Marginal and average tax rates in optimal tax policy

Aspen Gorry, Sita Nataraj Slavov for the American Enterprise Institute write: Introduction

Over the past several years, most of the public discussion over tax policy has focused on how much the wealthy should pay and what the top marginal tax rate should be. After extensively debating the disincentive effects of raising the top marginal rate from 35 to 39.6 percent, Congress took that step in January. During the 2012 presidential campaign, the low average tax rate paid by Republican nominee Mitt Romney sparked much controversy as well. However, far less attention has been paid to marginal and average tax rates at other points in the income distribution. In many cases, low-income households face implicit marginal tax rates that far exceed those paid by high-income households. And economic research suggests that the decision of low-income individuals to enter the labor market depends on the average tax rate that they face.

This article discusses the role of both average and marginal tax rates throughout the income distribution. Our analysis relies on optimal tax theory, which allows us to study the trade-off between two of the main goals of policymakers: progressivity and economic efficiency. We briefly review the implications of standard optimal tax theory for setting the top tax rate, then turn to the trade-offs involved in setting the marginal tax rate at other points in the income distribution. We then extend the model to allow for individuals to enter and exit the labor force. Introducing an extensive margin of labor supply implies that average tax rates can play an important role in influencing work incentives. We next consider life cycle concerns. We conclude with a discussion of how understanding the tradeoffs involved in optimal taxation might inform policy decisions. We argue that a proportional tax system with a universal transfer or personal exemption provides a transparent tax code that deals well with many of the trade-offs involved in setting marginal and average tax rates. In making connections between optimal tax theory and current policy, we focus not just on the tax system but also on the system of transfer payments. Tax and transfer systems should be considered together because phasing out a transfer payment as an individual’s income increases is economically equivalent to taxing the additional income.

Selection of key findings:

• Following extensive debate about the disincentive effects, Congress raised the marginal tax rate on the highest earners in January 2013.

• But low-income households face effective marginal tax rates nearly the same as upper income households (30%), according to the Congressional Budget Office. Individuals face high implicit marginal tax rates at lower incomes because of the phase-out of government benefits, which is economically equivalent to taxing the income.

• Similarly, secondary earners - usually married women -- face higher tax rates on their earnings because their entire income gets taxed at a rate that is at least equal to the primary earner's marginal tax rate.

• Taxing income discourages work, thus these individuals are incentivized to stay out of the labor force.

Policy Recommendation: 

A proportional tax system would improve transparency and efficiency by eliminating the variation in marginal and average tax rates within income groups.   It could be made progressive by adding a universal transfer payment or an income exemption.   CLICK HERE TO READ THE ENTIRE PAPER / ARTICLE