There are too many hidden "tax rates" in the welfare system

By one scholar's estimates, they can get as high as 103 percent.

Photo by USDA

One feature of public welfare policy in almost every economy is that the better you do, the more public support is taken away. While this helps contain costs, it can also make people feel like they're being punished for doing the right things, and even disincentivize them from doing those things. Last week, I discussed the issue in the context of disabled Americans on Supplemental Security Income and Medicaid.

But that’s a narrow example focused on a specific program. For a more general look at this issue, I highly recommend a report recently published by Ed Dolan of the Niskanen Center. He explains how policies interact with each other to create much greater effects in tandem than they do individually.

When a benefit is withdrawn as income increases, Dolan calls that a benefit reduction rate (BRR). And when he adds together all the phaseouts and tax rates that would apply to someone with that income level, he calls it an effective marginal tax rate (EMTR).

Benefit phaseouts might not seem like taxes to you⁠. After all, the government is paying money out, not taking it in⁠. But they have a similar property to taxes: for every additional dollar you earn, you end up with less than a dollar in extra income or benefits—potentially a lot less.

Dolan uses the concept of EMTRs to illuminate serious and unaddressed problems with our existing bundle of welfare benefits. And he argues that neither side of the political aisle is working well to solve the problem of EMTRs.

"Poverty advocates don't pay much attention to it,”  Dolan told me. Meanwhile, “conservatives don't have the right answer” because “they think the solution is work requirements or other punitive measures."

Ultimately, neither the left or the right even identifies the problem head-on: that there are many working people with low incomes and high effective marginal rates⁠—meaning that efforts to improve at their jobs and earn promotions or raises go unrewarded.

The 103 percent tax rates

Shockingly, Dolan found that a hypothetical family in the Boston area, with an adult and two children, could have an EMTR of over 103 percent. This family actually loses so much social support, for each dollar earned, that it becomes worse off as it increases its market income from $22,000 to $44,000. Dolan calls this income range, which lands between 100 and 200 percent of the poverty line, the “near-poor,” and he finds that, in general, EMTRs hit the near-poor hardest.

Let’s start with the Earned Income Tax Credit (EITC): at $22,000 of earned income, Dolan’s hypothetical family would earn the maximum EITC benefit ($6,164 in 2022.) However, this benefit phases out at a rate of 21.06 percent for each dollar earned after $20,130. The phaseout would be in effect all the way from $22,000 to $44,000, clawing back about $4,633 over that range. So $22,000 in extra earnings is whittled down to $17,367 once you factor in the EITC phaseout. A payroll tax rate of 7.65% takes another $1,683, reducing the total to $15,684.

And that’s just the tax system. The family is likely to lose Supplemental Nutrition Assistance Program (SNAP) benefits over that income range, and see its Section 8 housing vouchers and Child Care and Development Fund (CCDF) subsidies decline. Finally, it will lose Medicaid and instead go to the individual insurance exchanges from the Affordable Care Act, whose subsidies also phase out with income.

Put it all together, Dolan says, and earning $22,000 in additional market income actually costs this hypothetical family $22,624 in taxes and lost benefits, leaving them $624 poorer: “after taxes and transfers, the annual net income for this family actually falls a bit, from $87,686 to $87,062, as earned income increases from $22,000 to $44,000.”

There are caveats here: this family is atypical, and it requires a confluence of programs that are far from universal. Policies like Temporary Assistance for Needy Families (TANF) or Section 8 housing vouchers, or Child Care and Development Fund (CCDF) subsidies, aren’t used by many, or even most, of the people in the income brackets they’re intended to serve.

But the broader point remains even in the absence of the less-used programs. Even when Dolan looks at a more typical Boston family in that range, he still finds an 87 percent EMTR in that range from more universal programs alone. In a conversation with me, Dolan described this as a “danger zone,” where multiple programs⁠—like the EITC and SNAP, both broadly used⁠—phase out simultaneously. The EMTR is further worsened by payroll taxes, and in many cases, a phaseout of health care subsidies.

The key insight of Dolan’s report is that too many phaseouts have been jammed into the same zone just above the poverty line. Different programs are “all designed in silos,” Dolan says. “Nobody seems to have thought about the way they interact with other programs, and as a result you get these very severe cumulative effects.”

In an intellectually honest spirit, Dolan offers some mitigating factors, some counterarguments that might show rates aren’t as high as he suggests. He notes that benefit programs might not be valued at par relative to the cash income from work. And he notes in the report “it may be possible to conceal some earnings, such as tips or income from odd jobs, from tax and welfare authorities.” And as mentioned above, some of the programs are difficult enough to sign up for that they aren’t actually used.

But these arguments don’t exactly refute his findings. All of them, functionally, hinge on the tax and transfer state working poorly. If it were working as designed or as advertised, the marginal rates Dolan finds would reveal themselves to exist in practice, not just in theory.

And Dolan is at times more charitable than the program design actually deserves. He measures the tax rates in a stepwise manner, looking at the marginal rate from one multiple of the poverty level to the next. This helps hide the messiness of policies that drop out suddenly, rather than gradually phasing out. Measured more granularly, these “cliffs” create very high (essentially, infinite) tax rates.

Marginal tax rates are a necessary evil for reducing inequality

While the problem Dolan points out is relatively simple, the solution is not. Why not just bring the EMTRs down? Well, it turns out there’s an ironclad tradeoff between marginal tax rates and inequality reduction. In fact, marginal tax rates are reductions in inequality. Imagine some people earn $50,000 and some people earn $100,000. The difference in their living standards is $50,000. If you work to reduce that difference by 50 percent, to $25,000, then you’ve implemented a 50 percent EMTR of some kind. People get only $25,000 more when they earn a $50,000 raise.

In the real world, with many different definitions of income, or consumption, or wealth, this principle gets a bit harder to see clearly. But it’s always true. If a policy meaningfully reduces inequality, there’s a marginal rate somewhere. Perhaps it’s hidden in a phaseout, or an eligibility requirement, or a means test, or a cliff. But it’s there.

Might you get around this by extending program eligibility all the way up? That gets rid of the benefit reduction rates, but makes your program quite expensive⁠—and forces you to raise a lot of taxes to pay for it. Those taxes will then have marginal rates of their own.

There’s no way around this problem. Any system that reduces income inequality will impose an effective tax on incomes.

So marginal tax rates—either explicit or implicit—are a necessary evil. They have to be managed carefully, because you can never get rid of them. But an important principle is that you want steady marginal rates, at least at the low end, in order to minimize the drawbacks.

What are the drawbacks? From an individual’s perspective, the big downside to a tax is that you lose money. But economists aren’t necessarily thinking about that as a drawback—after all, the whole point of a tax is to transfer income to the government.

Instead, economists worry about the risk that a tax will induce people to change their behavior in ways that harm economic efficiency. For example, if you have an income around $22,000 and you face a 87 percent EMTR between $22,000 and $44,000, you have very little incentive to increase your income to $30,000 or $40,000. If you make more money—either by working more hours or earning a promotion—most of that extra income will be offset by lost benefits. So you might decide that working harder is not worth the trouble, which is bad for everyone.

The drawbacks from marginal tax rate grow more than linearly with the tax rate. That is, a 50 percent marginal tax rate is more than twice as distortionary as a 25 percent marginal tax rate, even though it’s only twice the rate and raises twice the revenue. You can represent this graphically or prove it formally with a model, but you can also think about this in a more informal way. The first 25 percent takes away 25 cents for each dollar earned, leaving the worker with 75 cents. But if you add another 25 percent to the rate on top of that, you’re taking away 25 cents for each 75 cents the worker would have had under the first system. While each 25 cent increment is the same to the government, the first one takes away a quarter of the worker’s income, while the second one takes away a third.

Solutions so far have fallen short. But we can do better

There aren’t easy solutions to the EMTR problem. And Dolan thinks both the left and right have it wrong.

On the left, there’s often denial about the implications of high EMTRs, as in this Center on Budget and Policy Priorities (CBPP) report from a few years ago. It finds roughly the same results as Dolan (very high marginal rates, especially just above the poverty line, and even more if you use some of the less-known programs).

Some other low-income families, typically those with incomes modestly above the poverty line, can face marginal tax rates of around 65 percent over a relatively narrow income range, such as between about $18,000 and $25,000 for a family of three.  (Their marginal rate can be higher if they receive benefits that go to only a modest minority of low-income households, such as housing assistance or child care assistance.)

And yet, its overall thesis is that this is little to be concerned about. Families, they say, aren’t that responsive to the structure of their benefits. (Dolan rejects this characterization: “Social workers say their clients are pretty savvy about these things,” he told me)

And some of the programs aren’t used by very many families. In other words, Dolan’s hypothetical family with the 103 percent EMTR is relatively rare. But as Dolan notes, CBPP regularly argues for expanding access to the lesser-used programs, which would make the problems of his hypothetical family much more common in real life. In effect, they’re having it both ways⁠—we need not think about the drawbacks of lightly-used programs because they’re lightly-used, but also, they should be expanded.

The right’s approach is also inadequate. “Conservatives don't have the right answer,” Dolan tells me. “They think the solution is work requirements or other punitive measures.”

Dolan argues that work requirements are ineffective because most people⁠ on welfare⁠—especially those in the danger zones he describes⁠—are already working. And of those who aren’t, many are disabled or have caregiving responsibilities. Where we should be more concerned is the intensive margin, the question of how much you’re rewarded for promotions or other increased work efforts.

I do think, though, there are some solutions and potential improvements we can make.

First, you can do a lot just by finding cliffs or steep phaseouts and turning them into more gentle ones. These sorts of simple expansions are a lot easier to put together than new programs; often you can write a very short bill and get it done and make the system better for everyone. Incremental tune-ups are underrated.

I would also say that policy analysis should use the poverty rate a little bit less often. It’s starting to outlive its usefulness. The reason is simple: people tailor their policies too much to the metric, making it subject to Goodhart’s Law. Many policies are designed to help people below the poverty line⁠—but then, as people cross the poverty line, the support is withdrawn, often hastily. It’s fine for one policy to do this, or two, but it’s not good for several to be withdrawn there simultaneously.

Another takeaway is that we’re better off consolidating programs⁠—especially those that are hard to sign up for⁠—into a handful of programs with a better user experience. This would be a good change, even absent any question of EMTRs, because it would reduce the administrative burden both for beneficiaries and the government.

For an example of how that might be done, consider the recently-unveiled plan from Sen. Mitt Romney (R-UT), which would expand the Child Tax Credit in part by eliminating some smaller, lesser-used policies like TANF and the Child and Dependent Care credit. (It also eliminates the deduction for state and local taxes, which would make it a non-starter for some Democrats.)

While this specific plan might not work for Democrats, our friend Dylan Matthews writes that Democrats should learn from Romney’s example. Matthews names a wide variety of welfare programs⁠⁠—even more than the expansive list Dolan considers. And then he makes this point about consolidation:

Conservatives and libertarians sometimes see this laundry list and think, “Look at how much we do for poor people!” I see it and think, “Look at how ridiculously complicated the system we make poor people navigate is.”

I think both sides should take this argument seriously, if only to reduce the resources wasted on complexity.

And a takeaway for the political left, specifically, is that the push for more universal benefits by groups like the People’s Policy Project makes more sense at the margin than more means-tested benefits, even if it takes higher tax increases to get it done. There’s a traffic jam of anti-poverty policies stuck in the same region of the income distribution, often stuck there because cost-conscious designers had to phase them out relatively quickly.

The way to unclog this policy area, from a social democrat’s perspective, is to raise taxes on middle and upper-middle-income families in order to pay for big benefit expansions, so that more of them phase out in the lower-middle and middle income ranges⁠—or even, never phase-out⁠—rather than phasing out yet another program in the near-poor range.