TCS Daily

Marginal Benefits

By James D. Miller - November 21, 2002 12:00 AM

All types of taxes destroy wealth, but not by equal measure. Republicans might use their election mandate to cut taxes. But to assess the benefits of new tax legislation, you need to understand how taxes reduce economic output.

Taxes annihilate wealth primarily by impeding mutually beneficial trades, the most important of which is the exchange of labor for money. Let's say you're willing to work an extra hour for $20 while your employer is willing to pay you $30 for another hour's work. Obviously, if you worked for $25 both you and your company would profit. Assume, however, that the government imposes a 50% tax on all your income. You would now be willing to work that extra hour only if you got at least $40 (so you could take home $20 after taxes), but $40 is more than your employer will pay. Consequently, the 50% tax destroys wealth because it stops you and your employer from coming to a mutually advantageous arrangement.

When deciding how much more to work, you should consider your marginal, not your average tax rate. The marginal tax rate determines how much you pay in taxes on your next dollar of income. To see the importance of marginal rates consider the following example: Assume that two workers make $100,000. The government imposes a 50% tax on the first worker's income. For the second worker, the government exempts the first $50,000 from taxes but imposes a 100% tax on all income above $50,000. Both workers pay the same in taxes and thus each have the same average tax rate. The first worker, however, faces a 50% marginal tax rate while the second pays a 100% marginal tax on all new income. Obviously, the second worker has no incentive to work harder and should even reduce his effort until he only makes $50,000. The first worker, in contrast, gets to keep one-half of anything extra he makes, so he has some incentive to work longer hours. The lower the marginal rate, the fewer disincentives to work taxes create. High marginal tax rates create a wedge between what an employer pays and what a worker gets, and this wedge encourages workers to substitute untaxed leisure for high-taxed work.

If the Republicans decide to lower taxes they should take the opportunity to reduce marginal rates. Imagine that it costs the same either to give all workers a $1,000 lump-sum tax rebate or to reduce the Social Security tax by some X percent. Giving workers a lump-sum payment does nothing to reduce marginal tax rates because everyone would still pay the same amount in taxes on their next dollar earned. Consequently, lump-sum payments don't reduce the negative economic effects of taxation. In contrast, reducing the Social Security tax increases most workers' after-tax take home pay for their next hour worked. Therefore, even though the lump-sum rebate and social security tax cut would reduce average taxes by the same amount, the Social Security tax cut would provide greater economic stimulus.

As with lump-sum payments, child tax credits also don't lower marginal rates. For example, giving all parents a $500 tax rebate wouldn't influence how much money they got to keep in return for additional work.

Retroactive tax cuts also do nothing to reduce marginal rates. Imagine that in July 2003 the government first announces that tax rates for the whole of 2003 will be lowered. There will be taxpayers who would have worked harder from January-June had they known of the rate cut. Taxpayers who lack time machines, however, won't be able to retroactively alter their working hours in response to retroactive tax reductions.

Marginal tax rates can be lowered for all economic classes, even the non-working poor. Government subsidies to the poor often decrease as income rises. Consequently, reducing subsidy penalties for the employed poor reduces marginal tax rates for the non-working poor.

Future Republican tax proposals will undoubtedly generate fierce battles. Everyone should at least agree, however, that regardless of which group a tax cut targets, all cuts should be used to reduce marginal rates.

James D. Miller is an assistant professor of economics at Smith College. His book Game Theory at Work will be published in April 2003.

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