Demand analysis, which has dominated American economic policies over the past 30 years, basically assumes that people work because they have jobs, not because they are paid, and that people save because their incomes are high, not because they earn an after-tax yield on their savings; incentives on an individual basis do not play a substantive role. The essential tenet of classical economics is that people alter their behavior when economic incentives change. Government, through taxes, regulations and restrictions, and by the composition of its spending, can significantly alter those incentives, hence the economy’s behavior.
The difference between what it costs a firm to employ a worker or acquire a unit of capital and what the worker or saver receives net is the tax wedge. An increase in the wedge on, say, labor, will raise the cost to the employer in the form of higher wages paid, causing firms to employ fewer workers, and reduce the net wages workers receive, causing them to work less. With fewer workers employed, the value of each unit of capital is lessened. As the demand for capital falls, less capital will be employed and both yields paid and yields received will fall. An increase in the tax on labor is thus associated with less employment, less investment and lower output. Furthermore, it will increase total tax revenues by less, possibly by much less, than one might figure by applying the percentage increase to the original revenues from the tax on labor, since the increase in revenues collected per worker will be offset by a decrease in revenues resulting from the fact that less workers and less capital are employed.
Similarly, an increase in the tax wedge on the returns to capital will raise the yields paid for capital while lowering the yields received by the owners of capital, the amount of both capital and labor employed, wages received and paid and overall economic output. A reduction in the tax wedge on capital would result in more investment, which would ultimately increase employment and raise wages. Reducing tax rates on wages would increase employment and thereby cause profits to rise. Lowering tax rates on either factor of production will lower total revenues by less than the initial tax base times the change in rate.
As well as the level of taxation (or government spending) the way taxes are collected is important. In particular, of all the pairings of tax rates on labor and capital that will yield the same level of tax revenues, there exists only one that will maximize output. Diverging from this pairing—shifting taxes from labor to capital, or vice versa—will prove counterproductive. How government spends the money it collects also influences economic behavior; different types of government spending have different effects on people’s income and on their incentives to work.