Making Taxes Work

Presented by Jon Forman at:Law, Society, and Taxation I:

What is Tax Reform?Law and Society Association

Annual MeetingJuly 7, 2006 Baltimore, MD

This paper draws from: Jon Forman, Making America Work (Urban Institute Press, forthcoming 2006).

2

Summary

• Empirical evidence shows that high tax rates discourage work effort and reduce labor supply

• The tax system should be designed to both minimize work disincentives and promote greater economic justice

• Low marginal tax rates will encourage greater work effort

3

Outline

• Overview of the current tax system• Show how the current tax system imposes relatively

high effective marginal tax rates on earned income• Explains how such high tax rates can discourage

work and work effort • Suggests some modest changes• More fundamental change

– Integrate the current income and Social Security tax systems into a single, comprehensive income tax system

4

Table 1 Federal Revenues by Source, 1940-2011 (Millions of dollars)

Fiscal Year Individual Income

Taxes

Corporate Income

Taxes

Social Insurance

and Retirement

Receipts

Excise Taxes

Other Total Receipts

1940 892 1,197 1,785 1,977 698 6,548

1960 40,715 21,494 14,683 11,676 3,923 92,492

1980 244,069 64,600 157,803 24,329 26,311 517,112

2000 1,004,462 207,289 652,852 68,865 91,750 2,025,218

2005 927,222 278,282 794,125 73,094 81,136 2,153,859

2011 estimate 1,466,869 292,012 1,096,698 83,124 96,158 3,034,861

5

Figure 1 Percentage Composition of Federal Receipts by Source: 1940-2005

0

10

20

30

40

50

60

1940 1950 1960 1970 1980 1990 2000

Year

Perc

ent

Individual Income Tax

Corporation Income Tax

Social Insurance and RetirementReceipts

Excise Taxes

Other

6

Table 2 Standard Deductions, Personal Exemptions,

Income Tax Thresholds, and Tax Rates, 2006 Unmarried Individuals

Married Couples Filing Joint Returns with Two Children

Heads of Householdwith Two Children

Standard deduction $5,150 $10,300 $ 7,550

Personal exemptions $3,300 $13,200 (4 × $3,300)

$ 9,900 (3 × $3,300)

Simple income tax threshold $8,450 $23,500 $17,450

Tax rate (imposed on taxable income): Rate Bracket

10 $0 to $7,550 $0 to $15,100 $0 to $10,750

15 $7,550 to $30,650 $15,100 to $61,300 $10,750 to $41,050

25 $30,650 to $74,200 $61,300 to $123,700

$41,050 to $106,000

28 $74,200 to $154,800

$123,700 to $188,450

$106,000 to $171,650

33 $154,800 to $336,550

$188,450 to $336,550

$171,650 to $336,550

35 Over $336,550 Over $336,550 Over $336,550

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Figure 2 Earned Income Credit Amounts Available to Married Couples in 2006

$412

$2,747

$4,536

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$0 $10,000 $20,000 $30,000 $40,000

Earned income

Am

ount

of

the

cred

it

Married Couple with No Children Married Couple with 1 child Married Couple with 2 or More Children

slope = -.2106

slope = -.1598

slope = -.0765

slope = .40

slope = .34

slope = .0765

8

Figure 3 U.S. Payroll Tax Rates: Selected Years

0

2

4

6

8

10

12

14

16

18

20

1940 1960 1980 2006

Year

Per

cent

pai

d jo

intl

y by

em

ploy

ee a

nd e

mpl

oyer

Medicare

Social Security

9

Figure 4 Effective Marginal Income Tax Rates on Married Couples with Two Children and Earned Income Only, 2006

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

$0 $50,000 $100,000 $150,000 $200,000 $250,000

Earned income

Eff

ecti

ve ta

x ra

te (

perc

enta

ge)

Effective Marginal TaxRate

10

Figure 5 Social Security: Effective Marginal Tax Rates on Earned Income, 2006

15.3%

2.9%

0%

10%

20%

30%

40%

$0 $50,000 $100,000 $150,000 $200,000 $250,000

Earnings

Mar

gina

l tax

rat

e (p

erce

ntag

e)

Effective Marginal Tax Rate

11

Figure 6 Combined Effective Marginal Tax Rates (income and payroll taxes), Married Couples with Two Children and Earned Income Only, 2006

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

$0 $50,000 $100,000 $150,000 $200,000 $250,000

Earned income

Eff

ecti

ve ta

x ra

te (

perc

enta

ge)

Effective Marginal TaxRateLinear Trendline

12

Figure 7 Combined Effective Marginal Tax Rates (income and payroll taxes), Heads of Household with Two Children and Earned Income Only, 2006

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

$0 $50,000 $100,000 $150,000 $200,000 $250,000

Earned income

Eff

ecti

ve ta

x ra

te (

perc

enta

ge)

Effective Marginal TaxRateLinear Trendline

13

Figure 8 How a 30 Percent Payroll Tax Can Reduce Work Effort

$0

$5,000

$10,000

$15,000

$20,000

$25,000

05001000150020002500Hours of work

Inco

me

afte

r ta

x

Income $10/hour

Income after Tax

Utility curve 1

Utility curve 2

(After tax: 1,750 hours, $12,500/year)

(Before tax: 2,000 hours, $20,000/year)

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Table 3 Poverty Levels and Net Federal Tax Thresholds After Tax Credits in 2006, for

Selected HouseholdsUnmarried Individual

Married Couple with No Children

Single Parent with 2 Children

Married Couple with 2 Children

Poverty Levels $ 9,800 $13,200 $16,600 $20,000

Simple income tax threshold (before credits)

8,450 16,900 17,450 23,500

Income tax threshold after the earned income and child tax credits

10,043 16,900 35,524 41,867

Social Security tax threshold

0 0 0 0

Combined income and Social Security tax threshold (i.e., net federal tax threshold)

5,380 5,380 24,590 32,101

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Figure 9 Hypothetical $2,000 per Worker Earned Income Tax Credit, With or Without a Phase-out

$2,000

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$0 $10,000 $20,000 $30,000 $40,000 $50,000 $60,000 $70,000

Earned income

Am

ount

of

the

cred

it

Universal $2,000 per Worker Credit

$2,000 per Worker Credit with Phase-out

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Figure 10 Universal Grants Result in Only Modest Reductions in Work Effort,Parent with Two Children ($2,000 per Person Universal Grants)

$0

$2,500

$5,000

$7,500

$10,000

$12,500

$15,000

$17,500

$20,000

05001000150020002500

Hours of work

Pos

t-tr

ansf

er in

com

e

Pre-transfer earnings at $5/hour

Income after Transfer

Utility curve 1

Utility curve 2

(1,400 hours, $13,000post-transfer income)

(1,500 hours, $7,500pre-transfer earnings)

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Figure 11 How a Simple Tax and Universal Grant System Would Affect a Single Parent with Two Children ($2,000 Universal Grants and 10, 20, and 30 Percent Tax Rates)

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$0 $50,000 $100,000 $150,000 $200,000 $250,000

Pre-transfer earnings

Pos

t-ta

x, p

ost-

tran

sfer

inco

me

Pre-transfer EarningsPost-tax, Post-transfer Income

18

Figure 12 Effective Marginal Tax Rates for a Parent with Two Children and Earned Income Only in a World of Universal Grants ($2,000 Universal Grants and 10, 20, and 30 Percent Tax Rates)

0%

10%

20%

30%

40%

50%

60%

$0 $50,000 $100,000 $150,000 $200,000 $250,000

Earned income

Mar

gina

l tax

rat

e (p

erce

ntag

e)

Effective Marginal Tax Rate

Linear Trendline

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Table 4 How an Integrated Tax and Transfer System Would Affect a Single Parent with Two Children

($2,000 Universal Grants, $2,000 per Worker Credits, and 20 and 35 Percent Tax Rates)

Pre-transfer

Earnings

plus Universal

Grants

plus Worker Credit

less Tax Imposed

Equals After-tax Income

0 $6,000 0 0 $6,000

$5,000 $6,000 $1,000 $1,000 $11,000

$10,000 $6,000 $2,000 $2,000 $16,000

$20,000 $6,000 $2,000 $4,000 $24,000

$30,000 $6,000 $2,000 $6,000 $32,000

$40,000 $6,000 $2,000 $8,000 $40,000

$50,000 $6,000 $2,000 $10,000 $48,000

$100,000 $6,000 $2,000 $27,500 $80,500

$150,000 $6,000 $2,000 $45,000 $160,000

$200,000 $6,000 $2,000 $62,500 $145,500

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Figure 13 How an Integrated Tax and Transfer System Would Affect a Single Parent with Two Children ($2,000 Universal Grants, $2,000 per Worker Credits, and 20 and 35 Percent Tax Rates)

$0

$25,000

$50,000

$75,000

$100,000

$0 $25,000 $50,000 $75,000 $100,000

Pre-transfer earnings

Pos

t-ta

x, p

ost-

tran

sfer

inco

me

Pre-transfer Earnings

Post-tax, Post-transfer Income

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Conclusion• An integrated tax system would be simpler to

administer than the current system• It would both minimize work disincentives and

promote greater economic justice than the current system.

• Low- and moderate-income individuals would have every incentive to get out there and work

• Even high-income individuals would face smaller work disincentives

• In short, this approach would make taxes work