CASE STUDY

ICELAND’S NATURAL EXPERIMENT

In the 19808, Iceland changed its tax system in a way that, as a side effect. provided a natural experiment to show how taxes affect an economy. Before the reform, people paid taxes based on their previous year’s income. After the reform, people paid taxes based on their current income. Thus, taxes in 1987 were based on 1986 income, but taxes in 1988 were based on 1988 income. Income earned in 1987 was never taxed. For this one year of transition, the marginal income tax rate fell to zero.

As reported in a December 2001 article in the American Economic Review. the citizens of Iceland took advantage of this tax holiday. Total hours worked rose by about 3 percipience 987 and then fell back to its normal level in 1988. The production of goods and services in 1987 (as measured by real GDP) was 4 percent higher than the average of the year before and the year after. This episode confirms one of the Ten Principles of Economics: People respond to incentives.

The fall in the Icelandic marginal tax rate was for one year only, and this fact surely influenced the response. On the one hand, some people may have put off vacations and worked’ overtime to take advantage of the temporary incentive. On the other hand, no one would alter career plans, and no business would restructure its work environment, in response to an incentive that would soon disappear. A permanent change in a marginal tax rate could have either a smaller or a larger incentive effect than a temporary change.

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