Originally published in THE BOSTON GLOBE
Tuesday, January 4, 2000
Tax rates that benefit no one
"Too-high 'marginal' levies are creating costly distortions"
by Martin and Kathleen Feldstein
Tax proposals are likely to be a central issue in the presidential campaign of 2000. Governor Bush has already set forth a detailed tax plan, and other contenders will undoubtedly follow suit.
A key consideration will be fairness. The two fundamental fairness issues are the size and the distribution of the tax burden. As economists, we are no more qualified to answer such fairness questions than anyone else. But we can help by presenting some of the numbers people need to make their own judgments.
Is it fair for government at all levels to take one third of national income in taxes? And what should be the distribution of taxes among people at different income levels? In 1997, the most recent year for which data are available, the 2 percent of taxpayers who earned over $200,000 paid 37 percent of total income taxes. Should that percentage be higher or lower?
Economists have a professional understanding of the adverse economic effects of high taxes on the economy. The key to those effects is the marginal tax rates that individuals face, that is, the additional tax that is due on an incremental dollar of income. We think the best way to convey the adverse effect of high marginal tax rates is to consider a simplified but realistic example:
Susan makes $20 per hour. She works 2,000 hours a year and has total income of $40,000. Single with no dependents, Susan pays $5,864 in personal income taxes. She and her employer together pay an additional $6,120 in payroll taxes. So Susan's combined total taxes are $11,984, or 30 percent of her income.
But Susan's 30 percent average tax rate is not her marginal tax rate. If she earns another $100, she will pay $28 in additional personal taxes, plus another $15 in employer-employee payroll taxes, for a total of $43. That means her marginal rate is 43 percent.
Now, think about what that high marginal rate does to Susan's incentive to work.
Let's imagine Susan's employer wants her to work an additional five hours and is willing to pay as much as $25 per hour - $5 more than Susan's usual pay, or $125 total. Since Susan values her leisure time, she would be willing to work the extra five hours only if she can keep at least $90 in extra pay.
In this example, it would clearly be in the interest of both employer and employee for Susan to work the extra five hours. Economists look at the difference between the amount the employer is willing to pay and the minimum amount necessary to induce the employee to give up leisure as the net gain.
Here, the net gain would be $35 - the difference between the $125 the employer would pay and the $90 minimum Susan would accept. That $35 might go completely to Susan if the employer pays $125 or completely to the company if the company only paid $90.
Either way, there is a gain of $35.
But we have not taken taxes into account. Even if Susan's employer paid her $125, Susan's 43 percent marginal rate would cut her take-home pay to $71.
Since she prefers the leisure to anything less than $90, Susan will stay home. And by distorting Susan's decision whether or not to work, the potential net gain of $35 is lost. Economists have a term for this waste: dead-weight loss. At a somewhat lower marginal tax rate, the transaction would have occurred, and society would have benefitted, along with Susan and her employer.
Let's say the marginal rate is only 20 percent. The employer would still be willing to pay $125, and Susan would get to take home $100, or $10 more than her minimum. And the nation would benefit from the extra $25 in taxes.
Now what does this simplified example have to do with the real world? Most important, the high marginal 43 percent rate is a realistic description of our current tax system. Any single taxpayer earning $40,000 pays a 43 percent tax to the federal government on additional earnings.
Indeed, once state income and sales taxes are included, the marginal tax rate for the typical single person earning $40,000 is more than 50 percent.
High marginal tax rates also adversely affect an individual's decision to take on more responsibility and to obtain more training. They can also influence the form of compensation that firms and individuals agree on, tilting it toward more tax-free fringe benefits.
Distortions have costs. That's why economists focus on marginal tax rates as well as fairness when they weigh tax proposals.
Bush has emphasized his goal of cutting marginal taxes for all income levels. He would replace the current five-rate structure with four lower rates: 10 percent, 15 percent, 25 percent, and 33 percent. The 25 percent rate, for example, would apply to income from $43,000 to $158,000 for a married couple filing jointly. Currently, it's 28 percent starting at $43,000 and rising to 31 percent starting at $104,000 for a married couple.
The Bush tax plan also uses a combination of lower marginal rates and a doubling of the child tax credit to take 6 million families off the federal income tax rolls, bringing their marginal tax rate to zero.
All groups would get lower marginal tax rates, but the greatest percentage tax cuts would go to taxpayers with the lowest incomes. Under the Bush proposal, taxpayers earning over $200,000 would pay 41 percent of total income taxes, a significantly higher percentage than today.
Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.