Wednesday, October 21, 2009

Incentives and Unknown Marginal Tax Rates

One effect of income taxes is to alter the incentives to work and save. Because income taxes change people's behavior - in theory, at least - they are said to "distortionary." What matters here is not the amount of taxation, but rather the marginal tax rate - e.g., a worker facing a 30% marginal tax rate will take home $70 for each additional $100 earned, so the tax reduces the benefit of working more (and decreases the cost of working less) by 30%. One of the central premises of the "supply side economics" that motivated the Reagan administration is that lower marginal tax rates would lead to an increase in work and investment (i.e., more "aggregate supply").

However, with our byzantine tax system it is difficult to calculate exactly what one's marginal rate is. An interesting post at TaxVox makes the point that effective marginal rates are altered by provisions tie benefits and tax breaks to income:
Many tax preferences are phased in or out according to income, and as a result, those who earn extra income may face either a hidden tax or a subsidy as their tax benefits change in value. For example, for those in the phase-in range of the earned income credit earning an extra dollar increases the credit and reduces their tax liability, driving their actual rate below their statutory rate. But once they make enough so the EITC begins to phase out, the opposite happens and the rate they actually pay climbs.

Altogether, half of taxpayers in 2009 face actual tax rates on additional earnings that differ substantially from their statutory rates. The tax on that last dollar – what economists call the effective marginal tax rate – is higher than the statutory rate for 32 percent of taxpayers and lower for almost 18 percent. Moreover, the difference between the two rates can be huge. For taxpayers whose effective rate is higher, the average discrepancy is almost 6 percentage points. For those with lower effective rates, the difference averages 11 percentage points....

Yet many don’t even know it. Statutory and effective rates differ so haphazardly that most taxpayers probably have no idea how much tax they owe on an additional dollar of income. What does this say about our current tax system? First, the phase-in and phase-outs of provisions really do bite. Second, in case you needed more proof that our current system is complex, here you have it. Finally, it suggests that many individuals are making decisions based on incorrect notions about the tax consequences of their behavior.
Not only does this remind us what a mess the tax code is, it also raises the question of how much we can depend on assuming that the incentive effects of taxes significantly alter behavior, if people cannot even determine what those incentives are.

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