Marginal and average tax rates in optimal tax policy

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Article Highlights

  • While the optimal top marginal tax rate has received substantial attention in recent years, optimalrates at other points in the income distributionhave received relatively less consideration.

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  • In practice, individuals often face high implicitmarginal tax rates at lower incomes, mainlythrough the phaseout of government benefits.

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  • A proportional tax system can be made quite progressive with either a universal transfer payment or an income exemption.

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Introduction

Over the past several years, most of the public discussion over tax policy has focused on how much the wealthy should pay and what the top marginal tax rate should be. After extensively debating the disincentive effects of raising the top marginal rate from 35 to 39.6 percent, Congress took that step in January. During the 2012 presidential campaign, the low average tax rate paid by Republican nominee Mitt Romney sparked much controversy as well. However, far less attention has been paid to marginal and average tax rates at other points in the income distribution. In many cases, low-income households face implicit marginal tax rates that far exceed those paid by high-income households. And economic research suggests that the decision of low-income individuals to enter the labor market depends on the average tax rate that they face.

This article discusses the role of both average and marginal tax rates throughout the income distribution. Our analysis relies on optimal tax theory, which allows us to study the trade-off between two of the main goals of policymakers: progressivity and economic efficiency. We briefly review the implications of standard optimal tax theory for setting the top tax rate, then turn to the trade-offs involved in setting the marginal tax rate at other points in the income distribution. We then extend the model to allow for individuals to enter and exit the labor force. Introducing an extensive margin of labor supply implies that average tax rates can play an important role in influencing work incentives. We next consider life cycle concerns. We conclude with a discussion of how understanding the tradeoffs involved in optimal taxation might inform policy decisions. We argue that a proportional tax system with a universal transfer or personal exemption provides a transparent tax code that deals well with many of the trade-offs involved in setting marginal and average tax rates. In making connections between optimal tax theory and current policy, we focus not just on the tax system but also on the system of transfer payments. Tax and transfer systems should be considered together because phasing out a transfer payment as an individual’s income increases is economically equivalent to taxing the additional income.

Selection of key findings:

  • Following extensive debate about the disincentive effects, Congress raised the marginal tax rate on the highest earners in January 2013.
  • But low-income households face effective marginal tax rates nearly the same as upper income households (30%), according to the Congressional Budget Office. Individuals face high implicit marginal tax rates at lower incomes because of the phase-out of government benefits, which is economically equivalent to taxing the income.
  • Similarly, secondary earners - usually married women -- face higher tax rates on their earnings because their entire income gets taxed at a rate that is at least equal to the primary earner's marginal tax rate.
  • Taxing income discourages work, thus these individuals are incentivized to stay out of the labor force.

 

Policy Recommendation: 

A proportional tax system would improve transparency and efficiency by eliminating the variation in marginal and average tax rates within income groups.   It could be made progressive by adding a universal transfer payment or an income exemption. 

Marginal and Average Tax Rates in Optimal Tax Policy

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For a complete listing of all On the Margin articles, please visit: www.aei.org/onthemargin/.

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About the Author

 

Aspen
Gorry
  • Macroeconomist Aspen Gorry studies employment and tax policy. His research focuses on jobs, specifically on how labor market policies impact employment outcomes for young workers. He has written about the impact of minimum wages on youth unemployment, optimal taxation over a worker's life cycle and the importance of early career experience for workers' labor market outcomes. Before joining AEI, he taught economics at the University of California, Santa Cruz.

  • Phone: 435-797-2397
    Email: aspen.gorry@aei.org
  • Assistant Info

    Name: Regan Kuchan
    Phone: 202-862-5903
    Email: regan.kuchan@aei.org

 

Sita Nataraj
Slavov
  • Economist Sita Nataraj Slavov specializes in public finance issues dealing with retirement and the economics of aging. Her recent work has focused on whether retiree health insurance encourages early retirement, the impact of widowhood on out-of-pocket medical expenses among the elderly and the optimal time to claim Social Security. Before joining AEI, Slavov taught a variety of economic courses at Occidental College: game theory, public finance, behavioral economics and econometrics. She has also served as a senior economist specializing in public finance issues at the White House's Council of Economic Advisers. Her work at AEI will focus on Social Security and retirement issues.


    Click here to view CV


    Follow Sita on Twitter

  • Phone: 202-862-7161
    Email: sita.slavov@aei.org
  • Assistant Info

    Name: Brittany Pineros
    Phone: 202-862-5926
    Email: brittany.pineros@aei.org

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