Thursday, September 4, 2008

How "Tax Cuts for Middle-Class Families" May Actually Mean "Heavier Punishment for Trying to Improve Your Lot"

Here is an example of an economic policy proposal that disrespects the first thing about economics.

My public finance students may remember our lengthy discussion last semester on the subject of marginal versus average tax rates, and how the marginal tax rate on income is the one that can be equated with a disincentive to work more hours or to improve someone's wage rate.

Obama's tax plan, which intends to "cut taxes for middle-class families," may in reality lead to increases in marginal tax rates for these same middle-class families. See this article written by Brill & Viard for details.

Increases in marginal tax rates can be translated in common language this way: (1) you'll receive a heavier punishment for trying to improve your lot; and (2) you may want to consider working less, after all a larger share of your top dollars will now end up in the government's pocket.

This "please don't work" effect doesn't depend on how much income tax you pay. The total value of your income tax payments could decrease under Obama's plan, and yet you may choose to reduce (or not improve) your income because at the margin (for your top dollars) you'll pay more income tax than before.

For example, consider a family with two earners. The one that makes less money may want to give up his or her job. After all, according to Obama's plan, the secondary earner may end up paying up to 45 cents to the government for each extra dollar that is earned -- a strong disincentive to work indeed. The current value is 34 cents, and a sensible tax plan should reduce this excessive amount, not increase it.

As it is, Obama's tax plan would represent a significant step backward in income taxation.

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