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Marginal Tax Rates: Often Overstated and Tough to Lower

With the House holding a joint subcommittee hearing tomorrow on whether the phase-down in government benefits for low- and moderate-income people (their so-called “marginal tax rate”) creates disincentives to work, here are a few things that policymakers should keep in mind.

Most importantly, as we’ve explained, the size of these marginal tax rates and their impacts on work are often overstated, while the trade-offs in lowering them are often understated.

The phase-down rate of program and tax benefits is often called a “marginal tax rate” because the reduction in benefits as earnings rise resembles a tax (with “marginal” referring to the effect on the next dollar of income).  If, for example, a worker faces a marginal tax rate of 30 percent, that worker will lose 30 cents of each additional $1 he or she earns through a combination of reduced benefits and higher taxes.

Unfortunately, critics often overstate the marginal tax rates that most low-income families face.  House Ways and Means Chairman Paul Ryan did just that in a speech today, claiming a worker could face a marginal tax rate of 90 percent for accepting a slightly higher-paying job.  He failed to mention, however, that a large majority of low-income households face much lower rates.

Most working-poor families don’t face high marginal tax rates largely because, at low income levels, the Earned Income Tax Credit (EITC) and Child Tax Credit rise with additional earnings, offsetting phase-downs in other programs (such as SNAP) and providing a work incentive.  In fact, families in which a parent has very low earnings or is out of work — the very families whose employment rates policymakers are generally most concerned about — often face a negative marginal tax rate.  As their earnings rise, their after-tax incomes rise by even more, providing a strong work incentive. 

All else being equal, policymakers and analysts of all political stripes prefer lower marginal tax rates.  But, the options for lowering the rates involve difficult trade-offs:

  • Phasing down benefits more gradually and extending them higher up the income scale.  That raises program costs significantly.  Policymakers could offset those added costs through spending cuts or tax increases elsewhere in the budget, but they must consider the pros and cons of both the expansion and the offsets.
  • Phasing down benefits more gradually and extending them to families higher up the income scale without raising costs by cutting the level of assistance to poorer families.  That reduces the support for the families and children who most need help and can push them deeper into poverty.
  • Eliminating all assistance to needy individuals and families.  That would eliminate the phase-down but leave needy families destitute.

Some policymakers promote more state control and flexibility over program rules as a way to reduce marginal tax rates.  But that would just shift these tough trade-offs to state policymakers, reduce federal accountability, and put critical safety net benefits for the poorest families at risk.  States already have significant flexibility to reduce marginal tax rates, such as in setting eligibility and phase-out rules in child care and the Temporary Assistance for Needy Families program, and the option to implement state EITCs to promote work.  Some have used that flexibility to help low-income families, but many haven’t.  And, additional state flexibility doesn’t address the constraints that come with limited resources. 

Lowering marginal tax rates would be a positive change if it didn’t harm poor families, but it could deepen poverty and harm children if policymakers offset its costs by cutting assistance to those already on the edge.