Does It Pay to Work?

Policy Reports | Taxes

No. 258
Monday, March 31, 2003
by Jagadeesh Gokhale, Laurence J. Kotlikoff, and Alexi Sluchynsky

Executive Summary

What is the economic reward for working? The answer is surprisingly complicated. Going to work, earning a living, and spending one's earnings over time raises a variety of taxes and government benefits and lowers a variety of taxes and benefits - and not just in the current year, but in all future years as well.

If you save and invest some of you current earnings and spend the proceeds in the future, you'll raise your future capital income taxes as well as consumption taxes. You'll also limit your ability to qualify for the receipt of future income- and asset-tested government tax credits and welfare benefits. Earning more today will also affect the calculation of your future Social Security benefits as well as the federal income tax assessed on those benefits.

In order to sort through all of these effects, we consider a two-earner couple at various levels of income. The couple has two children and they are assumed to take advantage of a wide array of tax avoidance opportunities, including the mortgage interest deduction, the earned-income tax credit, and the child tax credit. When qualified, the couple also receives the full array of transfer benefits, including Food Stamps and Medicaid.

By incorporating all of the fiscal policies that affect households through time, our model is able to calculate the lifetime consequences of a lifetime of employment. We conclude that:

  • The overall fiscal system is highly progressive, particularly at the low end of the income distribution.
  • Americans at every income level face a lifetime marginal net tax rate greater than 50 percent.
  • That is, for every dollar they earn, they will lose more than 50 cents in higher taxes and reduced transfer benefits.

Furthermore, the highest marginal net tax rates are not imposed on the highest-income families. They are imposed on those with the lowest earnings. For example:

  • At two times the minimum wage ($42,800), working couples get to keep less than 30 cents out of each dollar they earn.
  • At 1.5 times the minimum wage ($32,100), they get to keep less than 20 cents out of each dollar they earn.
  • By contrast, a couple earning $200,000 a year gets to keep 44 cents.

The disincentives to work at the low end of the income scale are even worse if we compare part-time with full-time work:

  • A minimum-wage couple that moves from half-time to full-time work will lose 97 cents out of every extra dollar they both earn.
  • At 1.5 times the minimum wage, the couple will lose $1.06 for every extra $1.00 they earn; for this couple, working more literally means having less.

What causes these marginal tax rates to be so high? In general, loss of transfer benefits is more important for lower-income families, while direct taxes on income are more important for higher-income families. Among full-time working couples:

  • At $32,100 (1.5 times the minimum wage), two-thirds of the marginal net tax rate consists of the loss of transfer benefits, while a little more than one in five dollars is lost to income and payroll taxes.
  • At $64,300 (triple the minimum wage), half of the marginal net tax rate consists of a loss of benefits, while two in five dollars are lost to income and payroll taxes.
  • At $321,400 (15 times the minimum wage), four in five dollars of the marginal net tax are lost to income and payroll taxes.

Marginal net tax rates for low-income families are so draconian because our system makes a very generous package of welfare benefits available to people who do not work and then begins taking away those benefits at a steep rate as they begin to earn a modest income. In our model, for example:

  • A couple with two children can expect $489,100 in lifetime benefits if they never work.
  • However, if both spouses work full-time and each earns about $16,000, the loss of Medicaid and other welfare benefits will cost them two-thirds of their income over the whole of their worklife.

When all taxes and benefits are considered, the American fiscal system is fairly progressive - at least toward the lower half of the income spectrum. That is, the lower your income, the more generously you are treated. But the price of that generosity is lifetime marginal net tax rates that make working for a living very unattractive.

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