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How Federal largesse traps the poor

Welfare, food stamps, the earned income tax credit, and healthcare insurance subsidies are all designed to help the poor and even much of the middle class. But the unintended consequence of these income assistance programs (i.e., transfer payments) is that they make it much harder for people to work their way out of poverty. That's because all that money being handed out has to be taken away as people climb the income ladder, and that has the effect of increasing marginal tax rates.

This chart, courtesy of the Congressional Budget Office, comes from a new study of effective federal marginal tax rates. The top range of each of the bars is the effective marginal tax rate faced by some people in various income groups covering 80% of all taxpayers. Note that some of those making 100-149% of the poverty rate face marginal tax rates of as high as 60%!! If someone at the poverty line wants to work harder, he or she may only be able to keep 40 cents of each additional dollar earned.

On average, the vast majority of workers have effective marginal tax rates of 30%. As Greg Mankiw notes, "In 2014, after various temporary tax provisions have expired and the newly passed health insurance subsidies go into effect, the average effective marginal tax rate will rise to 35 percent." That is almost as much as the marginal tax rates of the rich.

As the chart above shows, average tax rates for the poor are relatively low, with 80% of taxpayers in 2007 paying an effective average tax rate of between 4% and 17%. We do indeed have a very progressive tax code if all you look at are average tax rates (i.e., total taxes divided by income). But it's marginal tax rates which have the greatest impact on incentives, and marginal tax rates are much higher than average rates under a progressive tax system loaded with subsidies. On a marginal basis, our income tax is actually regressive—the poor face marginal tax rates that are much higher than those faced by the rich.

Although the CBO study is an eye-opener, the reality for some people could be even worse. In a post last year, I quoted Daniel Kessler's WSJ article, in which he describes the punitive marginal tax rates (higher than 100%!) that will be faced by some families if ObamaCare is implemented:

Starting in 2014, subsidies will be available to families with incomes between 134% and 400% of the federal poverty line. For example, a family of four headed by a 55-year-old earning $31,389 in 2014 dollars (134% of the federal poverty line) in a high-cost area will get a subsidy of $22,740. A similar family earning $93,699 (400% of poverty) gets a subsidy of $14,799. 
But a family earning $1 more—$93,700—gets no subsidy. Consider a wife in a family with $90,000 in income. If she were to earn an additional $3,700, her family would lose the insurance subsidy and be more than $10,000 poorer.

There is no getting around it: a highly progressive tax system that relies on subsidies and other income assistance for the poor and even upper-middle income earners will inevitably yield very high marginal tax rates. This makes climbing the income ladder more difficult, and effectively "traps" many of the poor. Why work harder if you can only keep a fraction of the extra income?

Greg Mankiw also provides a reasonable solution:

... we could repeal all these taxes and transfer programs, replace them with a flat tax along with a universal lump-sum grant, and achieve approximately the same overall degree of progressivity.

UPDATE: John Cochrane has an excellent post that nicely expands on the issue of how marginal tax rates for the poor have become prohibitively high, with several real-world examples and more charts. Simply put, very high effective marginal tax rates for those on the low end of the income spectrum end up trapping many people in poverty. The Law of Unintended Consequences is very much alive and well.

UPDATE 2: Here is an excellent presentation by Gary Alexander (Secretary of Public Welfare, PA) that illustrates how disastrous our welfare system is. More importantly, however, it also shows how this can be fixed relatively easily. Here are two charts from the presentation that show how welfare programs create "welfare cliffs" that result in marginal tax rates that exceed 100% (translation: many families on welfare find that they are better off working less than working more, since earning more can cause their disposible income to decline). (click to enlarge) HT: Brian McCarthy

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