Does It Pay to Work?

Studies | Taxes

No. 258
Monday, March 31, 2003
by Jagadeesh Gokhale, Laurence J. Kotlikoff, and Alexi Sluchynsky


Introduction

1Does it pay to work? That is a tough question to answer. In general, more work means a higher income and, therefore, higher taxes. A higher income usually also leads to fewer entitlement benefits (such as Food Stamps). Moreover, the effects of working today are not limited to today's higher taxes and today's loss of entitlement benefits. Income earned today also affects future taxes and future benefits. In particular, there are five important links between today's decisions and their future consequences:

  • Earning more today typically leads to more saving and, therefore, more assets and more income from assets in the future; however, that higher future capital income will result in higher future income taxes.
  • More assets and more income in the future also will mean fewer future benefits from entitlement programs that are linked to the income and assets of the recipients (such as Medicaid).
  • Earning more today typically will lead to more consumption in the future because asset accumulation makes more consumption possible; however, that higher consumption will result in higher consumption taxes.
  • Earning more today will lead to higher Social Security benefits in the future.
  • More non-Social Security income in the future, caused by higher earnings and more saving today, will increase the tax on future Social Security benefits.

"To determine if work pays, we must consider lifetime taxes paid and government benefits lost as a result of working."

Calculating the Costs and Benefits of Working. As the above list indicates, understanding the full consequences of deciding to work requires taking into account all future taxes workers will pay plus all future transfer payments workers will lose from going to work. To illustrate this lifetime tax analysis, we have chosen a representative two-earner couple. The couple is assumed to rent in the early years and eventually buy a house. They have two children, who grow up and attend college. Over time, the couple has many opportunities to interact with the tax system by, for example, taking advantage of the mortgage interest deduction and the child tax credit, deciding whether to itemize deductions, paying Federal Insurance Contribution Act (FICA) taxes, paying state income taxes, and using their after-tax earnings to pay sales taxes.

We assume that couples enter the labor market at a specific wage and that their income grows by 1 percent per year in real terms, and we consider this couple at different income levels. For example, if they earn a low income they benefit from the Earned Income Tax Credit (EITC) and the credit for retirement account contributions. If they earn a high income, they are penalized by the phase-out of itemized deductions and by the alternative minimum tax. We approach entitlement benefits in a similar way. If they earn a low income, the family qualifies for "welfare" benefits including cash assistance, Food Stamps and Medicaid. As their level of income or assets rises, these benefits phase out.

Our approach is also probabilistic. In any given year, there is some chance one or both spouses will die. The death of a spouse triggers entitlement benefits for the remaining spouse and the children (such as survivors benefits under Social Security). These benefits are also affected by what the deceased spouse was earning. We calculate expected taxes and expected benefits for the couple. We do so by calculating the taxes and benefits for each possible lifetime. To get an expected result, we sum over all possible lifetimes, each weighted by its probability of occurring.

Our approach is also comprehensive. We include every major tax and transfer program. In the case of taxes, we include employer-paid taxes, whether corporate income taxes or employer-paid FICA taxes.

"A low-income couple with children is eligible for many tax benefits and transfers that aren't available to middle-income workers."

The Complexity of the U.S. Tax and Transfer Benefit Programs. It is difficult to exaggerate the complexity of the taxes and transfer programs American workers face. Mastering the federal income tax alone is a major challenge because it has so many special provisions. These include the inflation-indexation of tax brackets, the partial and graduated taxation of Social Security benefits above two noninflation-indexed thresholds, the treatment of retirement account contributions and withdrawals, the phase-out of itemized deductions, the Earned Income Tax Credit, the child tax credit, the alternative minimum tax, and the recently legislated credit to low-income households for contributing to retirement accounts.

As if the federal income tax were not difficult enough to decipher, almost all states have income taxes with their own special provisions. For example, Massachusetts has an exemption for the elderly, a child deduction, a rental deduction, and a deduction for employee-paid payroll taxes. Compared to these state taxes, the FICA payroll tax seems straightforward.

As the various interrelated social welfare programs have grown, the U.S. system of transfer benefits has become extremely complicated. It now includes Food Stamps, Medicaid, traditional welfare - renamed Temporary Assistance for Needy Families (TANF), Supplemental Security Income (SSI), housing assistance programs, the Low-Income Home Energy Assistance Program (LIHEAP), the Special Supplemental Nutrition Program for Women, Infants and Children (WIC), and several other programs.

Software Program. Understanding the effective net tax on work requires an intertemporal model capable of carefully determining tax and transfer payments at each stage of a person's life cycle, based in part on economic choices in prior periods. This study uses ESPlanner, a financial planning software program developed by Economic Security Planning, Inc., to study the net tax levied on workers with different earnings capacities. ESPlanner smooths households' living standards subject to constraints on their capacities to borrow. In so doing, it makes highly detailed, year-by-year federal and state income tax and Social Security benefit calculations. [See Appendix for details.]

Reporting the Results. In expressing the results of this study, we have chosen multiples of the minimum wage. A full-time worker earning the minimum wage of $5.15 an hour will earn $10,700 a year. When both spouses earn the minimum wage, their family income will be $21,400. If both spouses earn twice the minimum wage ($10.30 an hour), their joint annual income will be $42,800.


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