Effects of Income Taxation on Division of Labor

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If a tax is paid on outsourced services that is not also charged on services performed for oneself, then it may be cheaper to perform the services oneself than to pay someone else — even considering losses in economic efficiency.


For example, suppose jobs A and B are both valued at $1 on the market. And suppose that because of your unique abilities, you can do job A twice over (100% extra output) in the same effort as it would take you to do job B. But job B is the one that you need done right now. Under perfect division of labor, you would do job A and somebody else would do job B. Your unique abilities would always be rewarded.


But now consider your choices when the total marginal tax rate (over all levels of government) is 50%. You are trying to decide whether to do job A twice over or to do job B. First, suppose you do job A twice over, for $2. Your $2 is taxed at 50%, so you end up with $1 which is just enough to pay somebody else to do job B. So there is no reward for doing what you are better at. If your extra output at job A were shy of 100%, then there would actually be a penalty for dividing the labor more efficiently!
 
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