Marginal Tax Rates and Cash Assistance

Michael Lewis

I recently attended the 21st Annual Basic Income Conference, which was held in Chicago, Illinois. While there, I moderated a panel on universal vs. targeted cash benefits. One of the presentations on that panel was focused on the crucial topic of marginal tax rates (MTRs). As I watched that presentation, it occurred to me that a more conceptual, less mathematical (other than basic arithmetic) presentation of MTRs might complement the way this topic was presented on that panel. That’s what I’m going to try to do in this post. Let’s start with what economists mean by “marginal.”

To understand what economists mean by this term, consider the seemingly unrelated topic of speed. When we say that a car is traveling at 50mph, we’re talking about how the distance the car is traveling changes as time changes; that is, for each hour that passes, the car has traveled a distance of 50 miles. Put a little differently, 50mph is the change in distance for each hour change in time.

Now there are many things in the world which change as some other thing changes. Our heights change as our ages change. If we’re climbing a tall mountain, the amount of oxygen in the air changes as our elevation changes. Thinking about the covid mess that’s been on many of our minds over the past few years, once someone gets infected, the number of viral particles in their body changes as time changes. In economics, changes that occur in one thing as some other thing changes are referred to as “marginal _______ .” The blank in the previous sentence stands for whatever change economists are interested in.

Even though they don’t focus much on the above types of examples, to economists, these would be examples of marginal height, marginal oxygen level, and the marginal number of viral particles. A marginal tax rate is also a change in something as something else changes; specifically, it’s the change in the amount owed in taxes as one’s income changes by one dollar (or one unit of any given currency).

For example, the U.S. federal government compiles tax tables that can be used to determine what one owes in taxes. The 2023 tax table tells us that, ignoring any tax breaks they may be entitled to, a single person whose income is between $0 and $11,000 inclusive would owe 10% of each dollar they receive as income in taxes. In other words, for each dollar they receive (a change in their income by one dollar), the amount they owe in taxes would increase by (that is, change by)10% or 10 cents. This means that if they make $11,000, they would owe $1,100 in taxes. This can be seen by multiplying $1*.10*11,000, which equals $1,100. So, the marginal tax rate faced by someone whose income falls between $0 and $11,000 inclusive is .10 or 10%. An obvious question to raise is why economists care about marginal tax rates.

The main reason they care about this is because something else they care a lot about is labor supply. That is, they care a lot about how many hours of their capacities to work people choose to sell to employers. The marginal tax rate people face influences how much labor they choose to supply. This is because the marginal tax rate determines how much of each dollar one earns actually ends up as take-home pay; the higher the marginal tax rate one faces, the less one ends up with as take-home pay, and the less that work pays. This can cause a person to supply less labor or, more colloquially, to work less. How does all this relate to cash assistance programs?

Many cash assistance programs are means-tested. For example, both the Temporary Assistance for Needy Families (TANF) Program and the Supplemental Nutrition Assistance Program (SNAP) are means-tested. To determine eligibility, means-tested programs set income or asset thresholds. To qualify for a means-tested program, one’s income or the value of one’s assets must be below a certain level. If we’re trying to calculate the marginal tax rate faced by a recipient of a given means-tested program, things get slightly more complicated.

This is because, as economists see it, if one receives benefits from a means-tested program and that person takes a job, there are two components of the marginal tax rate they would face: 1) the change in their tax bill for each dollar they earn and 2) the change in the amount of the means-tested benefit they receive for each dollar they earn. For example, suppose someone receives $5,000 in benefits from some means-tested program, and that only people with incomes below $10,000 qualify for this benefit. That is, anyone whose income is less than $10,000 is eligible for this $5,000 cash allotment, but anyone whose income goes one cent or more above $10,000 loses the entire $5,000 benefit. Let’s suppose that our recipient of the $5,000 grant has no other income and receives no other government benefits. (this is to keep the arithmetic simple).

Suppose our $5,000 recipient takes a job earning $11,000 per year. We saw above that because of the 10% MTR on their income, this person would owe $1,100 in taxes. But now we also have to consider that by earning $1,000 more than the $10,000 means-test threshold; they’ll lose $5,000 in benefits. Now let’s do some arithmetic.

By taking a job, they earn $11,000 but lose $1,100 + $5,000 = $6,100. So, their net income is only $4,900, exactly $100 less than it was before. To determine the MTR this person

faces, we divide $6,100 by $11,000 and obtain a marginal tax rate of about 55%. As I said earlier, this MTR leaves this person $100 poorer than they were before; that is, choosing to work had made them worse off than they were when they remained home and received $5,000. In fact, this MTR is higher than the 37% faced by people with earnings above about $578,000 (https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets).

Now this example was based on a made-up means-tested program because I thought the arithmetic would be easier to grasp. But the concept applies to means-tested programs which currently exist, such as TANF and SNAP, as well as to ones that might exist, such as a means-tested or income-targeted guaranteed income program. When trying to assess the marginal tax rates recipients of any means-tested benefit face, should they choose to work, we must look at both the taxes they have to pay and any means-tested benefits they lose. We then add the taxes they owe to the benefits they lose and divide this by their earnings from work. The result of this calculation is their MTR.

The fact that means-tested programs can leave recipients facing large MTRs is something supporters of means-tested programs, including targeted forms of guaranteed income, should keep in mind. It would be a shame if some well-intended, targeted guaranteed income program left recipients facing higher marginal tax rates than Jeff Bezos does.

Note: My calculations assume that the average tax rate (amount owed in tax divided by income) equals the marginal tax rate, which would only be true in a flat or proportional tax system. However, even in a progressive tax system, like the one in the U.S., any loss in government cash benefits would make the actual marginal tax rate higher than the statutory one.