Does it Pay to Work More?

Policy Reports | Taxes

No. 310
Tuesday, April 15, 2008
by Laurence J. Kotlikoff and David S. Rapson

Executive Summary

Does it pay to work more hours in order to earn more income?  The answer depends on what one earns after taxes.  Virtually all American households are confronted with high to very high marginal tax rates when they increase the number of hours they work in the current year or in future years.  Much of the system’s highest effective marginal taxation comes courtesy of government transfer programs, particularly Medicaid.  In fact, penalties for working are astronomical for some households, particularly lower-income families.  This study considers the entire panoply of taxes and transfers in measuring the total marginal effective tax rates facing American households with different levels of pre-tax earnings.

Determining the effective marginal tax on working additional hours is difficult because of the complexity of the tax code and the interaction of different government tax and transfer programs (such as food stamps) that are limited to households below certain income and asset ceilings.  As a result, many Americans face higher marginal tax rates than they think.  Earning an additional dollar can put a family over an income limit and cost thousands of dollars in lost benefits.

In this study, two types of marginal tax rates are calculated:  the rate for working additional hours in the current year, and the rate for working additional hours in all future years.  To calculate the effective marginal tax on working, this study uses financial planning software that determines tax and transfer payments at each stage of a person’s life, based in part on economic choices they make in prior periods.  The model assumes people try to even out consumption over their lifetimes.

The results:  The fiscal-tax system is regressive.  Due to the loss of benefits as household incomes increase, particularly among lower-income households, effective marginal tax rates are generally and substantially higher for them than for high-income households.

  • For 30-year-old couples earning $20,000 the marginal tax rate on an additional dollar earned is 42.5 percent; yet those earning $50,000 a year face a marginal tax rate of only 24.4 percent.
  • At age 45, couples earning $30,000 a year face a higher marginal tax rate (41.9 percent) than do those earning $200,000 a year (35.9 percent).
  • At age 60, couples earning $10,000 a year faces a marginal tax rate of 50.9 percent, compared to a 43.2 percent marginal tax rate for those earning $200,000!
    Moreover, single-parent households who qualify for more benefit programs than do couples face astonishingly high marginal tax rates beginning at lower incomes.  For example:
  • At age 30, a single parent earning $10,000 a year faces a 72.3 percent marginal tax rate on an additional dollar earned due to their loss of welfare benefits; this rate is substantially higher than the 36.9 percent tax rate on the single parent earning $200,000.
  • At 45 years of age, a single parent earning $20,000 faces a marginal tax rate of 42.9 percent; higher than a single parent earning $200,000.
  • A 60-year-old single parent earning $10,000 a year faces a 50.9 percent marginal tax rate, while those earning $200,000 face a rate of 43.2 percent.

For 30-year old couples who work additional hours over their lifetimes, the marginal tax rates are generally similar to those reported for them in the current year, with a few exceptions.  Couples earning $50,000 will pay a 32.3 percent marginal tax rate on an additional dollar earned over their lifetimes, compared to a 24.4 percent marginal tax rate in the current year.

For 30-year old singles, however, life-cycle and current-year marginal rates vary widely for those earning less than $125,000 a year.  For example, singles with annual incomes of $10,000 a year face a life-cycle marginal tax rate of only 0.8 percent on an additional dollar earned annually, compared to a substantial 72.3 percent in the current year.

The U.S. fiscal system penalizes lower-income households that should be given incentives to work more hours for additional income.  Policymakers should consider a major overhaul of the tax system to avoid penalizing those who make an effort to move up the income ladder.  That overhaul, however, should steer clear of proposing additional programs involving means-tested tax subsidies, as these can raise marginal tax rates even further for low- and middle-income families.

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