Governments need to be careful to avoid tax traps with high effective marginal tax rates

In yesterday's post, I referred to New Zealand's tax and transfer system, and its impact on inequality. One aspect I didn't refer to was the incentive effects of the system. These incentive effects are bound up in the effective marginal tax rate (EMTR), which is the amount of the next dollar of income a taxpayer earns that would be lost to taxation, decreases in rebates or subsidies, and decreases in government transfers (such as benefits, allowances, pensions, etc.) or other entitlements. A high EMTR creates a disincentive to earn more.

This is beautifully illustrated by this Financial Times article from March this year (paywalled):

How could a £1 pay rise leave you tens of thousands of pounds worse off? The answer is the childcare cliff edge in the UK tax system, which will get considerably steeper for higher-earning families from September.

The government’s expansion of free childcare provision in England this autumn means that working families with children aged under three will be able to claim 30 hours of government-funded childcare a week on top of the tax-free childcare scheme. Valuable benefits, but the bulk of this entitlement is lost if one parent’s adjusted net income is more than £100,000 per year.

In other words, earning more than £100,000 per year leads to a high EMTR. This is shown in the following figure from the article:

Notice how income after childcare expenses decreases markedly at £100,000 per year, and doesn't get back to the same level until income rises to nearly £150,000 per year. This creates a lot of negative incentives. The article gives several examples, one of which is:

Rob* works in tech. Since his daughter was born five years ago, he has turned down two promotions that would have taken his pay over £100,000 as he could not negotiate a high enough pay rise to compensate for the loss of childcare hours. Eventually, he quit his job and became a contractor. “This is riskier, but my earnings have jumped to the point where it is worth it,” he says. “My wife and I have decided to have no more children to maintain the quality of life we have with the one.”

The high EMTR causes people to avoid being promoted or take pay rises, to work less, change jobs, make riskier decisions, and avoid having more children. And all of that from a single example of one taxpayer.

The dumb thing is that this is not a new problem. The article notes that this threshold has been in place since 2017! That's more than long enough for the government to notice the negative incentive effects. The reason it has come to media attention now is that the threshold hasn't been changed in some time, and more and more families are being affected.

Governments need to be very cautious in setting up the tax and transfer system. While the system does generally reduce inequality, as yesterday's post showed for New Zealand, it can nevertheless create unintended consequences. Governments typically want people to work more and receive less assistance from the government. However, high EMTRs can create traps that keep people working less. The UK's childcare tax trap is unfortunately not unique in this.

Read more:

• Welfare programmes, effective marginal tax rates, and the US marriage penalty

Try this: Treasury's Income Explorer shows effective marginal tax rates

A new Treasury Analytical Note by Meghan Stephens, Yvonne Wang, and Liam Barnes presents data on effective marginal tax rates for different families (more on that in a moment). However, one cool thing that the note points to is Treasury's Income Explorer tool, which allows you to graph effective marginal tax rates (EMTRs) based on different historical tax schedules (from 2014 to 2024, and forecast tax schedules for 2025 to 2028. You choose the taxpayer's hourly wage, whether they are partnered (and the partner's work hours and pay rate), the number of children, and whether they are a homeowner or renting (which affects their eligibility for the accommodation supplement). This allows you to look at EMTRs for a whole variety of taxpayers in different situations.

As a quick reminder, the effective marginal tax rate for a taxpayer is the proportion of the next dollar earned that is lost to taxation and to decreases in government transfers, rebates, or subsidies. These rates can get quite high - sometimes over 100 percent (in which case, the taxpayer would be worse off in net terms by earning another dollar). As an example of a high EMTR, consider this graph (made in the Income Explorer tool) based on a single parent (with two children aged 0 and 2) earning $40 per hour in their job, and paying weekly rent of $450:

Notice that the EMTR varies depending on the number of hours worked (shown along the top x-axis) and annual income (shown along the bottom x-axis). There are points in the distribution where EMTRs are low, but others where EMTR is very high. And for this taxpayer, working between 38 and 42 hours leads to an EMTR that is 107.6 percent. The Income Explorer tool even breaks that EMTR down: it is made up of 34.6 percent wage tax (including ACC levies), 27 percent Working for Families abatement, 21 percent Best Start abatement, and 25 percent accommodation supplement abatement. Notice that most of the EMTR (73 percentages points out of 107.6) is made up of reductions in entitlements to government assistance for that taxpayer. This would clearly affect the incentives to work additional hours (at least, between 38 and 42 hours).

Fortunately, the results are not so bad across the board. Stephens et al. show that less than six percent of all taxpayers have EMTRs greater than 50 percent, as summarised in this table:

The majority face an EMTR between 25 percent and 50 percent, and for most people, their EMTR is equal to their marginal income tax rate (plus ACC levies).

Understanding EMTRs is important for understanding the incentive effects of the tax and transfer system. Treasury's Income Explorer is a great tool for visualising EMTRs (as well as replacement rates, participation tax rates, and other complementary measures). Try it out for yourself!

[HT: Les Oxley for the analytical note]

Effective marginal tax rates, and work incentives for older people

Tax rates matter for work incentives. When tax rates are high, there is less incentive for people to work. They may pass up additional work and choose leisure time instead. However, it isn't just taxes that matter. It is the loss of other entitlements as well. All of these are bound up in what is called the effective marginal tax rate (EMTR), which is the amount of the next dollar of income a taxpayer earns that would be lost to taxation, decreases in rebates or subsidies, and decreases in government transfers (such as benefits, allowances, pensions, etc.) or other entitlements.

Because they relate not just to tax rates, but to the loss of other entitlements, EMTRs can get very high (sometimes over 100 percent), and present a strong disincentive for work. This article in The Conversation this week, by Peter Martin (Australian National University) presents one example for Australia:

Pensioners who do go over the $227 per week limit lose half of every extra dollar they earn in a cut to their pension.

Plus tax, this means they lose a total of 69% of what they earn over the limit where their tax rate is 19%, and 82.5% on the portion of earnings taxed at 32.5%.

And this is after the boost designed to “incentivise pensioners into the workforce”.

So, the EMTR for older people in Australia could be as high as 82.5 percent. And the consequence of this, in comparison with New Zealand (where there is no reduction in national superannuation for older people who work):

In Australia, 15.1% of the population aged 65 and older are in some kind of paid work, up from 14.7% a year earlier.

In contrast, in New Zealand the proportion has just hit 26%. That’s right: more than one-quarter of New Zealanders aged 65 and older are employed.

That's a substantial difference, that is almost certainly explained in part by the difference in EMTRs between New Zealand and Australia. Now, sometimes government may have a good reason for high EMTRs and the work disincentives they create. For example, tertiary students in New Zealand who receive a student allowance face an EMTRs of 100 percent beyond the first $258.08 of additional work earnings. That ensures that students don't spend so much time working that they can't concentrate on their studies. However, it's hard to make a similar argument for older people. Would the Australian government want a high EMTR on older people who that they don't spend so much time working that they can't concentrate on their retirement?

Most governments want older people to work more, not less, in order to mitigate labour force shortages (e.g. see the Older Workers Employment Action Plan for New Zealand). Australia seems to be getting this wrong. As Martin concludes:

...New Zealand is certainly making it easier for retirees to work legitimately, rather than stay at home or accept cash in hand.

The income and substitution effects of a tax cut

Benjamin Franklin once famously wrote that "in this world nothing can be said to be certain, except death and taxes". Taxes may be certain, but the tax rate is not. Tax rates vary widely across the world, and have varied widely over time for each country. Economists are concerned about tax rates because, among other things, they affect the incentives to work.

However, it isn't just any tax rate that affects work incentives. We need to take into account all of the changes that affect a worker's income, as a result of working more. Working more results in more income tax payable, but might also reduce a worker's entitlement to government transfers (social security benefits, student allowances), or reduce their entitlement to subsidies (for example, subsidised housing or healthcare) or rebates (for example childcare rebates). All of those changes need to be taken into account.

The effective marginal tax rate (EMTR) is the amount of the next dollar of earnings that a person loses to taxes, to decreases in entitlements to government transfers, and to decreases in subsidies and rebates. It is the EMTR that best captures the incentive effects of the tax and transfer system. When a worker faces a high EMTR, there is a disincentive to work more. When the EMTR is lower, there is more incentive to work.

To see why, consider what happens if the EMTR decreases. For example, if the government offers an income tax cut, this will decrease the EMTR. The after-tax-and-transfers reward for working increases, making work more attractive. The opportunity cost of leisure time (measured as the after-tax-and-transfers wage) increases, making leisure time less attractive. The worker decides to work more. This is an example of the substitution effect. The relative price of working compared with leisure has increased, encouraging a shift to more work and less leisure.

However, there is also an income effect. The higher wage increases the worker's income, and they use that income to consume more normal goods. Leisure time is a normal good, so the worker wants to consume more of it (and work less). Notice that the income effect works in the opposite direction to the substitution effect here. They offset each other.

This leads to an interesting implication of a tax cut. For some workers, especially those on low wages, the substitution effect (work more) is larger than the income effect (work less). In general, a tax cut encourages those on low wages to work more. However, for other workers, especially those on high wages, the substitution effect (work more) is smaller than the income effect (work less). In general, a tax cut encourages those on high wages to work less. Why might the high wage workers work less? Those workers may realise that they can continue to earn the same amount as before, while working fewer hours. This allows them to continue to spend the same amount as before, and have more leisure at the same time. In fact, some workers may be able to both earn and spend more, and have more leisure time.

The income and substitution effects of a tax cut do not necessarily lead all workers to work more. Some workers will respond by working less. In fact, if we look at work and leisure time over the long run (as in this post), we see workers both earning more income, and spending more time on leisure (and working fewer hours). Changes in tax rates change the incentive to work, but they don't necessarily affect all workers in the same way.

Read more:

• How increased wages over the last century reduced the incentive to work

More on social security and work disincentives

Duncan Garner had an interesting article in the National Business Review yesterday (gated), on work disincentives associated with social welfare (or social security). And interesting timing, given that I had just written about this a few days ago (see here). Garner wrote:

Until recently, Eric was on the DBP with three kids and was paid $850 a week by Work and Income. They lived in a state house and paid $125 a week because it’s income-related rent. 

Life wasn’t easy but they could get by and Eric could drop off and pick up his kids before and after school and he was in control. Sure, the struggle was real but the state was there for him. 

But he hated the example it set his kids and wanted to show them he went to work each day and paid his way...

So Eric picked up a 40-hour truck driving job and was slowly removed from the welfare system. 

He was paid just over $30 an hour for the truckie job, which is well above the minimum wage and the new job took him all over Auckland. But then his state house rent went up by close on $200 because his income had gone up too. 

Then came the killer blow. How was he to pay for the kids after-school care? In reality he’d never paid a cent for care before because it was always his job, as a solo dad on the DPB. 

But now it could add another $200 to his weekly outgoings and, once you add the extra housing costs, it soon showed he was worse off working, by about $200 week.  

He was better off signing back on to the DPB. He hasn’t done that and wants to make paid employment work.

This again illustrates the problem of high effective marginal tax rates. The effective marginal tax rate (EMTR) is the amount of the next dollar of income a taxpayer earns that would be lost to taxation, decreases in rebates or subsidies, and decreases in government transfers (such as benefits, allowances, pensions, etc.) or other entitlements. In this case, Eric earns more as a truck driver, but then gives up more in lost welfare and entitlements (including the new obligation to pay after-school care) than what he would gain in higher income. On a purely monetary basis, he is worse off.

Interestingly, Eric notes that there are substantial non-monetary benefits from working, and those offset the net monetary loss. Not everyone would feel that way, and that's why high effective marginal tax rates provide such a disincentive for working. I don't necessarily agree with all of the broader points that Garner makes in his article, but on this we do agree:

We need to redesign welfare so these perverse outcomes don’t take hold.

Read more:

• Welfare programmes, effective marginal tax rates, and the US marriage penalty
• Work disincentives, and the income and substitution effects in social security 

Work disincentives, and the income and substitution effects in social security

In yesterday's post, I discussed effective marginal tax rates and the marriage penalty in the US social security system. The social security system can create incentives (and disincentives) for activities unrelated to working and income (in that case, marriage). However, most of the time when we talk about incentive effects in social security, we are talking about decreased work incentives.

I was reminded (by a note I left myself) that Abhijit Banerjee and Esther Duflo discussed these effects in their book Good Economics for Hard Times (which I reviewed here). In particular, Banerjee and Duflo note that there are both income effects and substitution effects associated with the social security system. Specifically:

...for people near the point between being takers from and payers into the system, there is potentially a strong disincentive to work. In other words, in addition to the income effect (I do not need to work if I have enough money to survive on already) that most policy makers worry about, such schemes can have a substitution effect (working is less valuable since what I make in extra income is taken out as reduced welfare payments).

The latter point relates to the effective marginal tax rate (the amount of the next dollar of income a taxpayer earns that would be lost to taxation, decreases in rebates or subsidies, and decreases in government transfers (such as benefits, allowances, pensions, etc.) or other entitlements). To see how these disincentives work, consider the diagram below. The income curve shows the distribution of income without any transfers. The poverty line (representing the minimum level of income necessary in order to lead a comfortable life) is M*. Now consider a perfectly targeted transfer, that would raise the income of any person whose initial income is below M*, exactly up to M*. People with initial income of M* or higher receive no transfer at all.

With this perfectly targeted transfer, poverty would be eliminated. However, what we are interested in is the incentive effects. Consider a person with income of M0. They initially have zero income (probably they are not working at all), and their income is raised to M*. They do very well from the transfer. Now consider a person with income of M1. Their transfer is less, and their income is raised to M*. However, they were working (perhaps part-time) and earning M1. Comparing themselves to the person with income of M0, the person with income of M1 might realise they don't need to work so hard and can still end up with an income of M* after the transfer. This provides a disincentive to work. This is the income effect described by Banerjee and Duflo. The person with an income of M1 couldn't be incentivised to work a bit more either. Every dollar of income above M1 is eliminated by a reduction in the perfectly targeted transfer (the effective marginal tax rate is equal to 100 percent). This is the substitution effect that Banerjee and Duflo described. Now consider a person with income of M2. They are earning more than M*, but they might also look favourably at the person with income of M0, and decide to leave work. The disincentive effects don't just apply to those below the poverty line, who are initially eligible for the transfer.

Finally, Banerjee and Duflo probably understated how wide the disincentive effects are. They note that they apply "for people near the point between being takers from and payers into the system" (which is people near the income of M*). However, I think they probably apply to everyone with income below M*, as well as some people with income higher than M*.

I noted in yesterday's post that the custodians of the social security system need to understand the unintended consequences that the social security system creates. They also need to understand how the system affects work incentives.

Read more:

• Welfare programmes, effective marginal tax rates, and the US marriage penalty

Welfare programmes, effective marginal tax rates, and the US marriage penalty

This week, my ECONS102 class covered the economics of social security. In countries like New Zealand and the US, the tax and transfer system (of which social security is one part) leads to a complicated relationship between income before taxes and transfers, and income after taxes and transfers are accounted for. The effective marginal tax rate (EMTR) is the amount of the next dollar of income a taxpayer earns that would be lost to taxation, decreases in rebates or subsidies, and decreases in government transfers (such as benefits, allowances, pensions, etc.) or other entitlements. Because of the variety of government programmes, benefits, and entitlements, it is not trivial to try to work out the effective marginal tax rate, and it varies widely based on circumstances. However, we should recognise that any time the EMTR exceeds 100 percent (or even when it is much lower than that), there will be significant incentive effects.

One example comes from this post by Ed Dolan on the Institute for Family Studies blog from earlier this year. Dolan notes the existence of a significant marriage penalty in the US:

What would happen if the two adults represented in Figure 1 moved in together to form a single cohabiting household with two adults and two children? What would happen if the cohabiting adults then married? 

Figure 2 shows the answer. It assumes that the two adults live in the home previously occupied by the parent with children, pool their incomes, and share all expenses. This time, the vertical lines are based on an FPL [Federal Poverty Line] of $27,750 for a four-person household. For convenience, the figure assumes that each of the two adults has approximately the same earnings...

The relation of net household resources to employment income differs dramatically for the two household configurations. Beginning from zero, the married couple at first does better. Total household resources are higher over most of the range up to the FPL. The married couple’s work incentives are also stronger. Over the range from zero to 100% of the FPL, net household resources rise by $1.28 cents for each dollar earned compared with $1.13 for the cohabiting couple. These advantages come partly from the fact that the EMTR and CTC phase in faster for the married couple, and partly because SNAP and health benefits do not phase out as quickly.

Beyond the FPL, however, the situation is reversed. Between earnings of $28,000 and $56,000, the red curve flattens dramatically as the married couple’s EMTR rises to a confiscatory 88%, compared to just 30% for the cohabiting couple. That is because SNAP, the EITC, and health benefits phase out simultaneously over this income range for the married couple. For the cohabiting couple, the phase-outs are spread over a much wider income range and overlap less. Due to the higher EMTR, net household resources for the married couple drop below those for the cohabiting pair soon after reaching the FPL. 

After earnings rise past twice the FPL, the difference in EMTRs essentially disappears, but the household resource gap never closes. Even when earnings reach $80,000 per year, the married couple is still worse off by more than $10,000.

The Figure 2 that Dolan refers to is shown below. The vertical axis shows net household resources (after taxes and transfers are accounted for), and the horizontal axis shows employment income. The dotted 45-degree line represents points where net household resources are equal to employment income (any transfers received from the government exactly offset taxes). When the solid lines are above the 45-degree line, the household receives more in transfers than they pay in taxes, and when the solid lines are below the 45-degree line, the household pays more in taxes than they receive in transfers. The EMTR is demonstrated by the slope of the lines (a higher EMTR is represented by a flatter slope). The marriage penalty is demonstrated by the fact that the red solid line is below the blue solid line beyond employment income of about US$30,000. This is mostly caused by the high EMTR for married couples from employment income of US$30,000 to US$55,000 (after that the slopes of the two lines are roughly the same).

It is clear from the figure that there is a substantial marriage penalty in the US, arising from how the broader system of taxes and transfers works. Dolan concludes that:

In short, although the welfare system gives a small marriage bonus to couples who are in deep poverty, it imposes a large marriage penalty on households that are just past the official poverty line but still striving to reach full self-sufficiency.

Fortunately, in New Zealand I don't think there is such a marriage penalty. Married and cohabitating parents are treated similarly, in terms of their entitlements. However, there has in the past been a penalty associated with cohabitating. For example, this 2019 report by Olivia Healey and Jennifer Curtin (both University of Auckland) notes that:

The weekly Supported Living Payment for those who are single with children is $379.19; compared to $237.09 each for those who are married, in a civil union or in a de facto relationship. Therefore, those who are partnered may be better off financially if they separated given two singles would receive a combined amount of $758.38 compared to $474.18 as a couple. The financial penalty on couples is a difference of $282.20 a week.

All countries with more than the simplest of all social security systems are likely to have a myriad of similar problems, which seem to raise issues of fairness and equity. The custodians of the social security system need to better identify the circumstances in which they will occur, consider what unintended consequences may arise, and then address those in a sensible way (which may include changing the rules to avoid these situations arising in the first place). Unless the goal really is to penalise married couples.

The minimum wage, the living wage, and the effective marginal tax rate

Advocates for the living wage tend to ignore that workers that currently receive the minimum wage also receive a lot of other government support, in the form of various rebates and subsidies, that they may not be eligible for if they earned a lot more. That means that increasing the minimum wage to the living wage would not necessarily lead to gains in net earnings that are as high as those advocates expect.

A worked example, based on U.S. data, is provided in this article by Craig Richardson. Here is the key figure:

Increasing the hourly wage from US$7.25 per hour to US$15 per hour would net a full-time worker only US$198.94, after accounting for all of the social benefits they would lose, and the additional taxes they would pay. Richardson writes:

There are some uncomfortable truths about raising the minimum wage from its current level of $7.25 per hour to $15 per hour that are revealed by an online tool created by our Center for the Study of Economic Mobility (CSEM) at Winston-Salem State University, along with our local research partner Forsyth Futures.

The tool, which we call the Social Benefits Calculator, enables anyone to go online and experience for themselves what it is like to be receiving social benefits and experience a monthly wage increase. Designed for Forsyth County, the calculator shows that with more than a 100% rise in the minimum wage, many people who currently receive social benefits will barely experience a change in their standard of living...

Let’s use the calculator and create a hypothetical example: a full-time working parent earning the minimum wage, who is unmarried with two children in subsidized day care. As seen in Table 1, after his or her wages more than double from $7.25 an hour to $15 an hour, earnings rise from $1,160 to $2,400, or a $1,240 change.

Sounds good, right? That’s an enormous bump up of wages by 106%. But after subtracting the decrease in benefits and higher taxes, that $1,240 increase erodes to just a $199 net improvement, or just a 16% change.

Imagine getting a big raise and seeing 84% of it go away. 

The effective marginal tax rate (EMTR) is the amount of the next dollar of income a taxpayer earns that would be lost to taxation, decreases in rebates or subsidies, and decreases in government transfers (such as benefits, allowances, pensions, etc.) or other entitlements. Taking the example of the table above, increasing the worker's wage from US$7.25 per hour to US$15 per hour increases their monthly before-tax-and-transfers income from $1160 to $2400. In other words, their income increases by $1240. With that higher income, they pay more federal and state taxes. Their monthly tax payments increase from $88.74 to $314.70. In other words, they pay an additional $225.96. The marginal tax rate over that interval is 18.2% (calculated as [225.96 / 1240]). But wait! Their entitlement to social benefits decreases from $3110.10 to $2295 monthly. In other words, they lose $815.10 in entitlements, as well as the additional taxes they pay. So, their effective marginal tax rate over the interval is 84.0% (calculated as [(225.96 + 815.10) / 1240]).

EMTRs are something that policy makers should keep a close eye on. When the EMTR gets too high, it can create some perverse outcomes. In some cases, workers could actually be financially better off by working less (this happens whenever the EMTR exceeds 100%). The problem is that every program has its own eligibility rules and thresholds, and keeping track of how the interaction between all of those works is incredibly difficult. You can try out the Social Benefits Calculator tool mentioned in the article here (it is based on data for Forsyth County, North Carolina). We really need a similar calculator for New Zealand.

[HT: Marginal Revolution]

A torturous average vs. marginal tax rates example

In ECON110 last week, we ran out of time to go fully through an example on the difference between average and marginal tax rates, and the difference between progressive and regressive taxes. Fortunately, in the last week Jodi Beggs at Economists Do It With Models has just written a couple of posts on taxes (see here and here). So, I'm going to borrow from her second post to illustrate.

Jodi outlines an income tax regime that works as follows:

• 10% for income $0 to $9,275

• 15% for income $9,275 to $37,650

• 25% for income $37,650 to $91,150

• 28% for income $91,150 to $190,150

• 33% for income $190,150 to $413,350

• 35% for income $413,350 to $415,050

• 39.6% for income $415,050+

Now, let's think about three taxpayers. Taxpayer 1 has income of $30,000; Taxpayer 2 has income of $90,000; and Taxpayer 3 has income of $450,000. What are their average and marginal tax rates, and why does it matter?

The average tax rate is just the proportion of income that is paid in tax. That can be calculated as [Tax Paid]/[Income]. When the tax system is not straightforward then calculating the tax paid can take multiple steps (see below). The marginal tax rate is just the proportion of the next dollar earned that would be paid in tax. The difference between the two rates is important, and people don't always appreciate why. It's the marginal tax rate that matters for decision-making, since we make decisions at the margin. If we are thinking about whether to work another hour or not, the tax we pay on that next hour of wages is the relevant tax rate. However, as Jodi notes:

...while you mainly want to keep your marginal tax rate in mind for decision-making purposes, I guess it could make you feel better to calculate your average tax rate and be reminded that the federal government isn’t taking all of your money in income taxes.

Back to our example. The tax paid by Taxpayer 1 (on their income of $30,000) is $4,036.25. They pay $927.50 on their first $9,275 of income ($9,275 * 10%), and then $3,108.75 on the remaining $20,725 of income between $9,275 and $30,000 ($20,725 * 15%). The average tax rate for Taxpayer 1 is 13.45% ($4,036.25 / $30,000). Their marginal tax rate is 15% (if they earned one more dollar, that's the rate of tax they would pay on that dollar).

The tax paid by Taxpayer 2 (on their income of $90,000) is $18,271.25. They pay $927.50 on their first $9,275 of income ($9,275 * 10%), then $4,256.25 on the next $28,375 of income up to $37,650 ($28,375 * 15%), and then $13,087.50 on the remaining $52,350 of income between $37,650 and $90,000 ($52,350 * 25%). The average tax rate for Taxpayer 2 is 20.30% ($18,271.25 / $90,000). Their marginal tax rate is 25%.

Finally, the tax paid by Taxpayer 3 (on their income of $450,000) is $134,370. They pay $927.50 on their first $9,275 of income ($9,275 * 10%), then $4,256.25 on the next $28,375 of income up to $37,650 ($28,375 * 15%), then $13,375 on the next $53,500 of income up to $91,150 ($53,500 * 25%), then $27,720 on the next $99,000 of income up to $190,150 ($99,000 * 28%), then $73,656 on the next $223,200 of income up to $413,350 ($223,200 * 33%), then $595 on the next $1,700 of income up to $415,050 ($1,700 * 35%), and then $13,840.20 on the remaining $34,950 of income between $415,050  and $450,000 ($34,950 * 39.6%). The average tax rate for Taxpayer 3 is 29.86% ($134,370 / $450,000). Their marginal tax rate is 39.6%.

Phew! You might think that the above example was difficult. That's why we have tax software to do the work. But this example is relatively straightforward when you compare with the complex system of rebates and tax deductions that most tax systems include (in New Zealand we have low income rebates, Working for Families credits, as well as social security payments and accommodation supplements, all of which decrease as more income is earned). Once we factor in decreases in government transfers, rebates, and entitlements, we are calculating what we call the effective marginal tax rate.

Notice that in the case of all three taxpayers the marginal tax rate is greater than the average tax rate. That characterises an income tax system that is progressive. This is a tax system where, as incomes increase, the proportion of the income paid in tax increases. In contrast, for a regressive tax system the marginal tax rate is less than the average tax rate (and higher incomes are associated with a lower proportion of income paid in tax), while for a proportional tax system the marginal and average tax rates are the same (and the proportion of income paid in tax is the same at all levels of income).

Unemployment benefits and work disincentives

A couple of weeks ago the NZ Herald had a couple of (short) opinion pieces on the choice for beneficiaries between working and remaining on the benefit - one by Karen Pattie, and one by Lindsay Mitchell. Karen writes:

There is a large percentage of my clients who approach our service and ask us to look at the viability of returning to work -- single parents who are committed to getting off benefit and excited about the prospect of returning to work.

When we break down the in-work tax credit, the childcare subsidy, accommodation supplement and temporary additional support, it is not uncommon that the working single parent ends up with under $50 a week more in their hand.

We then look at transport, parking, appropriate clothing etc. for work. Work and Income will assist with a percentage of this cost, however, not the total cost, which then gets taken off the $50.

Then, school holiday programmes need to be paid for along with childcare, which is subsidised, and the $50 in hand is reduced further.

Given this, most of our clients still opt to return to paid work because we can see the benefits of work experience which may lead to better work opportunities. 

Lindsay writes:

A Blenheim single mother of three finds she is only $34 better off working. She says, "When you weigh it up, is it worth going to work? The Government is trying to get everyone off the benefit but there is no incentive to work."

Of course, the 'choice' between working and remaining on the benefit is only relevant when there are jobs available. However, I'm not going to talk about that aspect. Instead, I want to discuss incentives (or rather, the work disincentives that benefits create).

One of the topics we cover in ECON110 is the economics of social security. Part of that topic involves considering the incentive effects of having a social safety net. If there is no safety net (for the unemployed, for example), then there are high incentives to take any employment that is available. The alternative is trying to live on zero income, relying on assistance from friends and family or non-government organisations, begging, etc. When there is a social safety net (for the unemployed), then the incentives for work are reduced, because the income difference between working and not working is lesser.

A rational (or quasi-rational) beneficiary who is offered the opportunity to work will weigh up the costs and benefits of working rather than remaining on the benefit. The costs of working (compared with being unemployed) are mostly the foregone leisure time (less time with the kids, gardening, or playing XBox). The benefits include higher income. If the difference between working and not working is only $34 (as per the example above), then it wouldn't be surprising for that to be insufficient incentive to encourage people to work.

A couple of additional points are important. First, there are non-monetary benefits to working that must also be factored in. Working provides a sense of purpose and identity. It can increase life satisfaction. So, it might not be surprising that some beneficiaries would return to work even if the monetary benefits were lower than the costs. Second, there may be long-run impacts. For example, the initial job taken may lead to improved future job prospects. As Lindsay notes:

Moving into work may provide little financial gain initially. But the individual's sense of well-being and future prospects are improved.

How do we reduce the disincentive for beneficiaries to return to work? We first need to recognise that the disincentives arise in two ways: (1) the relative generosity of the unemployment benefit; and (2) the rate at which the benefit is reduced as the beneficiary earns other income.

So, the disincentive to work can be reduced if the unemployment benefit was less generous. Clearly there is a trade-off here - you probably want the benefit to be high enough to provide for a minimum standard of living; however, making it too generous (compared with, say, the minimum wage) reduces the incentives to work.

The disincentive to work can also be reduced by allowing the beneficiary to continue to receive a (reduced) benefit if they go back to work. So, rather than taking away the entire benefit if a person returns to work, you simply reduce their benefit by an amount that depends on how much other income they earn. This way, you ensure that beneficiaries who take on part-time work can still attain a minimum standard of living, and you ensure that beneficiaries who work are financially better off than those who don't.

The abatement rate (the rate at which benefits reduce due to other income) matters because unsurprisingly it also affects incentives by contributing to the effective marginal tax rate (the proportion of the next dollar earned that is lost to taxation, decreases in rebates, and decreases in government transfers, e.g. benefits). If the marginal tax rate for low earners is 20%, and the benefit abatement rate is 50 cents for every additional dollar the beneficiary earns, then the effective marginal tax rate is at least 70% - quite a high disincentive to work. And then you have to factor in that the beneficiary might also have to pay student loans or child support from that additional dollar, and they might face a reduction in accommodation supplement and family tax credits, etc. So, there's not likely to be much left over. However, if the abatement rate is too low, then a large proportion of low (and medium) income earners will be eligible for income support, and you start to affect the incentives for people who would otherwise be working full-time, etc. So, again there is a tradeoff.

Social security is fraught with incentive issues and tradeoffs. Striking the right balance is always going to be a challenge.