Progressive Taxation in a Tournament Economy

Progressive Taxation in a Tournament Economy Not enough is known about the responsiveness of individuals, in particular those who tend to work under different incentives, to changes in marginal tax rates. We ask whether changes in marginal tax rates are less distortionary for workers engaged in a contest. To examine this potential rationale for a more progressive tax code, we first model the effort decisions of workers faced with progressive taxation under tournaments and piece rates. Because of the difficulty identifying any distortion that may be induced by the tax code in naturally occurring data, we then report on the results of a real-effort experiment based on this model. Consistent with a behavioral approach to public finance, we find that tournament workers are less sensitive, and conclude with a tentative evaluation of the welfare benefits of progressive taxation in tournament economies. NON-TECHNICAL SUMMARY Economists expect workers to adjust their efforts when tax rates change. Specifically, workers are expected to withhold effort when marginal tax rates increase because the net payoff from working is smaller. However, what if you are one of the many highly compensated workers employed under tournament incentives? If you work for a bonus or for a promotion you might not be so concerned about the marginal tax rate. Instead, you need to focus on winning these tournaments. If this is true, as our model and data suggest, there are large implications for the logic of progressive taxation. If tournament contestants do not pull back when the tax code becomes more progressive, the traditional argument against progressive taxation – it will cause too much distortion in the labor market – loses its power and overall welfare might actually rise as the tax code becomes more progressive. JEL Classification: H20, H41, J22, J33, C91