Example: Single parents with modest incomes in Minnesota can face ‘effective marginal tax rates’ over 100%
By John Spry
St. Paul Pioneer Press (MN) – Sunday May 9, 2010 – Page B9
Are we still a society that values honest work?
Our state and federal laws provide an unpleasant answer. Our tax code imposes punishing tax rates on work. Working more to increase pre-tax income can actually reduce a family’s take home pay.
The “effective marginal tax rate” is a technical term for the fraction of an additional dollar earned that is lost to taxation. It is a measure of the bite that taxes take out of your paycheck when you work a little more.
Too many Minnesotans face effective marginal tax rates that approach and even exceed 100 percent because of compounded taxes on top of other taxes and a mish-mash of social service programs.
High marginal tax rates create a disincentive to earn by reducing the rewards for work. Over time, these high effective tax rates debase our culture by undermining the virtue of hard work.
How can working more actually reduce take-home family income?
There are at least 16 federal and state programs in Minnesota to transfer cash and non-cash benefits to households with low or moderate incomes. Each of these programs has its phase-outs that “claw back” benefits as these households work more and increase their pre-tax income.
Phase-outs increase effective marginal tax rates. So the cumulative effect of households facing several program and tax phase-outs simultaneously can create what effectively is a tax rate of over 100 percent on additional income.
A study by the non-partisan Minnesota Taxpayers Association (MTA) provides a concrete example. Consider a single parent of two children who works more to increase gross family income from $33,000 to $34,000. The effective marginal tax rate from the federal and state earned-income tax credit phase-outs are about 21 percent and 10.3 percent, respectively. These rates reduce the family’s tax credits — in effect, its income — by about $210 and $103. In addition, benefits from the Basic Sliding Fee child-care program are reduced by $1,692 because of the sliding fee.
Thus, the reward for earning an additional $1,000 in gross wages is a reduction in take-home family income of $1,005 because of the combined effects of these three programs.
High tax rates are unfair to people seeking to help their family by working harder. A Minnesota House Research study found that — given the intersection of our tax system with various social programs — the average effective marginal tax rate for a single parent with two children and income between $23,500 and $41,700 was 104 percent. On average, working overtime to earn an additional $1,000 in gross income reduces household after-tax income by $40.
These programs and the tax code were created over time by different committees in St. Paul and Washington, D.C. There was no attempt to measure the compound effect of different sections of the tax code and the phase-outs of various programs on the incentives of real people to work. These disincentives to work are a barrier to opportunity and social mobility because working more or getting a better paying job means higher tax payments instead of higher after-tax income.
A rededication of society to the simple principle that work should pay is the start of a solution to the disincentive-to-work problem.
If society values work, then we should reward work by reducing effective marginal tax rates. This will require tax reform to broaden tax bases by ending tax loopholes while lowering tax rates. It also will require an overhaul of our social service programs. We need to examine Minnesota’s social programs as a whole system. A redesign of social programs could lower effective marginal tax rates for everyone below 50 percent.
Everyone should benefit from their own hard work by keeping the fruit of their labor.
John Spry of St. Paul is an associate professor in department of finance at the University of St. Thomas. Background on this subject can be found on the Web at: www.taxadmin.org/fta/meet/06re_data/pres/Wilson_low-income.pdf and at http://www.mntax.org/cpfr/disincentives.php