Progressives' Desires to Help the Poor Will End Up Hurting Them Instead

However, by expanding public assistance programs, the President’s plan will unavoidably impose a higher, hidden tax rate—known as an “implicit marginal income tax rate” (which we shorten to implicit tax rate)—on low-wage workers who receive welfare benefits. Those workers will pay an implicit tax rate because many welfare benefits are reduced as earnings rise. Ironically, the poorest Americans often pay implicit tax rates that are far higher than the IRS’s explicit marginal income-tax rates imposed on the country’s highest income earners.

Our analysis shows that making these changes in welfare policy will lead to a two-fold challenge that will have to be acknowledged. First, as welfare benefits go up with added programs and higher funding levels, the implicit tax rate facing low-wage workers will go up, because more benefits will be cut as earnings rise. The higher implicit tax rates will undermine low-wage workers’ incentives to work and search for higher paying jobs. In many cases, their implicit tax rate will exceed 100 percent, erasing all incentives to work, because their lost benefits will be greater than their additional earnings.

Second, if the administration attempts to moderate the rise in low-wage workers’ implicit tax rates, welfare benefits can be expected to be extended to a larger group of workers with higher incomes, including many workers in middle-class households. This means more Americans will face the implicit tax rates on higher earnings, which will impair their incentives to climb the economic ladder.

The Plan to Expand Welfare Programs

With considerable encouragement from progressive members of Congress, President Biden is seeking an increase in welfare expenditures over the next decade reaching into the trillions of dollars (with the number of trillions under heated debate at this writing). If the plan passes Congress, hundreds of billions of additional tax (and likely deficit) dollars will be distributed among a variety of new and expanded federally funded social programs, including two years of free preschool, paid worker leave for a variety of family problems, subsidized childcare, two years of free community college, expanded food subsidies, additional free school lunches, and a higher and permanent child tax credit, along with additional healthcare benefits.2

The President seeks to partially finance the added welfare spending by raising the top IRS-leveled explicit marginal income tax rate to 39.6 percent from 37 percent, increasing the corporate profits tax to 28 percent from 23 percent, raising the tax rate on capital gains and inheritances to 61 percent, and applying the 12.4 percent (combined employee and employer) Social Security tax to incomes above the current $400,000 cap. President Biden has repeatedly stressed that if Congress passes his American Families Plan, no American making less than $400,000 will pay “one single penny in additional federal taxes.”3 While that may be technically true, an expansion in welfare benefits will unavoidably lead to hikes in low-wage workers’ already high implicit tax rates.

The Implicit Marginal Tax Rate on Low-Income Groups

How do no-income and low-income Americans pay “taxes” when they are welfare beneficiaries? Very simply. Public assistance programs are “means tested,” structured to target households below certain income thresholds. The level of benefits a beneficiary receives under a given program falls at some rate as earned income rises, eventually reaching zero dollars in benefits.

Consider a household that receives benefits from only two welfare programs, with one tapering off at 20 cents for each added dollar earned and another tapering off at 40 cents for each added dollar earned. Those cuts create an implicit tax rate of 60 percent, which means the worker has only 40 cents in additional spendable income for each added dollar earned. This implicit tax rate can be expected to affect work incentives in much the same way that a federal income tax rate does.

To further illustrate, consider a real-life, low-income single mother of two children in Forsyth County, North Carolina earning $10 an hour in a full-time job, which means she has a monthly earned income of $1,600 (or $19,200 annually). Suppose the single mother receives monthly benefits from five welfare programs: $425 in food stamps, $1,471 in subsidized childcare, $370 in housing subsidies, $180 in WIC benefits, and $493 in an earned income tax credit (EITC). Her monthly welfare benefits will total $2,939 (or $35,271 a year).

Now, suppose the single mother takes a new job paying $15 an hour, a 50 percent increase. Her monthly earned income will rise by $800 to $2,400 (with her annual income rising to $28,800 a year, an annual earnings increase of $9,600). However, she will face decreases in four out of her five monthly benefit streams, with each benefit reduction based on the same $800-increase in earnings (a problem known among welfare researchers as the “cumulative stacked effect”). The single mother will lose $231 in food stamps, $80 in childcare benefits, $216 in housing benefits, and $166 in EITC. Her total decrease in monthly benefits will reach $694 (which means her annual benefit total will drop by $8,328).4 Her implicit tax rate on her added monthly earnings of $800 is 87 percent—more than two times the highest explicit marginal tax rate proposed for the rich. (The details of our calculations are in a table we have appended to the end of this article.)

In addition, the single mother will be required to pay an added $185 a month in federal and state income taxes on her added earned monthly income of $800, which is an explicit tax rate of 23 percent. Adding the 87 percent implicit tax rate to the 23 percent explicit tax rate leads to an overall tax rate of 110 percent. Her raise has left her $79 per month poorer in lost wages and benefits—surely a strong disincentive for her to take the higher paying job.5

But the total (implicit plus explicit) marginal tax rate on poor and low-income workers can be worse, and actually spikes to 1,400 percent at an earned income of around $43,000 (which is known as the “welfare cliff”).6 However, studies in different areas of the country show that the total marginal tax rate on poor and low-income workers within an annual earned-income range of $15,000 to $80,000 moves between 28 and 53 percent for full-time workers earning up to an annual earnings of $24,000 (or $12.50 an hour). The implicit tax rate for workers earning between $24,000 and $40,000 jumps to 90 percent.7

Why Welfare Increases Can Lead to Expanded Coverage of Low-Wage Workers

In addition to raising the implicit marginal tax rates on welfare beneficiaries, the added welfare programs and funding levels will likely be extended to cover American workers who earn significantly more than those in the poor and low-income classes, possibly including middle-income (and possibly higher income) workers—for reasons we explain with a simple graph.

To see how expanded welfare benefits can increase beneficiaries’ implicit tax rates on earned income, consider Figure 1, which has earned income on the horizontal axis and spendable income (earned income plus welfare benefits) on the vertical axis.

The 45-degree line that extends from the graph’s origin indicates points of equal distance from each axis, which means that the line represents points at which spendable income equals earned income (meaning no benefits are received). At point y, for example, a person earns and spends $5,000 annually. At points above the line, spendable income exceeds earned income.

Suppose the government establishes a welfare program under which a poor person earns nothing but receives $5,000 a year in subsidies across several welfare programs, or SI₁ on the vertical axis. If everyone (without regard to their earned income) receives the benefit, the points of spendable income would be a line (not shown) parallel to the 45-degree line, starting at SI₁. Importantly, there would be no implicit tax rate because the $5,000 in benefits would not decrease with earned income. However, such a welfare benefit would be very expensive since even billionaires would receive it (which means the never-decreasing benefit would likely receive little to no political support).

Added Welfare Benefits and the Implicit Marginal Tax Rate

In a more realistic case shown in the figure, the individual earning zero dollars and receiving a benefit of $5,000 a year (SI₁) will see the benefits decline by $500 for each additional $1,000 in earned income, represented by line SI₁a. Benefits end where SI₁a crosses the 45 degree line, which is at an earned income of $10,000. The individual in this circumstance would encounter an implicit tax rate of 50 percent, graphically illustrated by the slope of SI₁a.

If policy makers want to reduce the implicit tax rate on an earned income of $10,000 to less than 50 percent, they must increase the slope of SI₁a, which means that either the $5,000 benefit at zero earned income must be reduced or the break-even earned-income level must be raised, which means income earners above $10,000 would receive benefits. If the benefits are reduced to $3,000 at zero earned income, or to SI₂, but the break-even, earned-income level remains at $10,000, the implicit tax rate goes down to 30 percent (monthly welfare benefits would have to be reduced by only $300 a month for each additional $1,000 in monthly earnings to reach zero at $10,000 of earned income). However, that reduction in the disincentive to work and earn income comes with a reduction in the total welfare benefit going to the beneficiaries by the area bounded by SI₁aSI₂.

Extending the Benefits to Higher Income Earners

If the break-even earned-income is raised from $10,000 to, say, $15,000, or to EI₂, the line SI₁a will shift to SI₁b, resulting in an increase in the slope and, as before, a reduction in the implicit (marginal) tax rate, which will translate into an increase in initial beneficiaries’ after-tax incentives to earn additional income. However, more workers—all those with annual earned incomes between $10,000 and $15,000—will become beneficiaries and will face the same implicit tax rate (added to their explicit marginal tax rate) that all lower-income beneficiaries face.

For example, a person with an earned income of $5,000 will now have $8,000 instead of $7,000 in spendable income (point z instead of point x). The total increase in the government’s transfer expenditures would equal the shaded area in the figure bounded by SI₁ab, approximately half of which would go to previously uncovered beneficiaries, those with $10,000-$15,000 in earned income.

The increase in the break-even earned-income level would lower the implicit tax rate on the initial low-income beneficiaries (with earnings of up to $10,000) but would impose an implicit tax rate on those not originally covered (with earnings between $10,000 and $15,000), which will hike their total tax rate (implicit plus explicit) and their disincentives to earn additional income. Yet because more workers would be beneficiaries, fewer workers with earned income would share the welfare-induced added explicit tax burden. Thus, the explicit marginal tax rate on high-income workers could rise, further lowering their incentives to work and earn additional income.

Policy Tradeoffs

Our line of argument reveals the difficult (but largely unacknowledged) trade-offs policy makers unavoidably face when seeking to achieve the twin intertwined goals of helping poor and low-income Americans while minimizing their disincentives to earn additional income. To provide additional aid to low-income groups and contain their disincentives to work and earn additional income, policy makers must consider raising the break-even income level to cover workers not previously entitled to benefits.

Our analysis suggests a lesson that needs to be absorbed by well-meaning administration officials and their Congressional supporters: There are economic (incentive-based) as well as altruistic limits to the government’s ability to transfer income from well-off taxpayers to the deserving poor.

Conclusion

The American Families Plan has been criticized for extending various welfare benefits (for example, preschool, childcare, and free lunches) to people in the middle and higher-income classes. (A single head of a household earning up to $75,000 in income and a couple earning up to $150,000 are, as we write, eligible for a federal monthly per-child benefit of up to $300.) Critics have stressed that the administration’s goal is to institutionalize cradle-to-grave dependence in the country. Maybe so, but we suggest that the critics have missed our central point: The extension of benefits to Americans previously not entitled to welfare benefits has been pressed by the need to moderate the increase in poor and low-income households’ already high implicit marginal tax rates and, thereby, their disincentives to work harder and smarter and to find higher paying jobs.

The table was produced using CSEM’s user-friendly social benefits calculator, developed in conjunction with Forsyth Futures, and is available for the public to produce any number of different scenarios for Forsyth County, North Carolina. Future versions will include more locations in the United States.

Footnotes

[1] Fact Sheet: The American Families Plan. Available online at https://www.whitehouse.gov/briefing-room/statements-releases/2021/04/28/fact-sheet-the-american-families-plan/.

[2] For a brief discussion of the Biden administration’s proposed expansion in federal welfare programs, see Elizabeth Bauer, 2021. “7 Exorbitant Welfare Proposals Packed Into Biden’s ‘American Family Plan,'” The Federalist, May 3.

[3] Geoff Earle, 2021. “Biden Says Americans Earning Less Than $400,000 Will ‘Not Pay a Single Penny in Taxes,'” Daily Mail, May 3.

[4] The calculations for the implicit marginal tax rate are done as follows: (1-(net change in income + net change in benefits)/net change in income) * 100. Using figures from the table 1 in the Appendix, (1 – (800 – 694)/800) * 100 = 87%. For the explicit tax rate, the formula is nearly the same: (1- (net change in income – net change in taxes)/net change in income) * 100, or (1 – (800-185)/800) * 100 = 23%. Adding the two together yields an overall tax rate (implicit + explicit) of 110% in this example.

[5] These figures were created by the Social Mobility Calculator, through the Center for the Study of Economic Mobility at Winston Salem State University, in partnership with Forsyth Futures. The interactive tool is accessible at https://www.forsythfutures.org/benefits-calculator-intro/.

[6] Craig Richardson and Zachary Blizard, “Benefits Cliffs, Disincentive Deserts, and Economic Mobility” in Journal of Poverty (January 2021). Available at: https://www.tandfonline.com/doi/abs/10.1080/10875549.2020.1869665.

[7] Randy Albelda and Michael Carr, “Between a Rock and a Hard Place: A Closer Look at Cliff Effects in Massachusetts.” UMass Boston Center for Social Policy. Available at: https://www.umb.edu/editor_uploads/images/centers_institutes/center_social_policy/Rock_and_a_Hard_Place_Sept_2016.pdf. PDF file.