Does it Pay to Work More?

Studies | Taxes

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

Effective Marginal Taxes on Current Labor

"The effective tax on low-income couples employed full-time starts at a high level."



ESPlanner™ software is used to analyze how the various programs discussed above, in combination with federal and state income tax schedules and the payroll (Federal Insurance Contributions Act, or FICA) tax, determine overall work incentives.  This analysis considers representative single and married-couple house­holds at various ages and income levels.  Both household types are assumed to have two children born when the parents are ages 27 and 29.  A key finding is that marginal tax rates are extraordinarily high for low-income households — in most cases, higher than for rich households.

Marginal Tax Rates for 30-Year-Old Couples in the Current Year

Couples with Children.  Marginal tax rates for couples working extra hours in the current year are substantial at relatively low-income levels.  For instance:

  • For 30-year-old couples, the highest marginal tax rate is 42.5 percent for a couple earning only $20,000 a year, while those earning $50,000 a year face only a 24.4 percent marginal tax rate.  [See Figure I.]
  • For 45-year-old couples, marginal tax rates reach 41.8 percent for those earning $30,000 a year, due to the “clawback” of benefits;  this rate is even higher than for those earning $200,000 a year (with a marginal tax rate of 35.9 percent).  [See Figure II.]
  • For 60-year-old couples, the highest marginal tax rate is for those earning only $10,000 a year (50.9 percent); compared to 43.2 percent for the couple earning $200,000!  [See Figure III.]

"Marginal taxes are higher on a 60-year-old couple earning $10,000 than on a couple earning $200,000!"

The reason 60-year-old couples face such an extraordinarily high tax rate at the lowest income level is that since they no longer have young children in the house, their earnings exceed the EITC cutoff, and they lose benefits in other programs, such as food stamps.

"Low-income single-parent households face higher marginal tax rates than do couples."

Singles with Children.  Single-parent households face higher marginal tax rates at lower income levels than do couples since they qualify for more benefit programs and thus have more to lose when they earn an additional dollar.  For example:

  • A 30-year-old single parent earning $10,000 a year faces a 72.3 percent marginal tax rate on an additional dollar earned because the household loses TAFDC benefits; this tax rate is substantially higher than the 36.9 percent tax rate on the $200,000 income earner.  [See Figure IV.]
  • A 45-year-old single parent earning only $20,000 a year faces a marginal tax rate of 42.9 percent, a slightly higher rate than the single earning $200,000 a year.  [See Figure V.]
  • Among 60-year-old singles, whose children have left home, the highest marginal tax rate of 50.9 percent is paid by those earning only $10,000 a year, compared to the 43.2 percent rate for the single earning $200,000 a year!  [See Figure VI.]

Among all three age groups, singles with low to moderate incomes are hit with substantially higher tax rates than higher-income households.  In all three age groups, the highest marginal tax rates are paid by those earning $20,000 a year or less.

Age, as well as income, affects marginal tax rates.  With the exception of the lowest-income earners, middle-aged households face significant taxes on extra hours, in some cases more than younger households.  This is because their accumulated savings over the years disqualify them for some benefits that require asset tests.

"Low-income single parents whose children have left home face a 51 percent marginal tax rate!"

Marginal Tax Rates on Life-Cycle Labor Supply.  Suppose that young households work a higher number of hours for additional pay each year over their lifetimes.  For 30-year-old couples, life-cycle marginal tax rates are generally similar to the marginal tax rates reported for them in the current year.  The main differences occur at income levels of $10,000 and $50,000, where lifetime marginal taxes are significantly higher than those in the current year.  For instance [see Figure VII]:

  • Couples earning $10,000 annually will pay a 2.1 percent marginal tax on an additional dollar earned; while this seems negligible, it is much higher than the negative tax liability they would have working additional hours in just the current year.
  • Couples with annual incomes of $50,000 will pay 32.3 percent in taxes on an additional dollar earned, substantially more than the 24.4 percent marginal tax they would have in the current year.

For 30-year-old single-parent households, [see Figure VIII] life-cycle and current-year marginal rates are very different for earnings below $125,000, but quite similar at that level of earnings and above.

"For most 30-year-old singles, marginal taxes on a lifetime of additional work are similar to current year tax rates."

  • Those with annual incomes of $10,000 will face a marginal tax of only 0.8 percent per additional dollar earned (compared with 72.3 percent in the current year).
  • Single parents with higher annual incomes of $20,000 to $30,000 will pay a 34.7 percent to 36.7 percent marginal tax on an additional dollar earned (compared with 42.9 percent for both in the current year).
  • Single parents with annual incomes of $50,000 will pay a 32.6 percent marginal tax on an additional dollar earned (compared with 37 percent in the current year
  • However, at an income level of $125,000, marginal tax rates in the current year and over the life-cycle are very similar: 36.2 percent and 37.3 percent, respectively.

"For couples earning $10,000 and $50,000, lifetime tax rates on additional work are significantly higher than in the current year."

Lower-income households will typically face lower marginal tax rates over their life-cycle than during the current year.  Part of the reason is that low-income households eligible for Medicaid and TAFDC benefits in the current year will not receive these benefits throughout their lives because of changes in their household demographics and levels of asset income.


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