Levying Income Taxes Causes a Shift to a Higher Proportion of Consumption and a Lower Proportion of Saving and Investment

There is another, unheralded reason why an income tax will particularly penalize saving and investment as against consumption. It might be thought that since the income tax confiscates a certain portion of a man’s income and leaves him free to allocate the rest between consumption and investment, and since time preference schedules remain given, the proportion of consumption to saving will remain unchanged. But this ignores the fact that the taxpayer’s real income and the real value of his monetary assets have been lowered by paying the tax. We have seen in chapter 6 that, given a man’s time-preference schedule, the lower the level of his real monetary assets, the higher his time-preference rate will be, and therefore the higher the proportion of his consumption to investment. The taxpayer’s position may be seen in Figure 86, which is essentially the reverse of the individual time-market diagrams in chapter 6. In the present case, money assets are increasing as we go rightward on the horizontal axis, while in chapter 6 money assets were declining. Let us say that the taxpayer’s initial position is a money stock of 0M; tt is his given time-preference curve. His effective time-preference rate, determining his consumption/investment proportion, is t₁. Now, suppose that the government levies an income tax, reducing his initial monetary assets at the start of his spending period to 0M′. His effective time-preference rate, the intersection of tt and the M′ line, is now higher at t₂. He shifts to a higher proportion of consumption and a lower proportion of saving and investment.

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar’s ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 916-917.