebairn 2012). The taxation of savings and interests is also often accompanied by little subsidy to the interests that are paid on borrowed money. The result of increased tax on the interest that is earned on savings with no subsidy over the corresponding interest on borrowed money is reduced budget for future consumption (Yongzhi & Cohen 2011).
Taxation affects personal savings negatively, with the effects being supported by the existing empirical evidence. Savings allow individuals to benefit from the interest that is charged to their savings. When the rates of personal income tax are altered upwards, the amount of savings in a population reduces because of this interest. The available interest for future use is reduced with increased interest. This case discourages potential savings (Yongzhi & Cohen 2011). The existing taxation systems vary in relation to the taxation of earned vs. unearned interest (Yongzhi & Cohen 2011). The interest that is charged on unearned income is higher in most cases compared to that of earned income, with the result being that people who are earning end up being poorer compared to the few who earn their interest. The results of this observed effect in terms of earned vs. unearned interest include reduced investment in some areas that have reduced saving.
The other observed effect of increased personal income tax in relation to saving behaviours is that when the taxation on some parts of unearned income is reduced, the amount of savings in an economy improves (Freebairn 2012). Some countries such as the UK have recorded improved retirement savings in the past after institution of measures such as a reduction of taxation on some portions of the unearned income. Countries that have large rates of taxation for the unearned income are often competitive on the global front. Hence, the reduction of the interest rates that are charged on personal income is one way to improve competitiveness on the global front.
The rate of income tax that is levied on revenues also affects the available resources for families and other institutions. When this rate is so high, the effect is that the income that is available to the individuals reduces, with the result being a reduction in their output in addition to reduced savings. Organisations that offer savings for individuals in an economy are also affected by the prevailing income tax rates. When the personal income tax rates are high, individual savings do not multiply in an expected rate (Yongzhi & Cohen 2011). For countries that have savings schemes in place, the increase in personal income tax rates results in the reduction of other forms of savings.
The United States of America is one of the nations whose percentage saving has reduced over the years, with this reduction corresponding to the increase in the rates of income tax (Cebula 2013). The percentage that the Americans saved out of their income is significantly low, with the value obtained for 2012 being only 4% of the personal income (Celikkaya 2010). This proportion was obtained after tax, with the personal income remaining low after taxation. The relationship between personal income and personal tax has been the subject of many studies in different economic settings. The results of most of these researches indicate that the income tax rates cause the amount of income tax to reduce, with the result being discouragement for individual saving.
The interest rates that are charged on revenues also contribute to the reduced saving trends in most economies. When revenue is not available for individuals in the economy because of taxation, the only choice that individuals have is to use their money for basic goods and services instead of saving this money. The other relationship between savings and the rate of income tax is that savings result in stagnation of the money that might otherwise be used in other investments (Yongzhi & Cohen 2011). When the saved money is not available to individuals who earn little interest, the result is little saving. Therefore, an association is evident between savings and the level of personal income tax that is instituted in an economy.
In public finance, savings and taxation are related in that the volume of private savings is affected by taxation in the economy. This relationship has been the subject of many studies throughout the past decade, with some of the scholars insisting on the relevance of the topic. Some economists propose a taxation policy with an aim of improving personal savings, with the effects being inflation and employment variation (Cebula 2013). According to Cebula (2013), tax policies that are practiced in an economy may shift savings from the present to the future generation. Savings also transfer income from some individuals such as workers or other individuals or groups such as capitalists (Đurovi-Todorović & Đornević 2012). The results of such a transfer include reduced savings.
There are no clear implications of reduced rates of personal income tax rates on savings and the current saving practices. According to Celikkaya (2010), the enquiry of whether an outflow duty will give rise to a superior or inferior rank of classified investments in relation to a corresponding revenue levy is an affirmative one. Therefore, the implications of increased personal income tax rates on personal savings are dependent on the existing tax policy in an economy. Consumer decisions are important to consider when looking at the relationship between personal income tax rates and the savings that these individuals carry out. The decision-making process that is followed when considering saving involves an assessment of returns in a given period of time as compared to what the investment will attract if invested in other areas of the economy. In most areas where the personal income tax rates are high, the saving practices are reduced, with the available income being channelled to other potentially productive areas and investments.
The accessible pragmatic evidence supports reduced savings with increased rates of personal income tax. For economies that wish to improve in terms of personal savings for their population, a reduction of personal income tax rates may have a positive effect on the amount of savings. The implementation of reduced personal income tax rates also results in reduced performance of other parts of the economy and reduced revenues for these economies. Therefore, there is a need to balance the rates of personal income tax with other areas of the economy, with the aim being to attain a sustainable economic growth and performance. For economies that are strong enough to lower their personal income tax rates, the implementation should follow a manageable course.
Effects on Risk-taking
Risk-taking is an important part of investment and economic evaluation, with improved risk-taking being a positive indicator and determinant of the economic performance. Most of the organisations that have succeeded in the past stem from the practice of risk taking (Golombek 2011). The best performing economies are those that can sustain and encourage risk taking. However, the adverse practice of the same may have unwanted effects on the economy. Several factors determine the risk-taking behaviour of individuals in business, including tax regimes that are present in the economy. Risk taking may be measured through the number of new companies and organisations that register within a given period.
The question of the relationship between risk-taking and the rate of personal income tax can be accessed through the analysis of the existing empirical evidence. In general, risk-taking activities are significantly reduced in the presence of high personal income tax rates (Đurovi-Todorović & Đornević 2012). Risk taking is related to the amount of income that individuals want in their endeavours. In most studies on the relationship between risk taking and taxation, the amount of risk taking is related to the level of taxation. However, this relationship is not confirmed by many studies since different scholars obtain different results of the relationship.
When individuals have a strong financial backing in their endeavours, they are able to pursue any amount of financial projects with limited inhibition. This claim means that individuals with low tax regimes together with countries that offer these type or regimes are able to take more risks as compared to their counterparts in other nations and economies. Many theories support each of the stated relationships between taxation and the level of risk taking in a country or economy within a nation. In one of the theories, the researchers stated that the relationship is based on the low returns that are associated with investment while personal income taxes rates are raised (Colaiezzi, Oehlers & Cataldo 2013). Most of the researchers who uphold this theory use different economies as proof of the theory, with the most widely used one being the Russian economy after the collapse of the Soviet Union. In this economy, researchers found that risk-taking was significantly low due to the personal income taxes that were levied on the population.
The rates of income taxes that are prevalent in a population are important in the determination of its investment activities. In most of these instances, investors have to take note of the prevailing interest rates and the personal income tax rate. Different individuals have different levels of threshold for investment. However, the largest population of investors is influenced by the rate of personal income tax. While the general population considers low tax rates an advantage while pondering on the investment to make, corporations are affected by the same factors while making their investment decisions and hence their risk-taking behaviour. It is important to note that any miscalculations that exist within an organisation may lead to poor decision making. Hence, organisations spend a significant amount of resources to establish the right decisions to make in investments. The returns that an investment will attract are heavily influenced by the prevailing personal income tax rates.
Over the past decade, the personal income tax rates for the US have been changing at a constant rate. Most of the researches that have been done in this area are aimed at establishing whether there is any relationship between risk-taking activity and tax rates. In some of the studies, the population was significantly affected by the rates, with one of the manifestations being reduced savings and poor risk taking activities. Over the last decade, this nation has recorded significant success while encouraging its citizens to take risks in investment. Organisations carry out numerous campaigns to make the population increase their risk-taking behaviour as it relates to investment. However, studies demonstrate that unless personal income tax rates are altered, such campaigns will not be beneficial to the general population.
Risk taking is affected other factors that are in turn affected by the existing personal income tax rates. One of these factors is the level of education of the general population, with the other being the performance of the economy in general. When the economy is underperforming, income tax rates generally increase to provide a boost to the national revenue for use in the national agenda for the nation (Gongloff 2013). When personal income rates increase, the finance that is available to the general population is diminished. Few people are willing to invest this money in some areas that they are not sure about the returns (Čok, Sambt, Košak, Verbič & Majcen 2012). The reduction in investment during this period can be classified as a reduced risk taking.
On the other hand, when the economy is performing well with the available cash for investment, many individuals develop confidence on different parts of the economy. The result of this confidence is improved investment in the sectors that they are happy with. This observation means that risk-taking behaviours in individuals are associated with the economic performance of a nation or economy, with a positive correlation existing in better performing economies. Throughout the last few decades, the US national economy has continued to perform significantly well. This situation has reflected well on risk-taking behaviours of individuals within the nation. This relationship can be associated with the personal income tax rates, which have been improving ever since the economy performed well.
The hazard-taking behaviours of a population are hard to predict based on the different results that have been obtained from the different researches. While some researchers state that risk-taking is positively related to personal income tax rates, some people hold the opinion that many factors have to be present for this kind of relationship. While the US economy performed well over the last decade, personal savings as a proportion of the net income continued to depreciate. As discussed earlier, the depreciation may be associated with the existing taxation measures in the country, one of which is the level of income tax that individuals have to part with. However, the effect on hazard-taking behaviour is dependent on many factors, with examples being the age of the population, the available income, and the general performance of the economy.
Just as the performance of the economy is affected by international interest rates and the prevailing economic situations around the world, personal income taxes are adjusted based on the same plan. Different countries and economies that have different personal income tax rates report different levels of risk taking, despite the existence of monetary and fiscal policies that are aimed at ensuring increased threat taking and assurance of similar levels of personal income tax rates. The difference between different nations in terms of personal income tax rates further supports the theory that the risk-taking habits of a population are affected by a host of factors as opposed to the rate of personal income tax.
In conclusion, the rate of personal income rate affects many micro and macroeconomic factors in any economy. While this factor of any economy is dependent on several other factors, the effects on the supply of work effort, personal savings, and risk taking behaviour have been of importance in this paper. The relationship between the supply of work effort and the rate of personal income tax is an inverse one. When the rate of tax increases, work effort and labour that are available in an economy go down.
The available empirical evidence shows that personal savings in an economy reduce with increased rates of personal income tax. Savings are inversely proportional to the amount of personal tax rates that a nation or economy imposes on its population. The last factor that has discussed in the paper is the risk taking behaviour in the general population in relation to the existing personal income tax rates. The obtainable empirical evidence supports the theory that the rate of personal income tax may affect risk-taking behaviour in different ways. These effects may be positive or negative depending on other factors as listed in the paper.
Cebula, J 2013, ‘New and Current Evidence on Determinants of Aggregate Federal Personal Income Tax Evasion in the United States’, American Journal Of Economics & Sociology, vol. 72 no. 3, pp. 701-731.
Celikkaya, A 2010, ‘Dual income tax: A reform option for personal income tax in Turkey’, Business & Economic Horizons, vol. 3 no. 3, pp. 47-57.
Čok, M, Sambt, J, Košak, M, Verbič, M & Majcen, B 2012, ‘Distribution of personal income tax changes in Slovenia’, Post-Communist Economies, vol. 24 no. 4, pp. 503-515.
Colaiezzi, T, Oehlers, P & Cataldo, A 2013, ‘Business Use of the Personal Residence: Everyman’s Tax Shelter’, Journal Of Financial Service Professionals, vol. 67 no. 3, pp. 66-72.
Đurovi-Todorović, J & Đornević, M 2012, ‘The connection between progressivity and sufficiency in the personal income tax system’, Economic Themes, vol. 50 no. 1, pp. 33-45.
Freebairn, J 2012, ‘Personal Income Taxation’, Economic Papers, vol. 31 no. 1, pp. 18-23.
Golombek, J 2011, Bye-bye Bonus! Why small business owners may prefer dividends over a bonus, Web.
Gongloff, M 2013, The 1 Chart That Reveals Just How Grossly Unfair The U.S. Tax System Has Become, Web.
Warren, N 2014, ‘Towards a holistic analysis of personal income tax reliefs and their reform’, Australian Tax Forum, vol. 29 no. 1, pp. 83-108.
Yongzhi, N & Cohen, R 2011, ‘Personal Income Tax Gap for Business Income Earners in New York State: From the Real Estate Tax Perspective’, Journal Of State Taxation, vol. 29 no. 6, pp. 27-66.