The Folly of Obsessing over Marginal Tax Rates
It’s often wise to pay more attention to marginal tax rates than to average tax rates. If you can make your first $100 tax free but the 101st dollar is taxed at a marginal rate of 99% you’ll probably decide to earn $100 at most.
But what is marginal? When it comes to career choices or the state you’ll live in or whether to have an extra child the marginal decision is very big, and a rational person will base that decision mostly on the average long run costs and benefits. In cases like this, the official marginal tax rate won’t matter nearly as much as the long run average tax rate.
This isn’t just a theory: It appears to be true for that most economistic of organizations, the multinational corporation. When multinationals are deciding which country to invest in, they don’t pay that much attention to marginal tax rates. According to Glenn Hubbard,
…investment location decisions are more closely related to average rather than marginal tax rates.
When making the go/no-go decision, corporations care more about their long run tax bill. That’s because the marginal decision is the go/no-go decision.
This matters for the current debate over taxes on high earners. Speaker Boehner is open to raising taxes on the rich as long as it raises average rates not marginal rates. But when people are deciding whether to become medical doctors or mere professors, lawyers or struggling novelists, entrepreneurs or Xbox champions, these go/no-go decisions will be shaped by the average tax rate that the rich will have to pay for decades to come.
Why did the 90% marginal tax rates of yesteryear have so little apparent impact on labor supply? I suspect part of the reason is because of the unlimited home interest deduction that used to be in the tax code: You knew that if you doubled your salary you’d move into a bigger house pretty soon, consuming much of your extra income tax free in the form of housing.
That’s just a case of applying Hubbard’s idea: the marginal tax rate didn’t matter when you chose your career, but the average tax rate–after deductions–mattered enormously.
In the long run we should worry more about average tax rates.