President Barack Obama and challenger Mitt Romney both advocate lower taxes for the middle class, but they disagree about how to accomplish it. In his first term, Obama used mostly tax credits, which reduce an individual’s effective tax rate. Romney has proposed lowering all tax brackets, a reduction in the marginal tax rate, but many Americans don’t fully understand the different effects of these changes.
The marginal rate is defined as what you pay for an additional dollar earned. Marginal rates can have a large effect on influencing the behavior of individuals to work more or less. Consider an example: A family makes $50,000 per year and pays $5,000 in taxes, an effective tax rate of 10 percent. The family is considering working overtime or sending another individual into the workforce to earn an additional $12,000. However, their marginal rate is 50 percent and therefore, they will only take home $6,000 after taxes. Suddenly the overtime effort is much less attractive. Reducing the effective rate lowers their current tax burden. However, on the decision to work more, the marginal rate has significantly more impact than the effective rate.
The stark contrast between effective and marginal rates in this example is not an uncommon circumstance. Deductions and credits can tremendously increase this discrepancy. Often forgotten when discussing tax rates are the effect of various government assistance programs. An individual who receives Medicaid will see his benefit decline as his income rises. Because a government assistance program is economically equivalent to a negative tax, phasing out the benefit as income rises is the same as imposing a marginal income tax.
Some clarification may help. A family of four makes $50,000 per year but does not receive health care benefits from their employer. Under the Affordable Care Act, their health insurance is subsidized by a tax credit. If the family comes to earn an additional $12,000, the size of their subsidy is reduced by $1,870. This reduction in after-tax income is equal to 16 percent of the $12,000 change in income. Therefore, the loss of health insurance subsidy is equivalent to a 16 percent marginal tax. However, this isn’t their only marginal tax; it is added to the existing rate.
One might wonder how high the existing rate is. If our family of four lives in Minnesota, they would pay $6,615 after state income, federal income, payroll and Medicare taxes, less standard deductions. At $62,000, the family’s tax burden increases by $3,120, 26 percent of the incremental gain. Moreover, if the family spends its additional income on goods in Minneapolis, it must pay sales tax of $545. Consequently, 46 percent of this middle class family’s additional $12,000 of income goes to taxes.
The ACA also has a significant marginal rate problem by cutting off subsidies at four times the poverty level. If a family has an income of $93,500, or 3.99 times the poverty level, the ACA mandates that this family cannot be allowed to pay more than 9.5 percent of its income on its healthcare insurance and thus, the rest is covered by the government. If the policy holder is 50 years old, the subsidy is approximately $7,500. However, if the family earns an additional $500, it is now at 4.01 times the poverty level and loses the entire subsidy. This glitch results in a marginal tax rate of 1,500 percent.
These situations outline a fundamental problem in our tax code. The massive, complicated web of deductions, loopholes and subsidies can result in exorbitant marginal rates, all the while the effective rate, which determines the level tax contribution, may still be low.
This problem is perhaps worst for low-income individuals. In a recent study by Eugene Steuerle of the Urban Institute, Dr. Steuerle outlines how the myriad of assistance programs available to low-income households often results in marginal rates between 55 and 80 percent and, in some instances, even exceeding 100 percent. For these struggling individuals, earning an extra dollar can actually result in lower after-tax
income.
Not only is this marginal rate problem tough on middle-income families trying to improve their living conditions, it harms the economy at large. Individuals do not ignore these high rates; their behavior is affected as their incentive to work diminishes. GDP, productivity and tax revenue decline. When GDP and productivity decline, businesses suffer and cannot hire as many workers.
Much of the middle-class tax cuts that Obama likes to brag about come from a temporary credit, which was part of the stimulus package. This credit was gradually phased out, thereby adding to marginal tax rates, and only lasted two years, thereby failing to provide lasting relief for the middle class. Furthermore, a White House spokesman said on Saturday that Obama is not considering a specific new tax cut plan at this time. Romney’s proposal to decrease all marginal rates would provide permanent relief to the middle class, and it would mitigate the adverse incentives against climbing the economic ladder.
Yes, we should invest further in the middle class, but right now we are placing high incentives against these individuals investing further in their own prosperity, and that’s just bad policy.
