What the fiscal cliff means for the next dollar you earn

October 11, 2012

Laura Fritz, 27, fills out a form for government assistance in Lakewood, Co. (Kristen Wyatt -- Associated Press)

Everyone knows that the fiscal cliff means a big tax increase. The Tax Policy Center puts the number at $755 for a family in the middle-income quintile.

But what's arguably more important than the cliff's effect on the average tax rates that families pay is what it does to their marginal tax rates. Think of it this way. If you're a married couple making between $75,000 to $100,000 a year, you're paying around 8.1 percent of that in federal income taxes. But you're most likely in the 25 percent tax bracket. That means that for each additional dollar you earn, 25 cents goes to income taxes.

Marginal tax rates thus tend to influence peoples' economic choices a lot more than their average tax rates. If I'm deciding whether to work overtime and get $1,000 more on my paycheck, I don't care about what tax I'm paying on all my income. I care what tax I'd have to pay on that $1,000. High marginal tax rates thus function as a work disincentive. If I get to keep less of each additional dollar I earn, I'm not going to be as inclined to earn additional dollars.

Unsurprisingly, the expiration of the Bush tax cuts, the stimulus tax breaks, the Alternative Minimum Tax "fix" and the payroll tax holiday all combine to raise marginal tax rates across-the-board. But what's perhaps surprising is that the hike is big for the very poor and very rich and less severe for those in the middle.

The Tax Policy Center quietly released numbers last week estimating marginal tax rates in 2013 under both current policy (that is, if we avoid the cliff) and under current law (if we go over it). People in the middle actually aren't hit much. Households making between $40,000 to $50,000 a year, which is pretty close to the median, see marginal rates on wage income go up from 32.4 percent to 33.1 percent, when you count both the income and payroll taxes. That's something, but probably not enough to deter a lot of people from working more.

Millionaires, by contrast, see their marginal rates of wages go from 38 percent to 44.2 percent. And the poor see rates go way up as well. Households making between $10-20,000 a year see marginal rates on wages go from 16.4 percent to 20 percent. Indeed, the marginal tax rate hike for poor people, as a percent of their previous tax rate, is enormous:

To some extent this isn't surprising. Poor people face some of the highest marginal tax rates of anyone. This is largely because they rely on programs like food stamps and the Earned Income Tax Credit which have "phase-out" periods. So if you're on one of those programs and start earning more income, you'll lose some of your benefits. That decreases your incentive to work more, and helps trap people in poverty.

And because things like the stimulus increase to EITC and the payroll tax holiday all disproportionately benefit poor people, their expiration will disproportionately hurt the poor. When the payroll tax rate goes up from 4.2 percent to 6.2 percent, that's another 2 percent of each additional dollar that poor people have to pay in taxes. On the margin, that discourages work and keeps people reliant on government transfers to get by.

There's been a lot of talk this campaign about whether the Obama administration's changes to welfare will discourage work. There's no evidence that they will. But if the administration and Congress don't act, a totally different set of policies will start to work against the goal of getting people off federal support and into good, paying jobs.

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