What is the difference between a marginal tax rate and a tax bracket?
A tax bracket is a range of taxable income that is subject to a specific tax rate. The Federal income tax, for example, currently has six tax brackets, ranging from 10 percent to 35 percent:
Let’s suppose your taxable income from wages and salary is $30, 501 and you claim no deductions. Your Federal income would be calculated by applying the 10 percent tax rate to $8,500 and a 15 percent tax rate for your income in excess of $8,500:
10% of $8500 = $850
Plus 15% on your income above $8500, which equals 30,501 minus 8501 = 15% of $22,000 = $3,300
Your total tax = $850 + $3,300 = $4,150
Note in this example that while your taxable income places you in the 15 percent tax bracket, your average tax rate tax is 13.6 percent of your taxable income. This is because the 15 percent tax rate is applied only to your taxable income above $8,500 (up to $34,500). This 15 percent is referred to as the marginal tax rate on any addition taxable income above $8,500 and less than $345,501 and reflects the additional tax rate on those additional income dollars.
How do marginal tax rates affect people?
The principle at work to address this question concerns marginal anticipated benefits and costs associated with an individual’s actions. Economists usually think of individual behavior in terms of marginal actions, which are evaluated by the individual actor according the additional (i.e. marginal) expected benefits the action is likely to generate against the additional costs that action is likely to entail. The fact that we go through life making choices between doing one thing rather than something else, all choices imply what economists call “opportunity costs.”
There is much empirical work that finds that marginal tax rates have a considerable effect on how individuals evaluate the desirability of extra work (i.e., labor supply), undertaking entrepreneurial or business risks, and capital formation. As the marginal tax rate rises, for example, the after tax income of those additional hours worked decreases. So, if I can work an extra 20 hours a week and if that additional income is taxed at a higher tax rate, the value to me of giving up an additional 20 hours each week for R&R activities may induce me to forego that additional income and not work those 20 more hours. This reasoning also applies to entrepreneurial activities in that higher marginal tax rates may deter such activities. Even the production of human capital, such as investing in our education, may be adversely affected by higher marginal tax rates because they reduce the net return on investment.
From a policy perspective, the above considerations mean that individual effort cannot be disassociated from the tax system and specifically marginal tax rates. Raising tax rates to increase government tax receipts requires a presumption that individuals do not respond to perceived costs and benefits; if incentives matter, we must expect that higher marginal tax rates may actually reduce the incentive to earn or seek out additional income.
The aforementioned is one kind of “unintended consequence” of higher marginal tax rates, but there are others. To identify just a few others, we should anticipate that higher tax rates provide an incentive for productive activity to relocate to lower tax rate environments outside the U.S. Also, at higher tax rates, there is an increased incentive to hide or not report income to the IRS. Studies have shown that higher tax rates substantially increase underground economic activity.
Can you think of a better way to design tax rates? If so, how would the better design help?
I think lowering taxes and lowering tax rates would spur and widen economic activity, while hopefully (and as importantly) reclaim resources from the government for use in the more productive private sector. Many economists now have become attracted to a “flat tax” which taxes all taxable income at the same rate. This would avoid the disincentives associated with a progressive tax rate system, such as we currently have and also, together with simplifying the tax system, reduce the costs, ambiguities and headaches taxpayers now face in preparing tax returns. Some economists have argued on efficiency grounds for simply eliminating the personal income tax and existing tax system and replacing it with a “value-added tax” (or national sales tax), which European countries have widely adopted.
While I recognize these advantages, making the tax system more “efficient” by adopting a flat tax or a VAT is not the complete solution. For example, while the VAT would (hopefully) eliminate special subsidies and political payoffs to certain constituencies, it is also extremely easy to use the VAT to accommodate ballooning government spending by raising it in small, hardly noticeable, increments. Because the VAT is collected at the point of sale for consumption goods and makes retailers tax collectors, it is a very difficult tax to dodge and a very efficient way for the government to absorb wealth from the private sector.
Removing perverse incentives from the tax system, making it easier for taxpayers to pay their taxes, and greatly circumscribing (or eliminating) the IRS are all, in my opinion, positives. That said, I think that any tax reform should be undertaken in the context of reducing the size of government’s command over resources in the economy.
Butos is the George M. Ferris Professor of Corporation Finance and Investments at Trinity College.