Marginal Tax Rates and Economic Opportunity

Key Findings

• The marginal tax wedge is relevant for understanding how workers might benefit (or not) from an increase in pay once taxes enter the picture.
• Marginal tax wedges might deter workers from pursuing additional income and working extra hours.
• In 2021, at certain income levels, Canadian, French, and Italian workers lost up to 60, 93, and 116 percent of additional earnings to spikes in marginal tax rates from the provincial Canadian health-care premium, the French “contribution d’équilibre générale,” and Italian local income taxes.
• Single parents with two children can face marginal tax wedges as high as 98 percent in the United States, 652 percent in Australia, and 359 percent in Japan. These marginal tax wedges are due to policies like the Earned Income Tax Credit (EITC) and the 2021 Recovery Rebate Credit in the United States, Family Tax Benefit and the Parenting Payment in Australia, or the child-rearing allowance and child benefits in Japan.
• On the other hand, Lithuania’s and Australia’s tax design for single workers avoids unnecessary tax spikes by applying a flat social security contribution and a flat or slightly progressive income tax. In Finland, the local income tax and the central income tax are coordinated so that they do not generate marginal tax rate spikes like the ones observed in Italy or Japan.

Introduction

Research has shown that spikes in tax rates can act as barriers to upward mobility, locking people in poverty or discouraging them from advancing in their careers.

High marginal tax rates, as we will see below, might directly influence the decisions workers make about accepting a raise, working additional hours, or whether they might remain on government benefits. These high rates are often hidden in complex tax and benefit structures. This report shines a light on the underlying policies that drive marginal tax rate spikes that workers at different earning levels are subject to across countries in the Organisation for Economic Co-operation and Development (OECD).

The Problems Created by High Marginal Tax Rates

Empirical research has shown that labor taxation impacts employment, unemployment, participation rates, hours of work, and even poverty.[1] Nevertheless, the tax burden that workers face has different components: income taxes that in many cases are progressive and, in some countries, levied at different administrative levels and payroll taxes or social security contributions that are typically flat-rate. Government benefits provided to workers can also be withdrawn at certain income levels and push up marginal tax rates on additional earnings.

This is the case of a Japanese single parent who earns a rough equivalent of US$39,981 and faces a 57 percent marginal tax rate. With just a small increase in pay of $599, she would face a 359 percent marginal tax rate. A Japanese parent who benefits from a government program worth $5,123 might lose 100 percent of that benefit if he or she earns above the earnings threshold. Therefore, in addition to examining the overall tax wedge on earnings and statutory tax rates, it is important to look at marginal tax rates on labor income.

The marginal tax wedge differs from the statutory rate and is generally higher than the average tax wedge. In general, a tax wedge is the difference between what someone is paid and what they earn after accounting for taxes. The average tax wedge is the share of labor and payroll taxes applied to all earnings. The marginal tax wedge is the share of labor and payroll taxes applicable to the next dollar earned. This makes the marginal tax wedge relevant for understanding how workers might benefit (or not) from an increase in pay once taxes enter the picture.

Workers face a wide range of marginal tax rates depending on their income level. The differences in marginal tax rates are often driven by progressive individual income tax schedules, payroll tax or social security rates, and tax credits or cash benefits. As workers earn more, they face a higher tax wedge on their marginal dollar of earnings. However, the many marginal tax rates on labor income make tax codes more complex and disincentivize additional work at the margin, which translates into lower productivity and less economic growth.

Marginal tax rates influence labor supply both in terms of employment/unemployment rates as well as in the number of hours worked. For workers, marginal tax rates affect the number of hours worked, whether to transition or not from a part-time job to a full-time one or even taking an additional job. Also, high marginal tax rates may discourage people from searching for a better job as a larger part of their additional income will be taxed away. High marginal tax rates might discourage individual labor supply and savings, thus potentially reducing the total size of the economy.

For the unemployed, high marginal tax rates (especially those arising from the withdrawal of benefits) might deter them from searching for a job. Therefore, to encourage the unemployed to enter the labor market, an appropriate design of the tax and benefit system is key.

How much marginal tax rates affect labor supply depends on two factors explored by economists. On one hand, higher marginal tax rates make working less attractive relative to leisure (not working). On the other hand, higher marginal tax rates could push people to work more hours or take a second job in order to maintain their level of income, consumption, and savings. Empirical studies have shown that, in general, a reduction in marginal tax rates translates to more working hours.[2] As we will see below, which one prevails in real life depends on the level of income, marital status, benefits, or gender; it might differ from country to country and could also change over time.[3]

For example, in the United States, an increase in effective marginal tax rates encouraged workers to reduce either productivity or the number of hours worked.[4] On the other hand, a sharp benefit reduction when a person moves from unemployment to employment reduced the incentive to work.[5] Additionally, high effective marginal tax rates caused by benefit reductions, the so-called “twice-poverty trap,” generate disincentives to increase household earnings above a minimum amount when moving towards two times the poverty level or beyond.[6]

Moreover, different groups of people are affected differently by the marginal tax rates. In the United Kingdom, research has shown that taxes and benefits affect both the decision to enter the job market as well as the number of hours worked.[7] Marginal tax rates influence the decision of entering the labor market for highly educated workers as well as low-educated ones. However, marginal tax rates have a smaller effect on the number of hours worked.

In Italy, the tax-benefit system affects women’s participation in the labor market more than men’s participation. This effect is even more pronounced for low-income households.[8]

A similar effect was observed in the United States where low-income single mothers were better off working than relying solely on welfare.^[9] However, they benefited little from raising their wage from $5.15 to $9.00 per hour. In the United States, programs like the Earned Income Tax Credit (EITC) have proved to be successful at keeping low-income working households out of poverty. However, the tax-benefit system has proved to be less efficient regarding upward mobility since the loss of benefits, including childcare and transportation costs, needs to be taken into consideration.[10]

Additionally, there are striking differences across U.S. states. A 2012 study found that when moving from poverty-level income to 150 percent of the poverty level, a single parent with two children faces a marginal tax rate that goes from 26.6 percent to over 100 percent, depending upon the state in which the parent lives.[11] A more recent study also finds major differences in marginal and average net taxation across the states.[12] One in four low-wage workers faces marginal net tax rates above 70 percent, and more than half face remaining lifetime marginal net tax rates above 45 percent. The richest 1 percent also face a high median lifetime marginal tax rate of 50 percent.

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[1] Agustin Velasquez and Svetlana Vtyurina, “How Does Taxation Affect Hours Worked in EU New Member States?” IMF Working Papers, 2019, 19. 1. 10.5089/9781498315708.001.

[2] Edward C. Prescott. “Why Do Americans Work So Much More than Europeans?” Federal Reserve Bank of Minneapolis Quarterly Review, 2004.

[3] Tess M. Stafford, “Do workers work more when earnings are high?” IZA World of Labor, 2018: 455 doi:10.15185/izawol.455.

[4] Congressional Budget Office, “Effective Marginal Tax Rates for Low- and Moderate-Income Workers,” Report, November 2012.

[5] Robert Moffitt and Anuradha Rangarajan, “The Work Incentives of AFDC Tax Rates: Reconciling Different Estimates,” Journal of Human Resources 26 (1), 1991, 165−179.

[6] Linda Giannarelli and C. Eugene Steuerle, “The Twice Poverty Trap: Tax Rates Faced by AFDC Recipients,” Urban Institute, 1995.

[7] C. Meghir and D. Phillips D., “Labour Supply and Taxes,” in T. Besley, R. Blundell, M. Gammie and J. Poterba, Dimensions of Tax Design: the Mirrlees Review (Oxford, UK: Oxford University Press, 2010), 202–274.

[8] Rolf Aaberge, Ugo Colombino, and Tom Wennemo, “Heterogeneity in the Elasticity of Labor Supply in Italy and Some Policy Implications,” CHILD, Working Paper No. 21, 2002; and Rolf Aaberge and Ugo Colombino, “Designing Optimal Taxes With a Microeconometric Model of Household Labour Supply,” CHILD, Working Paper No. 6, 2008.

[9] Gregory Acs and Elaine Maag, “Irreconcilable Differences? The Conflict between Marriage Promotion Initiatives for Cohabitating Couples with Children and Marriage Penalties in Tax and Transfer Programs,” Assessing the New Federalism, Urban Institute, Policy Brief No. B-66, 2005; and Robert McClelland and Shannon Mok, “A Review of Recent Research on Labor Supply Elasticities,” Congressional Budget Office Working Paper No. 12, 2012.

[10] Center on Budget and Policy Priorities, “EITC and Child Tax Credit Promote Work, Reduce Poverty, and Support Children’s Development, Research Finds,” 2015, https://www.cbpp.org/sites/default/files/atoms/files/6-26-12tax.pdf.

[11] Elaine Maag, C. Eugene Steuerle, Ritadhi Chakravarti, and Caleb Quakenbush, “How Marginal Tax Rates Affect Families at Various Levels of Poverty,” National Tax Journal 65:4, December 2012, 759–782.

[12] David Altig et al., “Marginal Net Taxation of Americans’ Labor Supply,” NBER Working Paper 27164, May 2020, https://www.nber.org/papers/w27164.