Arnold Kling  

Marginal Tax Rates, Again

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A reader recommends a paper by Laurence J. Kotlikoff and David Rapson. The reader views this paper as contradicting the article I linked to earlier. Kotlikoff and Rapson report marginal tax rates of closer to 40 percent than 100 percent for people in the lower income ranges. One difference is that Kotlikoff and Rapson do not include housing subsidies. Otherwise, it is difficult to trace the sources of the difference.

The incentive structure for low-income households is a maze, which Kotlikoff and Rapson describe as "bizarre." There are some hypothetical profiles where tax rates are extremely low, and some where they are extremely high.

Some quotes from the paper follow.

Take couples age 30. The marginal rate is -14 percent at $10,000 in earnings, 42 percent at $20,000, 24 percent at $50,000, 37 percent at $75,000, 46 percent at $150,000, 37 percent at $200,000, and 44 percent at $500,000.
In addition to anomalous patterns of marginal rates with income, holding age constant, there are also unusual patterns with respect to age, holding income fixed. Take singles earning $10,000. Thirty-year old members of this group face a marginal net tax rate of 72 percent. Were they age 45, their marginal rate would be -10 percent. And were they 60, their marginal rate would be 39 percent...
One way to appreciate the size of work disincentives facing this [45 years old, $25,000 income] household is to ask how much more it must earn, after losing all its benefits, to achieve the same living standard it enjoys when earning $25,000 and receiving all its benefits. The answer is roughly $50,000. I.e., the couple has to double its earnings simply to break even with respect to maintaining its living standard. Such high net taxes apply to all low-income households, regardless of age or marital status.
...To further appreciate the nature of life-cycle labor supply disincentives, consider our 60 year-old couple earning only $10,000. For this couple earning $55,000 a year for the duration of its working life is only marginally better than earning $10,000.

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COMMENTS (12 to date)
John Thacker writes:

"Kotlikoff and Rapson report marginal tax rates of closer to 40 percent than 100 percent for people in the lower income ranges. One difference is that Kotlikoff and Rapson do not include housing subsidies. Otherwise, it is difficult to trace the sources of the difference."

Note that the 40% rates are for couples. The article you linked to before was for a household of a single parent with two kids. The single parent two kid household gets more government assistance programs in housing, childcare, children's health insurance, etc., all for understandable reasons, but they all phase out.

Jody writes:

household is to ask how much more it must earn, after losing all its benefits, to achieve the same living standard it enjoys when earning $25,000 and receiving all its benefits. The answer is roughly $50,000

That sounds like the result of the original article.

Mike Rulle writes:

I wonder if the "underground economy", represented by unreported income, is most active with those individuals in the income ranges with the more bizarre disincentives.

tjames writes:

There is a lot of talk about incentives and disincentives, but I wonder how much incenting and disincenting is actually accomplished if it takes mutliple experts doing dediciated research to even begin to piece it all together.

Let me say this another way. Many of these incentives and disincentives are structued in such a way that a lot of the people facing them can not easily do the tradeoff calculations, or they do them but assign the wrong values to things.

What type of decision making does an individual engage in when they cannot tell the difference, a priori, between working more and losing subsidies, and working less while maintaining them? The implications of these 2 articles is that people somehow sense this and feel generally disincented to earn more when they are in the lower income quintiles.

I'd be interested to see research linking the incentives people actually faced vs. the incentives they felt they faced and the actual decisions they made.

Morgan writes:

Don't think that the working poor are unaware of the incentives facing them, or are unable to evaluate these incentives. Yes, they are complex, especially in the aggregate. No, it isn't impossible to evaluate the impact of increased earnings. Looks like the internet is a new tool for getting advice where once acquaintances had to serve.

See posts like this one:

http://uk.answers.yahoo.com/question/index?qid=20090116154750AAddYi9

Don Lloyd writes:

tjames,

"I'd be interested to see research linking the incentives people actually faced vs. the incentives they felt they faced and the actual decisions they made."

But having a tax system so complex and deceptive that people do not and cannot know what disincentives they actually face is far worse than just the actual disincentives themselves.

Regards, Don


tjames writes:

Mike - I believe all reported income faces a positive marginal tax rate, once all taxes and subsidies are factored in. I an unaware of any situation where reporting more income actually lowers your overall tax burden.

Therefore, all income brackets face at least some incentive to hide income from the IRS. This is a particular problem for the IRS when it comes to all self-employed people from babysitters to highly compensated lawyers, doctors, and small business owners. The IRS claims that, overall, the self-employed dodge a lot of taxes this way.

Dan Weber writes:

Even if we don't understand the incentives, we can still be influenced by them.

Consider biological evolution for a moment. An organism with a beneficial mutation is probably unaware of it -- it just so happens that it is able to, say, process glucose more efficiently. It still ends up with a reproductive advantage.

If there are two 30-year-olds making $15,000. One of them saves his money, the other doesn't. Since (according to the linked PDF) the one who saves faces a 260% marginal tax on savings, he is worse off for his decision. Even if unaware of why, he will be at a disadvantage compared to his spending colleague. Their 29-year-old colleagues will tend to replicate their successful elder.

tjames writes:

Don - couldn't agree more. I'd love a simpler tax system. I suspect that means changing the incentives facing tax legislators, who wish to be re-elected, which is a whole different problem.

Morgan - I didn't mean to imply the working poor are unaware of incentives, merely that they weren't able to evaluate them well because of complexity. Yes, there is the internet. But I'm related to a number of people who qualify as working poor, have at least some internet access, but still couldn't, or won't, be able to use it to get these answers. I doubt any of them is able to tell me the impact on their EITC if they willingly work all that overtime they are offered until it's too late, and that's a problem (note: The IRS website to figure this out says to bring your W-2s and prepare to spend 20 minutes on their calculator.) The last thing we need is poor people not maximizing their limited resources, be it time or money.

Any individual incentive might be easy to understand. It's the aggregate that can get downright confusing, especially when there are complex rules applied.

Sorry - didn't mean to hi-jack this dicsussion.

Joe Cushing writes:

I would suspect that most poor people are young, single, no children. A large chunk of them probably come from middle class families and they just haven't advanced in their careers yet. These people don't qualify for a lot of the programs talked about. They also envision themselves earning more than enough to not qualify for any programs. So most of them are not receiving many government subsidies. I bet the average marginal tax rate for many people grossing under $25,000 is probably closer to 15%. The problem comes once someone enters the system. Then they get stuck.

Today we have created a temporary system with unemployment. This system captures people who wouldn't normally be caught. unemployment imposes a 50% marginal rate on all income up to twice the level of benefits on a weekly basis. This amount is Over $700 a week in Michigan. Unemployment prevents people from taking part time or very short temporary work and it drives people into the underground economy.

Douglass Holmes writes:

The incentive to work or not work is incredibly complex for anyone. I have no idea how hard I should be looking for work right now. I can keep sending out resumes. That's looking for work, right? And as long as I'm 'looking for work' I'll keep getting my unemployment checks. The real question is, how soon should I start working REAL HARD to find that job? When do I become desperate enough to relocate?

Maybe I should just go back to school and get a degree in something useful like economics.

Jeremy, Alabama writes:

Everybody, of all ages and all politics, should read this paper.

A system that punishes the working poor who are trying to elevate themselves is fundamentally flawed. It will never be fixed, in fact it will get worse, as the poor vote themselves ever greater poverty-trap marginal rates while the well-off reduce wealth creation or even leave the country.

High marginal rates on the poor is how you destroy a country.

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