Early on in my federal income tax class, I usually spend a bit of time with my students on the idea of the marginal tax rate. The point I stress to them is that even as you earn more money and your tax rate goes up, you still take home more money working an additional hour than not working that hour. I sometimes get the sense many of my students hadn’t understood that prior to my class.
Of course, there’s a caveat to this simple marginal tax story: the high marginal rates that result from cliff effects, particularly those in tax and spending programs aimed at addressing low-income Americans. While I usually talk about these cliff effects when discussing the Earned Income Tax Credit, Manjoj Viswanathan’s recent work reminds me that these income-based cliff effects are pervasive in the Code.
Poverty scholars have long been concerned about the ways the loss of federal benefits can thrust the working poor back into poverty. As readers of this blog know well, even programs like the EITC, which are carefully tailored to encourage work by gradually phasing out the benefit, create cliffs when family structure changes, creating a special marriage penalty for the working poor. Similarly, low-income people with disabilities worry that their eligibility for SSI may be threatened by increasing their work hours.
Viswanathan observes that not all cliff effects are created equal but rather that any bright line rule in the Code can create a cliff effect. Thus, holding period requirements or tax benefits only available to small businesses with less than fifty employees similarly create large differences in tax treatment based on small numerical differences in the days an asset is held or the number of employees a business has. Nevertheless, eliminating all such cliffs would create tremendous complexity. Further, some cliffs may be purposefully designed to encourage changes in behavior. As an example, he considers a proposed sales tax exemption that would apply to all low sugar drinks. Defining low-sugar via a bright line rule of less than one gram per ounce would be “effective because the provision intends to change taxpayer behavior and taxpayer behavior may be extremely responsive to this additional cost.”
The Article suggests that many income-based cliffs are not so carefully targeted, noting that low-income taxpayers may not have the ability to regulate their income in ways that respond to the changing tax incentives. Further, to the extent many of these cliff effects would induce taxpayers to work less that would seem to be an unintended (or at least unavoidable) result of the current policy design. In particular, he looks at the ways the phaseout of subsidies for the Affordable Care Act create cliffs for health insurance costs. For example, households earning less than 400% of poverty are eligible for health insurance, while those subsidies phase out completely for those earning more than 400% of poverty. Viswanathan estimates that for a family of four earning 400% of poverty results in the loss of a premium credit worth an average of approximately $1377. (Of course, on average masks many differences. Because the subsidy is offered to keep the cost of healthcare below a specific percentage of income, in certain low-cost jurisdictions, the subsidy may phaseout due to low premium costs before taxpayers hit the 400% income threshold.)
Viswanathan notes that more gradual phaseouts could reduce the problem of cliff effects, but would not entirely eliminate the problem of high marginal tax rates around the phaseout threshholds. He offers several solutions to this problem including a tax credit designed to prevent the taxpayer from losing post-tax income due to a phaseout and a statutory marginal rate limit. As he writes, “If, for example, this maximum marginal tax rate were 40%, a taxpayer would be assured that any additional income earned would increase her net economic position by at least 60% of the additional income earned.” Of course, a tax credit might create marginal tax rate problems of its own. Viswanathan suggests similar solutions might work with respect to the marginal tax rates imposed by cliffs in eligibility for federal and state poverty programs as well. While both ideas are intriguing, I would not envy the person charged with designing or drafting such legislative provisions.
There’s bipartisan consensus that our poverty programs (including those poverty programs embedded in the tax code) should encourage work, though there’s much debate about the best way to do that. It’s hard to imagine a politician on either side of the political divide providing a full-throated endorsement of cliff effects and marginal tax rates over 100%. Nevertheless, solving these problems would, in many cases, make these programs more expensive and add complexity to the Code. It seems unlikely that expanding these programs is in the cards for the current Congress, but Viswanathan’s ideas are worth noting for those thinking about reforming these programs in the coming years.