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The recent public debate over taxes has tended to focus on the tax rates faced by the highest earners. But it might come as a surprise to many that the highest effective marginal tax rates are found not at the top of the income distribution, but at the bottom. This occurs as a result of policymakers’ attempts to make programs progressive by phasing out government benefits – such as the Earned Income Tax Credit (EITC), the child tax credit, and Medicaid – as an individual’s income increases. The reduction of these benefits with income has the same economic effect as imposing a tax on the additional income.
Phase-outs out of government benefits are well-intentioned: they aim to ensure that the rich do not benefit from programs intended for the poor and middle-class. However, they result in a complex, nontransparent tax and transfer system that punishes work and traps many low-income families in poverty.
Reform should aim to provide support for needy Americans while preserving work incentives. Rather than attempting to achieve progressivity in every single government program, we should focus on the overall level of redistribution in the system.
Consider the Williams family, a married couple with two children living in Brewster County, Texas. They pay rent of $500 per month, and their only asset is a car worth $1,200. Mr. Williams works for 40 hours per week and earns the minimum wage of $7.25 per hour. Mrs. Williams also earns the minimum wage, but works for only 15 hours per week. Suppose Mrs. Williams is considering increasing her weekly hours to 20. According to the Urban Institute’s Net Income Change Calculator, this change would raise the family’s pre-tax monthly earnings by $157, from $1,727 to $1,884.
However, as a result of the higher income, the Williams’ federal income tax refund would go down by $19 per month, mainly as a result of the phase-out of the EITC. Mrs. Williams would also pay an additional $12 per month in payroll taxes. Finally, the family would lose an additional $44 per month in nutrition assistance and housing subsidies. Thus, the net increase in the family’s income is only $82, giving rise to a marginal tax rate of ($157-$82)/$157 = 48 percent. Mrs. Williams will only increase her weekly hours if the $82 she earns from her work is greater than the personal cost – including any additional child care required – of working.
This example is not unusual. If anything it understates effective marginal tax rates for low income workers. Eugene Steuerle of the Urban Institute shows that low income individuals often face effective marginal tax rates that reach levels above 80%. Greg Mankiw of Harvard University points to evidence showing that these rates can even exceed 100% over some ranges of income.
With such a low payoff from working, it is not surprising that many individuals from low-income families decide to leave the labor force. These strong disincentives for work are often described as poverty traps.
But the problems created by the myriad of overlapping anti-poverty programs don’t end there. These programs also create an extremely opaque welfare system. It is nearly impossible to figure out the effective marginal tax rates faced by a typical low-income family because there are a large number of different programs with nuanced eligibility requirements, many of which vary by state. This non-transparency makes it more difficult to evaluate the benefits and scope of such programs. Moreover, this complexity makes the system costly to administer and unfair. Many individuals do not claim benefits that they are entitled to, either because they are dissuaded by the application procedure or because they are unaware of the program’s existence.
The system could be drastically improved by rethinking the way that we construct our tax and transfer system. In that spirit, here’s one possible reform. Rather than evaluating the progressivity of each program individually, we could raise tax revenue through a flat tax on income or consumption. And instead of an elaborate system of overlapping welfare programs, progressivity could be generated by providing a flat cash grant to each individual.
Many opponents of such flat tax schemes argue that they end up hurting the poor because they do not have an increasing marginal rate structure. But that is not the case. Consider a system in which each individual receives a cash payment of $10,000, and all income is taxed at a flat 20% rate. A person earning $30,000 faces a net tax rate of ($6,000-$10,000)/$30,000 = -13.3%. In contrast, a person earning $300,000 faces a net tax rate of ($60,000-$10,000)/$300,000 = 16.7%. Thus, the system imposes much higher net tax rates at the top of the income distribution compared to the bottom. Indeed, Louis Kaplow of Harvard University shows that any desired level of redistribution can be achieved with such a system, simply by varying the tax rate and the level of the cash transfer.
Moreover, Greg Mankiw has pointed out that poor families already face, on average, an effective marginal tax rate of about 30 percent (and much higher rates under some circumstances), similar to the tax rates found at the top of the income distribution. Thus, the overall amount of redistribution in our current system could be achieved much more efficiently through a cash grant coupled with a flat tax.
In our recent article, we argue that such a proportional tax system is transparent and provides good work incentives. Because of its simplicity, it forces politicians to be explicit about their desired level of redistribution. It removes the poverty trap created by the phase-out of numerous welfare programs. It also reduces the disincentives for entering the labor force faced by secondary earners and those nearing retirement.
While such a change is certainly extreme, a reform that moves in this direction is worth considering. A reformed system has the potential for making our current tax and transfer system fairer, more transparent, and more generous to the poorest individuals while improving work incentives and saving on administrative costs.
Aspen Gorry is a research fellow at the American Enterprise Institute (AEI) and an assistant professor at the University of California, Santa Cruz and Sita Nataraj Slavov is a resident scholar at AEI.
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