Marginal Tax Rates
By Alan Reynolds
The marginal tax rate is the rate on the last dollar of income earned. This is very different from the average tax rate, which is the total tax paid as a percentage of total income earned. In 2003, for example, the United States imposed a 35 percent tax on every dollar of taxable income above $155,975 earned by a married taxpayer filing separately. But that tax bracket applied only to earnings above that $155,975 threshold; income below that cutoff point would still be taxed at rates of 10 percent on the first $7,000, 15 percent on the next $14,400, and so on. Depending on deductions, a taxpayer might pay a relatively modest average tax on total earnings, yet nonetheless face a 28–35 percent marginal tax on any activities that could push income higher—such as extra effort, education, entrepreneurship, or investment. Marginal decisions (such as extra effort or investment) depend mainly on marginal incentives (extra income, after taxes).
The seemingly arcane topic of marginal tax rates became the central theme of a revolution in economic policy that swept the globe during the last two decades of the twentieth century, with more than fifty nations significantly reducing their highest marginal tax rates on individual income (most of which are shown in Table 1). Tax rates on corporate income (not shown) were also reduced in most cases (e.g., to 12.5 percent in Ireland). Table 1 also shows, however, that a handful of countries did comparatively little to reduce the highest, most damaging tax rates—notably, most of Western Europe, Scandinavia, Canada, and Japan.
Why did so many other countries so dramatically reduce marginal tax rates? Perhaps they were influenced by new economic analysis and evidence from optimal tax theorists, new growth economics (see economic growth), and supply-side economics. But the sheer force of example may well have been more persuasive. Political authorities saw that other national governments fared better by having tax collectors claim a medium share of a rapidly growing economy (a low marginal tax) rather than trying to extract a large share of a stagnant economy (a high average tax). East Asia, Ireland, Russia, and India are a few of the economies that began expanding impressively after their governments sharply reduced marginal tax rates.
|*. Hong Kong’s maximum tax (the “standard rate”) has normally been 15 percent, effectively capping the marginal rate at high income levels (in exchange for no personal exemptions).|
|**. The highest U.S. tax rate of 39.6 percent after 1993 was reduced to 38.6 percent in 2002 and to 35 percent in 2003.|
|Trinidad and Tobago||70||35||35|
|Source: PricewaterhouseCoopers; International Bureau of Fiscal Documentation.|
Economic Growth by Robert J. Barro and Xavier Sala-i-Martin (MIT Press, 2004, p. 514) lists among the world’s twenty fastest-growing economies Taiwan, Singapore, South Korea, Hong Kong, Botswana, Thailand, Ireland, Malayasia, Portugal, Mauritius, and Indonesia. As Table 1 shows, all these countries either had low marginal tax rates to begin with (Hong Kong) or cut their highest marginal tax rates in half between 1979 and 2002 (Botswana, Mauritius, Singapore, Portugal, etc.). This might be dismissed as a remarkable coincidence were it not for a plethora of economic studies demonstrating several ways in which high marginal tax rates can adversely affect economic performance.
Numerous studies, ably surveyed by Karabegovic et. al. (2004), have found that high marginal tax rates reduce people’s willingness to work up to their potential, to take entrepreneurial risks, and to create and expand a new business: “The evidence from economic research indicates that … high and increasing marginal taxes have serious negative consequences on economic growth, labor supply, and capital formation” (p. 15).
Federal Reserve Bank of Minneapolis senior adviser Edward Prescott, corecipient of the 2004 Nobel Prize in economics, found that the “low labor supplies in Germany, France, and Italy are due to high [marginal] tax rates” (Prescott 2004, p. 7). He noted that adult labor force participation in France has fallen about 30 percent below that of the United States, which accounts for the comparably higher U.S. living standards.
Even in the United States, marginal tax rates are really higher than statutory rates suggest. In a study aptly titled “Does It Pay to Work?” Jagadeesh Gokhale et al. (2002) include state and local taxes, the marginal impact of losing government benefits (such as Medicaid and food stamps) if income rises, the progressive nature of Social Security benefits (which are least generous to those who work the most), and the phasing out of deductions and exemptions as income rises. They conclude that even “those with earnings that exceed 1.5 times the minimum wage face marginal net taxes on full-time work above 50 percent” (Abstract). At higher incomes, the estimated federal, state, and local marginal tax rate is about 56–57 percent. Marginal tax rates are higher still, however, in countries where statutory rates are higher.
Lifetime family work effort and entrepreneurship are not the only things affected. Nobel laureate Robert Lucas emphasized the deleterious effect on economic growth of high tax rates on capital. Philip Trostel focused on the impact on human capital, finding that high marginal tax rates on labor income reduce the lifetime reward from investing time and money in education. There are evidently many channels through which high marginal tax rates may discourage additions to personal income, and thus also discourage marginal additions to national output (i.e., economic growth). As the variety among these studies suggests, each separate effect of high marginal tax rates is typically examined separately, which makes the overall economic distortions and disincentives appear less significant than if they were all combined.
Despite widespread reduction of marginal tax rates throughout the world, there remains considerable misunderstanding about what marginal tax rates are and why they matter. The common practice of measuring tax receipts as a percentage of GDP, for example, is too static. It ignores the destructive effects of tax avoidance on tax revenues, the numerator of that ratio, and on the growth of GDP, the denominator. A sizable portion of productive activity may cease, move abroad, or vanish into inefficient little “informal” enterprises. And just as so-called tax havens attract foreign investment and immigrants, countries in which the combined marginal impact of taxes and benefits is to punish success and reward indolence often face “capital flight” and a “brain drain.”
OECD in Figures (2003) shows total taxes as 45.3 percent of GDP in France, compared with 29.6 percent in the United States. But it would be a mistake to conclude that the higher average tax burden in France is a result of that country’s more steeply graduated income tax. French income tax rates claim half of any extra dollar at incomes roughly equivalent to $100,000 in the United States, and exceed the highest U.S. tax rates at even middling income levels. Yet these high individual income taxes account for only 18 percent of revenues in France, about 8.2 percent of GDP, while much lower individual income tax rates in the United States account for 42.4 percent of total tax receipts, or 12.5 percent of GDP. Countries such as France and Sweden do not collect high revenues from high marginal tax rates, but from flat rate taxes on the payrolls and consumer spending of people with low and middle incomes. Revenues are also high relative to GDP partly because private GDP (the tax base) has grown unusually slowly, not because tax revenues have grown particularly fast.
People react to tax incentives for the same reason they react to price incentives. Supply (of effort and investment) and demand (for government transfer payments) respond to marginal incentives. To increase income, people may have to study more, accept added risks and responsibilities, relocate, work late or take work home, tackle the dangers of starting a new business or investing in one, and so on. People earn more by producing more. Because it is easier to earn less than to earn more, marginal incentives matter.
To the extent to which a country’s tax system punishes added income with high marginal tax rates, it must also punish added output—that is, economic growth.