The reader is advised to read again Chapter 2 of Keynes’s 1936 General Theory. The General Theory is in my perception an effort to seriously develop dynamics. Keynes’s precursors did discuss dynamic developments, but always ended up in static modelling. See also Patinkin (1976:140 footnote 4).
In the following quote, Keynes discusses a real wage reduction caused by prices. For our purposes, we might substitute a real wage reduction caused by taxes.
“To sum up: there are two objections to the second postulate of the classical theory. The first relates to the actual behaviour of labour. A fall in real wages due to a rise in prices, with money-wages unaltered, does not, as a rule, cause the supply of available labour on offer at the current wage to fall below the amount acually employed prior to the rise of prices. To suppose that it does is to suppose that all those who are now unemployed though willing to work at the current wage will withdraw the offer of their labour in the event of a small rise in the cost of living. Yet this strange supposition apparently underlies Professor Pigou’s Theory of Unemployment [voetnoot] and it is what all members of the orthodox school are tacitly assuming.” (Keynes (1936:12-13)).
Note, by the way, that the format of Figure 19 can always be used in terms of the average wage W. So the format of Figure 19 may be inviting to our intuition, in that we think that we indeed can draw a diagram like that, but we then should be aware that our true model is heterogeneous labour and not homogeneous labour.
A complex view
An alternative view is more empirical, thus inherently more dynamic, and builds on Keynes’ observation. Empirical research, see e.g. Ashenfelter & Layard (1986), Theeuwes (1988), Hum & Simpson (1991) and Gelauff (1992) shows that marginal tax rates have ‘surprisingly’ low elasticities. The reason for a lesser importance of marginal rates is that labour supply is not flexible, but rather fixed. That labour supply is primairily given by demographic factors, is for example a well known assumption of practical models developed at the Dutch Central Planning Bureau. In Western economies people will have to become active on the labour market in order to earn a living, and taxes hardly form a barrier. People are still very much like Marx’s proletariat, and they have little else to fall back on but to supply their labour. There is some choice for partners and for people on benefits, but this does not have a major impact. For the majority, if anything, the average wedge is more important than the marginal one, see Den Broeder (1989). Recently Minford & Ashton (1993) see scope for a larger effect of marginal rates, but, their study is still far from explaining stagflation, partly for the reason that it is not fully dynamic.
By consequence, the major equilibrating forces exert themselves on the wage and the related employment. Here arises the dynamic situation of (wage) inflation and unemployment, and thus the issue of the Phillipscurve. Thus, conceptually, tax rates have their major impact not on labour supply but on the Phillipscurve.
The next question then is whether their effects are positive or negative. The common argument is that a higher marginal rate fuels inflation. Whether this is the case then becomes the next issue.
Efficiency wages intermezzo
Before we can continue the discussion, a note on the ‘efficiency wage theory’ is required. The idea is here that, though people are forced to work to earn a living, they still can choose whether they shirk or not. They take account of a probability of getting caught and getting fired, but supervision would be expensive, and, if fired, one eventually could find another job. Unemployment then is required to discipline the workers. Borjas (1996:459) provides an introductory discussion, and the graphs are quite similar to the supply and demand schedules of old.