Does It Pay to Work?

Studies | Taxes

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


Lifetime Marginal Net Tax Rates

Table II - Marginal Net Tax Rates

To those for whom progressivity is an important value, these results should be heartening. Yet this progressivity comes at a terrible price. Many entitlement benefits, it turns out, are available to people whether they work or not. And when they decide to work, the withdrawal of benefits plus the imposition of taxes creates very high marginal tax rates.

"All full-time working households face marginal tax rates higher than 50 percent."

Working Versus Not Working. To calculate marginal tax rates, we ignore benefits to which people are entitled whether they work or not. We want to identify changes in taxes paid and benefits received as a result of the decision to work rather than not work. The additional taxes paid plus the net reduction in transfer benefits received divided by the income from working is called the marginal net tax rate. These are depicted in Table II.

The first thing to note is that all full-time working households face marginal net work tax rates in excess of 50 percent! In going to work, all American households hand over half or more of every dollar they earn to state and federal government in taxes paid net of benefits received.

The second thing to note is that the lowest-income households face the highest marginal net tax rates:

  • The marginal net tax rate of households earning 1.5 times the minimum wage is 81 percent; families at this income level keep less than one-fifth of the income they earn.
  • At two times the minimum wage the marginal net tax rate is 72 percent; these families keep less than 30 cents out of each dollar they earn.
Figure IV - Marginal Lifetime Tax Rates for Full-Time Working Couples

The third thing to note is that at higher income levels, marginal net tax rates decline as income rises. On the whole, marginal net tax rates tend to be regressive, imposing the highest burdens on those with the lowest earnings. [See Figure IV.]

Perhaps the most striking feature of Table II is that the minimum wage household faces a 67 percent net marginal tax on working full time. This family keeps only one in every three dollars it earns on net! The principal reason is that households in which no one works receive very substantial transfer benefits. Many of these benefits are either entirely lost or greatly reduced when household members go to work full time. In addition, the household must pay federal income, state income, and FICA taxes on its earnings. Offsetting these factors is the increase in Social Security benefits associated with working and the availability of the Earned Income Tax Credit.

"A minimum wage household faces a 67 percent marginal net tax on full-time work."

Households earning 1.5 times the minimum wage also lose benefits when they go to work. In addition, they lose virtually all of their Earned Income Tax Credits. In addition, their higher earnings limit the degree of progressivity of the Social Security benefit schedule.2 This is the reason marginal net tax rates are higher for households earning 1.5 times the minimum wage than for those with higher incomes.

The Composition of Marginal Net Tax Rates. Figure V shows the composition of marginal net tax rates for couples at different income levels. Note that the lower the family's income, the more important the loss of the transfer benefits is. Conversely, the higher the family's income, the more important direct taxes on income are. For example:

  • At $32,100 (1.5 times the minimum wage), two-thirds of the marginal net tax rate consists of the loss of transfer benefits, while a little more than one in five dollars is lost to income and payroll taxes.3
  • At $64,300 (triple the minimum wage), half of the marginal net tax rate consists of a loss of benefits, while two in five dollars are lost to income and payroll taxes.
  • At $321,400 (15 times the minimum wage), four in five dollars of the marginal net tax are lost to income and payroll taxes.
Figure V - Marginal Net Tax Rates

Working Part-Time. Table II also shows marginal net tax rates for those who go from no work to part-time work and from part-time to full-time work. As the table reveals, fiscal policy discourages full-time work more than half-time work for low- and moderate-income couples:

  • At the minimum wage, the marginal net tax rate on going to work half-time is 36 percent versus 67 percent for working full-time.
  • At 1.5 times the minimum wage, the rate for half-time work is 55 percent versus 81 percent for full-time work.
  • At two times the minimum wage, the rate for half-time work is 67 percent versus 72 percent for full-time work.

Thus fiscal policy encourages families at the bottom of the income ladder to work half-time rather than full-time, if they work at all. However, at higher income levels, these incentives are reversed.

  • A family earning three times the minimum wage faces a marginal net tax rate of 81 percent for half-time work versus 63 percent for full-time work.
  • At four times the minimum wage, the rates are 72 percent for half-time versus 59 percent for full-time.

"For low-income workers, the marginal cost of working is mostly lost benefits."

Another way of looking at this issue is to ask what happens to people who move from half-time to full-time work. As Table II shows:

  • A minimum-wage couple that moves from half-time to full-time work will lose 97 cents out of every extra dollar they both earn.
  • At 1.5 times the minimum wage, the couple will lose $1.06 for every $1.00 they earn; for this couple, working more literally means having less.
Figure VI - Marginal Net Tax Rates for Full-Time Working Couples at Different Ages and Income Levels

Marginal Net Tax Rates at Different Ages. Figure VI shows marginal net tax rates for couples at different ages. Note that at higher income levels, marginal net tax rates are roughly the same regardless of the amount earned. However, at lower income levels, there is a significant difference. Specifically:

  • At 1.5 times the minimum wage, the marginal net tax rate is 60 percent and 61 percent for couples ages 25 and 35 respectively.
  • At ages 55 and 65, these rates drop to 14 percent and 22 percent respectively.

The difference stems from taxes and spending programs that relate to children and are means-tested. These programs impose steep marginal net tax rates on young couples. It is ironic that the very fiscal policies designed to help children are the ones most responsible for discouraging low- and moderate-income families from working.


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