Walden: Who pays the highest tax rates?
What if I told you there are some households who pay tax rates of 60 percent, 70 percent or more on additional financial resources? You’d probably agree that you’ve heard of such high tax rates, and you would be correct.
Now, what if I asked you what types of households pay such high tax rates? You’d probably say very high-income, or rich, households. With this answer, you would be only partly correct. Rich but also some poor households can pay these sky-high tax rates.
Before explaining, I need to be clear what kind of tax rates I’m discussing. There are actually two relevant tax rates used in discussions about the impact of taxes on a household’s financial resources. The average tax rate is simply the average amount of taxes paid per dollar of your financial resources.
So, let’s say your financial resources are $50,000 (maybe this is your annual salary), and the taxes you pay are $15,000. Your average tax rate is then $15,000 divided by $50,000, or 0.30, or 30 percent. In other words, you pay 30 cents out of each dollar in taxes.
The second tax concept - and the focus of this column - is the marginal tax rate. The marginal tax rate addresses this question: What if your financial resources increase by a certain amount - say $1,000?
How much in additional taxes would you pay? If the amount is $400, then your marginal tax rate is $400 divided by $1,000, or 0.40, or 40 percent. But if the amount is $600, then your marginal tax rate is $600 divided by $1,000, or 0.60, or 60 percent.
Some of you may be surprised that the marginal tax rate is not the same as the average tax rate. This is because some taxes - in particular, income taxes - have different tax rates that apply to different ranges of taxable income. For the federal income tax, higher ranges of taxable income are taxed at a higher rate. When combined with other taxes (payroll, state and local taxes), this is why high-income households can pay taxes on additional income at rates of 60 percent or 70 percent.
But notice in my introduction I said some low-income households can also pay very high marginal tax rates. But how? By definition, low-income households aren’t earning enough to be subject to the highest marginal tax rates of the income tax.
The answer has to do with the financial value of public assistance that many low-income households receive, and specifically the rate at which this public assistance is reduced when the low-income household experiences an increase in earnings from working.
Most programs providing financial public assistance to households, like food stamps, Medicaid, and housing vouchers, etc., have income cutoffs. This means that as recipient households earn more money from working, their amount of financial public assistance drops.
The problem is that the rate at which the monetary value of the public assistance is reduced for each additional dollar of earnings can be very steep. A recent report from the Congressional Budget Office found the loss in public financial assistance for every dollar of additional work earnings is commonly between 40 and 50 cents and sometimes as high as 70 to 80 cents for many low-income households. If the lost public assistance is considered a “tax” on the new earnings, then these results imply marginal tax rates of 40 percent to 50 percent and sometimes 70 percent to 80 percent.
These high marginal tax rates for households receiving public assistance are not new. More than 15 years ago, I served on a state commission studying programs that helped limited-income households and the incentives for them to move from public assistance to work. Our work found that high effective marginal tax rates on new earnings were a deterring factor.
Then why aren’t the public assistance programs changed so that less of any new dollars from work will be countered by reductions in public assistance? A big reason is that at least initially, it is more costly. If, for example, a household loses only $200 in public assistance when earnings rise by $1,000 - rather than losing $500 - then the program’s costs today will rise.
Of course, in the long run, the costs of the public assistance programs could fall if the lower marginal tax rates on work earnings encourage more work and ultimately less reliance on public help.
Changes to taxes and tax rates are hot political topics today, both in Washington and Raleigh. While the focus will be on what workers keep when they earn more, we should also consider what limited-resource households might lose in public assistance when their work earnings increase. Judging what this tradeoff should be can have a major impact on moving households to self-sufficiency. You help decide!
Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy.