Does It Pay to Work?
Monday, March 31, 2003
by Jagadeesh Gokhale, Laurence J. Kotlikoff, and Alexi Sluchynsky
Table of Contents
Lifetime Taxes and Lifetime Transfer Benefits
In order to assess the consequences of going to work, we need to calculate over a lifetime the extra taxes paid and extra benefits received or sacrificed as a result of that decision. In what follows, all lifetime taxes and transfer benefits are reported as present values.
"At different income levels, a two-earner couple faces different lifetime tax burdens and lifetime benefits."
Lifetime Taxes. Table I presents the couple's expected lifetime taxes and benefits, measured in current dollars. If we ignore the lowest income levels, the table shows:
- A couple earning twice the minimum wage can expect to pay more than $300,000 in taxes over the course of their lifetimes - an amount equal to about seven times their initial annual income.
- A couple earning about $100,000 can expect to pay close to a million dollars in lifetime taxes - an amount equal to almost 10 times their initial annual earnings.
- At higher levels of income, expected lifetime taxes tend to be between 10 and 11 times initial annual earnings, regardless of the amount earned.
On the tax side, then, our system is mildly progressive. As a percent of lifetime income, the tax burden rises modestly as income rises, then levels off once income rises above $100,000.
The Composition of Lifetime Taxes. One reason why the overall tax system is not more progressive is that people pay different types of taxes at different income levels. Although the rate structure of the federal income tax system is fairly progressive, payroll taxes tend to be proportional to income (although typically capped at a certain income level) and consumption taxes tend to be regressive, taking a larger portion of lower family incomes. In general, the tax burden borne by lower-income families tends to be weighted toward proportional and regressive taxes. As Figure I shows:
- For a family earning $32,100 a year (1.5 times the minimum wage), half the taxes paid are payroll taxes and only 30 percent are income taxes.
- By contrast, for a family earning $321,400 (15 times the minimum wage), three-fourths of all taxes are paid in the form of income taxes, and less than one in five tax dollars comprises payroll taxes.
Lifetime Transfer Benefits. Returning to Table I, note that a couple in which both spouses initially earn the minimum wage and remain at the bottom of the income ladder throughout their working lives can expect to pay more than $100,000 in taxes over their lifetime. However, they can expect to receive back almost $270,000 in benefits. Thus a low-income household gets a very good return on its taxes. (Note, however, that it is very difficult to work full time and earn only a minimum wage income for four to five decades.) Going beyond the lowest income level, Table I shows that:
- A couple earning twice the minimum wage ($42,800) can expect to receive about $94,000 in lifetime entitlement benefits, measured in current dollars.
- At four times the minimum wage ($85,700), the couple's expected entitlement benefits rise to $104,000.
- At an income level of about $150,000, the couple's entitlement benefits reach about $127,000, where they remain, regardless of the size of the family's income.
"A high-income couple pays three-fourths of its taxes in the form of income taxes."
Unlike taxes, which tend to be proportional to income once a certain income level is reached, transfer benefits tend to be constant once a certain income level is reached. This means that benefits as a percent of income tend to fall as income rises.
- At twice the minimum wage, couples can expect to get back about $1 in transfer benefits for every $3 they pay in taxes.
- At four times the minimum wage, couples can expect to get back less than one in seven dollars they pay in taxes.
- At about $200,000 in income, they can expect to get back less than one in 16 tax dollars.
"About 70 percent of the transfer benefits of a minimum wage couple is Medicaid, while Social Security is three-fourths of the benefits of high-wage couples."
Composition of Transfer Benefits. The principal reason why transfer programs tend to be more progressive than the tax system is that many programs are means-tested. Although rich and poor alike participate in Medicare and Social Security, only low-income families have access to means-tested benefits, the most important of which is Medicaid. As Figure II shows:
- About 70 percent of all transfer benefits received by a couple earning the minimum wage over the course of their working lives consists of Medicaid benefits, and only one in four dollars is in the form of Social Security and Medicare benefits.
- By contrast, a couple earning $150,000 (seven times the minimum wage) receives all of its transfer benefits in the form of Social Security (73 percent) and Medicare (27 percent).
"The system as a whole is quite progressive, especially over the bottom end of the income distribution."
Policy Implications. From these observations, we can draw three conclusions with important public policy implications. First, most Americans can expect to get back in the form of entitlement benefits only a fraction of what they pay in taxes, although they do receive other government services that presumably are worth paying for. Second, the system as a whole is quite progressive, with low- and moderate-income families having a more favorable relationship with the state than higher-income families. Third, most of the progressivity in our system comes on the benefit side rather than on the tax side of fiscal policy.
One way to appreciate the amount of overall progressivity in the system is to calculate an average lifetime net tax rate, defined as the ratio of lifetime taxes net of any transfer benefits received to lifetime income. The result of that calculation is shown in Figure III. As in Table I, Figure III shows that a couple in which both spouses earn the minimum wage over the whole of their working lives can expect to receive far more in transfer benefits (including EITC refunds) than they pay in taxes. (Yet, as noted above, it is very difficult for someone to stay at the minimum wage over the whole of a work-life.) At 1.5 times the minimum wage, the couple experiences a positive net tax burden, however, and above that figure those who earn more pay more of their income (on net) to the state. Overall, the system is progressive, but as income rises it becomes only mildly so.