Source: Slate

Happy tax season. To celebrate the most wonderful time of the year, I wrote an explainer on marginal tax rates and what they mean for individuals with different incomes.

By John Gerard Beattie

Unfortunately, survey data show that many Americans completely misunderstand how marginal tax rates work. In 2021, Credello ran a survey asking respondents to mark 1 of 2 statements as correct: “you pay your marginal tax rate on all of your income” or “you pay the same as others on income up to a certain amount, then a higher rate on every dollar until the next threshold.” Amazingly, 51% of respondents agreed with the first statement.

And fortunately for you, your friendly undergraduate economics columnist is here to explain to you why this statement is incorrect. First, let’s consider this hypothetical income tax schedule:

i. $0-99,999.99 of your total income is taxed at a marginal rate of 5%

ii. $100,000 and above is taxed at a marginal rate of 7%

In this example, someone making $50,000 would be taxed at 5%, resulting in disposable income of $47,500. Their marginal rate is applied to their entire income. Now, someone making $125,000 falls in our second tax bracket, but that entire $125,000 is not taxed at 7%. Instead, the first $99,999.99 is taxed at 5%, and the next $25,000.01 is taxed at 7%. This leaves our tax-paying citizen with approximately $118,250 in disposable income. Notice that they are not paying their top marginal tax rate on all of their income, only the relevant rate that corresponds to a portion of their income. The real theme here is that tax rates are marginal.

If the US tax system operated in such a way that 51% of those respondents believe it does, there would be huge and catastrophic incentives in place for workers at the margin of the two tax brackets. 

Consider an example of this alternative: someone who makes $99,000 in pretax income would be left with $94,050 in disposable income. If they were offered a raise, more working hours, or a better job to earn $100,000, they would be left with $93,000. This worker earns an additional $1,000 from the market, but only comes home with less money. This relationship between pre-and-post tax income is referred to as an average effective tax rate, which in the fictional case above is quite steep at about 205%.

In reality, the US income tax follows a similarly generous average effective tax, but not only because incomes are taxed marginally. There is a second and more implicit feature of the income tax schedule which causes average effective tax rates to be generous: there are no steep increases between tax rates between tax brackets. Following our hypothetical scenario above, this too would increase average effective tax rates. For example, consider a top marginal tax rate of 50% instead of 7%. Holding everything else constant with a worker who can earn $101,000 instead of $98,000, their average effective tax rate is 230%! In other words, a worker who is offered this raise with this tax schedule has a high incentive to be complacent at their current salary. Luckily, the US tax schedule is largely absent of steep marginal tax rates. Most workers offered a higher salary will and should accept without any mental calculation on benefits lost from the government per dollar earned from their job.

Keyword most. If you are poor and receiving welfare benefits, these sorts of ugly tax rates do exist. Consider the Earned Income Tax Credit, one of the United States’ most infamous and well-funded welfare programs, where a single parent with three children with the prospect to earn an additional thousand dollars from $30,000 to $31,000 faces an average effective tax rate of 78%:

Source: Congressional Research Service

For context, a similar family jumping between two tax brackets from $578,000 to $579,000 faces a much more generous rate of 29.3%.

Or New Jersey’s Child Tax Credit, which has average effective marginal tax rates up to infinity between income groups:

Source: Jain Family Institute

And these designs aren’t limited to just the tax code either. Medicaid is a culprit as well: “In states that have expanded Medicaid coverage: You can qualify based on your income alone. If your household income is below 133% of the federal poverty level, you qualify.” If a household finds themselves at this threshold but able to earn more, chances are that it would be suboptimal for them to do so because they could risk paying thousands of dollars in extra healthcare bills.

Again, the effect of such  steep tax rates means that families may consider themselves better off by earning less. This is exactly the effect that would arise in a world where one’s entire income is taxed at their marginal rate. In other words, the sorts of anti-work effects which respondents in the survey above really do exist for the poorest people in America.

 This disastrous incentive is even more present when we consider a family using multiple US welfare programs with complex benefit schedules coinciding. One study finds that one in four low-wage households in the bottom quintile of income face average effective tax rates above 50% considering all programs that they participate in. This implies work disincentives stemming from multiple programs, and the empirical evidence confirms this implication from steep marginal tax rates. Here are the results of one study from Paul Trampe:

Measuring the effects of the entire phase-out disincentive, with a negative 0.38 coefficient, a person facing a 21.1 percent phase-out rate, all else being equal will reduce her work by 8 hours per week as compared to what they would be doing in the absence of the EITC altogether.

In other words, a worker with a 21.1 % average effective tax rate from the EITC will reduce their working hours by 8 hours per week when compared with a baseline case where they are not receiving EITC benefits. These are not exactly the incentives that US policymakers should seek out. In fact, Congress long concerned itself with promoting “pro-work” policies, especially for the poorest Americans. However, our current system of welfare benefits are flooded with hidden work disincentives. Instead of this, our welfare system should encourage work unconditionally without welfare cliffs, along with the ultimate goal of lifting people out of poverty. I have a few thoughts on how to do this, but that is a discussion for another column.