Does it Pay to Work More?

Studies | Taxes

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

Measuring Effective Marginal Taxes on Working

The effective marginal tax rate on labor is the sum of taxes paid plus any reduction in gov­ernment benefits when an additional dollar of income is earned.  But what one earns today can affect not just the net taxes one pays today, but also the net taxes one pays tomorrow.  Hence, determining today’s marginal tax rate requires taking into account how working additional hours today affects all current and future tax payments as well as all current and future benefits.

There are a host of different taxes and benefits that must be considered.  The list of taxes includes federal and state personal income taxes, federal and state corporate income taxes, the federal payroll (FICA) tax, state sales taxes and federal excise taxes.  The benefits include Social Security, Temporary Assistance to Needy Families, Supplemental Security Income, Medicaid, Medicare, food stamps, nutrition assistance for women, infants and children (WIC), housing assistance and energy assistance.  To properly measure marginal taxes, one must determine how each of these taxes and transfers is calculated, how they interact, and how their amounts change through time.

This study uses ESPlanner™, a personal financial planning software program developed and marketed to the public by Economic Security Plan­ning, Inc., to analyze the marginal tax levied on workers with different expected lifetime earnings.  This software program determines a household’s highest sustainable living standard and the saving and insurance needed to sustain it.  In the process, the program makes highly detailed, year-by-year federal and state income tax and Social Security benefit calculations.2

"Effective marginal tax rates include taxes and lost government benefits."

The gain from extra work is measured in terms of its impact on current consumption.  Thus, if a worker earns an extra $100 this year, permitting this year’s consumption to rise, at most, by $50, the worker faces a 50 percent effective marginal tax rate on his or her labor supply.  The term “effective” refers to marginal taxes paid net of marginal transfer payments received.

Of course, working and earning more in the current year is just one potential choice when it comes to expanding a worker’s labor supply.  Some workers may be in jobs in which the hours they work are preset by their employer and can’t be changed.  For such workers, the only way to adjust their annual hours worked is to switch jobs.

In this study, two types of marginal tax rates are calculated: 1) the rate for working additional hours in the current year, and 2) the rate for working additional hours in all future years.  The second of these labor supply changes is referred to as an increase in life-cycle labor supply.  To measure the net tax rate on life-cycle labor supply, this study compares the change in the present value of lifetime income — before any taxes and transfer payments arising from a permanent increase in annual hours — to the change in the present value of lifetime spending permitted by this additional labor supply.  To simplify, it is assumed that workers’ real wages per hour remain fixed over their lives.

Consistent with economic theory as well as actual behavior, the simulations used in this study assume that, other things equal, people will try to maintain their standard of living — or smooth their consumption — over their  lifetimes, even though their wage income fluctuates.  For example, a couple starting out with a modest income may borrow to buy a house or to pay education expenses for their children.  At middle age, when their children have left the nest and their wages are higher, the couple will accumulate savings and retire their mortgage.  During their retirement years, they live on the savings accrued during their working years.  [See the Appendix for more information on household characteristics and calculations.]

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