There are too many hidden "tax rates" in the welfare system

By one scholar's estimates, they can get as high as 103 percent.

By Alan Cole of Full Stack Economics. Excerpt:

"One feature of public welfare policy in almost every economy is that the better you do, the more public support is taken away. While this helps contain costs, it can also make people feel like they're being punished for doing the right things, and even disincentivize them from doing those things. Last week, I discussed the issue in the context of disabled Americans on Supplemental Security Income and Medicaid.

But that’s a narrow example focused on a specific program. For a more general look at this issue, I highly recommend a report recently published by Ed Dolan of the Niskanen Center. He explains how policies interact with each other to create much greater effects in tandem than they do individually.

When a benefit is withdrawn as income increases, Dolan calls that a benefit reduction rate (BRR). And when he adds together all the phaseouts and tax rates that would apply to someone with that income level, he calls it an effective marginal tax rate (EMTR).

Benefit phaseouts might not seem like taxes to you⁠. After all, the government is paying money out, not taking it in⁠. But they have a similar property to taxes: for every additional dollar you earn, you end up with less than a dollar in extra income or benefits—potentially a lot less.

Dolan uses the concept of EMTRs to illuminate serious and unaddressed problems with our existing bundle of welfare benefits. And he argues that neither side of the political aisle is working well to solve the problem of EMTRs.

"Poverty advocates don't pay much attention to it,”  Dolan told me. Meanwhile, “conservatives don't have the right answer” because “they think the solution is work requirements or other punitive measures."

Ultimately, neither the left or the right even identifies the problem head-on: that there are many working people with low incomes and high effective marginal rates⁠—meaning that efforts to improve at their jobs and earn promotions or raises go unrewarded.

The 103 percent tax rates

Shockingly, Dolan found that a hypothetical family in the Boston area, with an adult and two children, could have an EMTR of over 103 percent. This family actually loses so much social support, for each dollar earned, that it becomes worse off as it increases its market income from $22,000 to $44,000. Dolan calls this income range, which lands between 100 and 200 percent of the poverty line, the “near-poor,” and he finds that, in general, EMTRs hit the near-poor hardest.

Let’s start with the Earned Income Tax Credit (EITC): at $22,000 of earned income, Dolan’s hypothetical family would earn the maximum EITC benefit ($6,164 in 2022.) However, this benefit phases out at a rate of 21.06 percent for each dollar earned after $20,130. The phaseout would be in effect all the way from $22,000 to $44,000, clawing back about $4,633 over that range. So $22,000 in extra earnings is whittled down to $17,367 once you factor in the EITC phaseout. A payroll tax rate of 7.65% takes another $1,683, reducing the total to $15,684.

And that’s just the tax system. The family is likely to lose Supplemental Nutrition Assistance Program (SNAP) benefits over that income range, and see its Section 8 housing vouchers and Child Care and Development Fund (CCDF) subsidies decline. Finally, it will lose Medicaid and instead go to the individual insurance exchanges from the Affordable Care Act, whose subsidies also phase out with income.

Put it all together, Dolan says, and earning $22,000 in additional market income actually costs this hypothetical family $22,624 in taxes and lost benefits, leaving them $624 poorer: “after taxes and transfers, the annual net income for this family actually falls a bit, from $87,686 to $87,062, as earned income increases from $22,000 to $44,000.”

There are caveats here: this family is atypical, and it requires a confluence of programs that are far from universal. Policies like Temporary Assistance for Needy Families (TANF) or Section 8 housing vouchers, or Child Care and Development Fund (CCDF) subsidies, aren’t used by many, or even most, of the people in the income brackets they’re intended to serve.

But the broader point remains even in the absence of the less-used programs. Even when Dolan looks at a more typical Boston family in that range, he still finds an 87 percent EMTR in that range from more universal programs alone. In a conversation with me, Dolan described this as a “danger zone,” where multiple programs⁠—like the EITC and SNAP, both broadly used⁠—phase out simultaneously. The EMTR is further worsened by payroll taxes, and in many cases, a phaseout of health care subsidies.

The key insight of Dolan’s report is that too many phaseouts have been jammed into the same zone just above the poverty line. Different programs are “all designed in silos,” Dolan says. “Nobody seems to have thought about the way they interact with other programs, and as a result you get these very severe cumulative effects.”"