Public Finance and Public Choice

3. Financing Government

3.1. Case in Point: What Are Marginal Tax Rates?

We speak often of the importance of tax rates at the margin - of how much of an extra dollar earned through labor or interest on saving will be kept by the decision-maker. It turns out, however, that figuring out just what that marginal tax rate is is not an easy task.

Consider the difficulty of untangling just what those marginal tax rates are. First, Americans face a bewildering complex of taxes. They all face the federal income tax. Each state - and many cities - levy additional taxes on income. Then there is the FICA payroll tax, federal and state corporate income taxes, and excise taxes, as well as federal, state, and local sales taxes. A person trying to figure out his or her marginal tax rate cannot stop there. Gaining an additional dollar of income will affect not only taxes but eligibility for various transfer payment programs in the level of payments the individual or household can expect to receive. Given the enormous complexity involved, it is safe to say that no one really knows what his or her marginal rate is.

Economists Laurence J. Kotlikoff and David Rapson of Boston University have taken on the task of sorting out marginal tax rates for the United States. They used a commercial tax analysis program, Economic Security Planner™, and added their own computer programs to incorporate the effect of additional income on various transfer payment programs. Their analysis assumed the taxpayer lived in Massachusetts, but the general tenor of their results applies to people throughout the United States.

Consider a 60-year-old couple earning $10,000 per year. That couple is eligible for a variety of welfare programs. With food stamps, there is a dollar-for-dollar reduction in aid for each additional dollar of income earned. In effect, the couple faces an effective marginal tax rate of 100%. Considering all other taxes and welfare programs, the economists concluded that the couple faced a marginal tax rate of about 50% on labor income. Overall, they found that a pattern of marginal rates for various ages and income levels could be described in a single word: "bizarre".

The tables below give the economists' estimates of marginal rates for current year labor supply for a single individual and for couples with children at various incomes and ages. While the overall structure of taxes in the United States is progressive, the special treatment of welfare programs can add a strong element of regressivity.

Marginal Net Tax Rates on Current-Year Labor Supply (Couples, percentages)
Total Annual Household Earnings (000s)
Age 10 20 30 50 75
30 -14.2 42.5 42.3 24.4 36.9
45 -11.4 41.7 41.8 35.8 36.1
60 50.9 32.0 36.3 36.3 45.5
100 150 200 300 500
30 37.0 45.9 36.8
43.9 44.0
45 36.1 45.1 35.9 40.0 43.2
60 45.5 47.7 43.2 45.8 45.0

Marginal Net Tax Rates on Current-Year Labor Supply (Individuals, percentages)
Total Annual Household Earnings (000s)
Age 10 20 30 50 75
30 72.3 42.9 42.9 37.0 37.0
45 -0.8 42.9 42.6 37.0 36.1
60 39.5 37.3 37.7 46.4 45.5
125 150 200 300
30 36.2 36.9 42.0
45 36.1 36.5 42.0 41.5
60 38.8 44.0 45.0 44.0

Look again at our 60-year-old couple. It faces a very high marginal tax rate. A younger couple with the same income actually faces a negative marginal tax rate - increasing its labor income by a dollar actually increases its after-tax income by more than a dollar. Why the difference? The economists assumed that the younger couple would have children and thus qualify for a variety of programs, including the Earned Income Tax Credit. The couple at age 60 still faces the dollar-for-dollar reduction in payments in the Food Stamp program. No one designed these marginal incentives. They simply emerge from the bewildering mix of welfare and tax programs households face.