As Washington works out a deal (or doesn't) to resolve the fiscal cliff, negotiations will center on federal marginal income tax rates. President Barack Obama wants rates to go up on high earners, with the top rate returning to nearly 40 percent. Congressional Republicans would prefer to trim back tax deductions to avoid rate increases.
But marginal tax rates are not as large a problem for the wealthy as they are for the poor and working classes. According to a recent report from the Congressional Budget Office, the Americans paying the highest effective marginal tax rates are, for the most part, low- to middle-income individuals. It's these Americans -- not House Speaker John Boehner's "job creators" -- who are materially discouraged by their effective marginal tax rates.
If the Bush tax cuts on the highest income brackets are allowed to expire, individuals and married couples earning more than $398,350 in adjusted gross income will pay a marginal tax rate of 39.6 percent next year, up from 35 percent in 2012.
Compare that with a hypothetical single mother earning $18,000 a year before taxes and transfer payments: She will pay a marginal tax rate of 88 percent, down from 95 percent this year. That means she will keep only 12 cents from each additional dollar she earns in pretax income after taxes and transfers. Yes, that’s better than keeping only 5 cents of every dollar. But it's nevertheless a rate high enough to be a severe disincentive against the work that would secure her economic independence.
How is that possible? Don't lower-income individuals pay virtually nothing in federal income taxes?
Yes: On net, average federal income tax rates are negative -- post-tax income exceeds pretax income -- for the two lowest income quintiles. But that's not the same as marginal tax rates, which measure the amount of money taken out of each additional dollar earned. It's the marginal rate, most importantly, that creates the disincentive to work.
The poor face high marginal tax rates because they receive transfer payments -- income subsidies such as the Earned Income Tax Credit and needs-based benefit programs such as Medicaid -- which are phased out as their pretax earnings rise. (Other such programs include Temporary Assistance for Needy Families, the Supplemental Nutrition Assistance Program and the Children's Health Insurance Program.)
Because of this, our hypothetical single mother would have almost no more in after-tax income earning $8,000 before taxes than she would if she earned $25,000. That, as Megan McArdle and Matt Yglesias have pointed out, poses a severe disincentive for the poor to seek work, which will probably be low-paying. A study completed in 2002 on a Canadian social program found that halving the effective marginal tax rate from 100 to 50 percent doubled the percentage of workers who secured employment during a trial period.
Economists have long known that the transfer system generates extraordinarily high marginal tax rates on the poor and working class. In a 2006 study, Laurence J. Kotlikoff and David Rapson called the effective marginal tax rates "bizarre" and "all over the map."
"America’s tax-transfer system confronts the vast majority of American households with either high, very high, or astronomically high total effective marginal tax rates on labor supply and saving," Kotlikoff and Rapson wrote. The CBO's latest study on the effective marginal tax rates of low- and middle-income workers is also a more in-depth examination of an issue first broached by a similar CBO report in 2005.
What the recent CBO report reveals, however, is that Kotlikoff and Rapson’s findings are not just abstract, nor do they apply to just a few people trapped in a badly designed tax code. The high effective marginal tax rates hit a substantial swath of the working class.
The marginal tax rate of earners making 100 percent to 150 percent of the federal poverty level -- between $23,050 and $34,575 for a family of four -- is more than 30 percent, as compared with a federal statutory rate of 15 percent. Almost one-third of earners in this range -- tens of millions of Americans -- paid a marginal tax rate higher than 39.6 percent, the top statutory rate. The average person paying a 40, 50, 60, or even 70 percent marginal tax rate isn't well-off: More likely than not he or she is below middle-income.
This problem is not entirely avoidable. In order to have a balanced budget, it is necessary for the government to gradually take away benefits from lower-income Americans as they earn more money. And the more transfers the poor receive, the higher marginal taxes must climb, flattening out the relationship between pre- and post-tax income to raise revenue.
One solution is to raise marginal tax rates on higher-income individuals. But there simply are not enough wealthy people for this to go very far; at some point, high marginal tax rates cannot be shifted further up the tax code while remaining deficit-neutral. There is also some (limited) evidence, as Ezra Klein writes, that the incomes of the rich are more sensitive or "elastic" to marginal tax rates, which would make it more difficult to raise sufficient revenue at the top of the income scale to cover transfers. (Disclosure: I am also a writer for Klein's Wonkbook newsletter.)
So these effective high marginal tax rates on low and middle incomes are, to some extent, the downside of a worthwhile trade-off to achieve sharply negative average tax rates for the poor. Although their marginal rates limit their economic incentives to work for more income, it's thanks to the negative average rates that they have any income at all. In terms of priorities for public policy, incentives for work are important, but it’s unreasonable for them to trump a concern for basic quality of life.
(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)
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