13 November 2009

Who Faces Implicit High Marginal Tax Rates?

There are people in the United States who face marginal tax rates close to 100%.

Who are they?

Not the rich, but the working poor. For a family of three, near 100% implicit marginal tax rates impact those making between about $15,000 to $30,000 a year.

Their marginal federal income tax rates are low or zero. But, FICA taxation, the phase out of the earned income tax credit, state income taxes, and the phase out of means tested benefits like food stamps, Medicaid/SCHIP, Section 8 housing benefits, and cash welfare payments combine to give the working poor little incentive to earn more, unless it is a whole lot more.

Those with high incomes, in contrast, can often cast their income as capital gains rather than ordinary income, can often defer income, and are no longer subject to the Social Security part of FICA taxation when their income is characterized as earned income. Of course, they also aren't facing the phase out of means tested government benefits.

Conceptually, it isn't very hard to change these incentives. One can have benefits that aren't phased out at all (like Alaska's permanent fund dividend), a negative income tax (an idea that has floated around think tanks since the Nixon administration), phase out benefits more slowly, or create an exclusion for a certain amount of earned income in FICA taxation, for example.

Mechanically, it wouldn't be that hard to change the incentives. The vast majority of them are set by the federal government, and most are administered by just a few government departments (mostly the IRS, the Department of Health and Human Services and HUD). The tax code is tinkered with several times a year, and only a few sections, most of which are of little concern to most corporate tax lobbiests, matter in creating incentives for the vast majority of low income taxpayers. A handful of statutory sections and accompanying regulations govern the means tested benefits programs.

The problem is not an issue of choice (i.e. inability to know how to solve the problem or inability to recognize the problem) but of power.

The trouble is that there is really no one to lobby for the interests of the working poor. Union households typically make enough to lift them out of this working poor "dead zone." The concerns of the elderly, who have powerful representation in the form of the AARP and high rates of political participation are very different. The adult working poor and their children, in contrast, have low levels of political participation and are largely unorganized. They don't see themselves as a coherent political unit and don't have the means or the ability to advocate for themselves in a long drawn out Congressional battle. The middle class, in contast, participates more actively, if sporadically, in politics, and is suspicious of the notion of welfare for those who aren't genuinely poor, even though it may improve the incentive of those who are poor to earn more.

The rich, in contrast, frequently moan and groan about the impact that higher marginal tax rates may have on their incentives to work, despite the fact that their marginal tax rates are not meaningfully higher than those of other Americans. But, they do have the means and organization to fight Congressional battles, so their message is heard.

The only really organized political entity that disporportionately represents the working poor is the Democratic party, which has great political power at the moment. But, political parties have been so neutered by progressive reforms that tried to reduce the political corruption associated with 19th century political machines by weakening political parties, that they have become brand names rather than policy making centers. And, at any rate, few powerful Democratic party political figures have taken on the issue of implicit marginal tax rates for the working poor.


Michael Malak said...

Marginal tax is an issue that interests me so much that I registered marginaltax.com (nothing there yet).

The highest marginal tax I've found so far is 50,000% (if we restrict ourselves to dollar increments rather than penny increments). Bush's 2006 education tax deduction is either $2,000 or $4,000 depending on MAGI. Earning an extra dollar lowers the tax deduction from $4,000 to $2,000. The cut-off falls within the 25% tax bracket, so that results in a $500 difference in tax bill. An additional $500 in taxes for an extra $1 earned is 50,000%.

See page 40 of

Billll said...

The flat area on the curve is todays legacy of Lyndon Johnsons War on Poverty. One could go on at some length as to what it involved, why it was done, and what became of it.

Getting political power involves getting votes. Getting votes involves money, as all votes are bought, one way or another. The votes of the poor are the cheapest to buy, especially if you're buying them directly with other peoples money.

The cleverer folks in the economic doldrums recognize what's going on and either take up jobs with significant unreported income or else begin working their way through college to land a job that gets them out of the trap.

The Democrat party today represents union labor, tort lawyers, and government employees. This plus the obligate poor provide enough votes to get power if the opposition falls out of favor for any reason.