Effective Marginal Tax Rates: A Growing Discussion
Salim Furth /
Did you notice how your paycheck shrank in January? The expiration of temporary payroll tax cuts boosted marginal tax rates about two percentage points for most Americans.
That might not be a very large number on its own, but taken together with the full range of government policies affecting workers of modest means, effective marginal tax rates are sometimes depressingly high.
Government policies often cut into the rewards of and incentives to work. The effect of taxes is fairly straightforward—taxes reduce the incentive to work, and higher tax rates have even more damaging effects. Less familiar is that most government benefits phase out as the recipient’s income rises. So some income gains are offset by lost benefits. The amount of each dollar of additional earned income lost to taxes and diminishing benefits is the “effective marginal tax rate.”
Two studies undertaken in 2012 quantified the effective marginal tax rate for a single parent at different income levels. A November Congressional Budget Office study, which Heritage summarized and discussed in a recent Issue Brief, looked at how the disposable income for a single parent with one child varied across the income scale in 2012.
The inconsistency of government policy is troubling: At some income levels, the example single parent worker can keep 70–80 percent of an additional dollar of income. But at other levels of income—from about $10,000 to $23,000—he can keep much less: between 5 cents and 34 cents on the dollar.
Another study, published in the National Tax Journal by Elaine Maag, Eugene Steuerle, Ritadhi Chakravarti, and Caleb Quakenbush, goes into further detail at the state-by-state level. Because state tax and Medicaid policies differ widely, the effective marginal tax rates may be much different from state to state. They look at a single parent with two children and estimate her effective marginal tax rate across broader income levels in each of the 50 states and the District of Columbia. They find that in 10 states, she could increase her earned income from $17,350 to $26,025 while increasing her disposable income less than $1,700, a marginal effective tax rate of above 80 percent. In four of those states, her disposable income would actually decrease as she worked more.
Above $26,025, it only gets worse. If a single parent with two children worked even more, she would keep even less. From $26,025 to $34,700, she would keep less than 20 cents on the dollar in 27 states. In 20 of those states, she would keep less than 5 cents on the dollar. In seven states, she would actually lose money by working more.
The authors point out that many individual situations are not so extreme. For example, someone who works only part of the year may be eligible for benefits during other months. And many people who are eligible for government benefits do not enroll, so they do not experience the loss of the benefit as they work more.
In his book The Redistribution Recession, economist Casey Mulligan shows that the disincentives to work were made worse in the government’s response to the Great Recession. He goes through welfare expansions such as extended unemployment insurance and the first-time homebuyers’ tax credit, government responses to the recession that have slowed the recovery by diminishing the reward for work.
Instead of increasing the reward to work, government continues to diminish it. The expansion of food stamps, which was justified as a response to the recession, has never been rescinded. Extended unemployment benefits remain in effect three-and-a-half years after the recession ended. And as of 2013, every low- and middle-income worker’s effective marginal tax rate rose two percentage points.
Congress should take incentives seriously when considering legislation that raises taxes or benefits on potential workers.