The Problem:
Disincentives, or Too Many Good Reasons NOT to Be Productive
Consider a parent with two children living in Texas. Under reasonable assumptions, this family would receive $12,684 in benefits from Temporary Aid to Needy Families (TANF), Food Stamps, and Section 8 Rental Assistance. In addition, the family would have medical coverage from Medicaid. What happens if the parent begins to earn income? The income is taxed and the benefits are taken away. Both of these have the same effect: The amount left to spend goes up by less than the additional amount earned.
For the sake of this discussion, let us use the term "marginal tax rate" to indicate the percentage of the increase in income taken by the government, whether it be in taxes or in reduced benefits due to means testing. This rate indicates the incentive one has to improve his or her situation. A high "marginal tax rate" indicates that there is little incentive to earn income. Why work for a dollar if most of the dollar is taken away? A low "marginal tax rate" means that more of the earnings will be available to improve the family's standard of living.
The following table shows the progression for this family from zero income to making six figures:
| Taxes Paid | Government Assistance | ||||||||
| Annual Earnings | Medicare Tax | Social Security | Income Tax | EIC | TANF | Food Stamps | Rental Assist | Net | Marginal Rate |
| $0 | $0 | $0 | $0 | $0 | $2,412 | $4,272 | $6,000 | $12,684 | |
| $1,440 | $21 | $89 | $0 | $576 | $2,412 | $4,272 | $5,568 | $14,158 | -2.35% |
| $2,000 | $29 | $124 | $0 | $800 | $2,065 | $4,272 | $5,400 | $14,384 | 59.65% |
| $4,000 | $58 | $248 | $0 | $1,600 | $825 | $4,272 | $4,800 | $15,191 | 59.65% |
| $5,330 | $77 | $330 | $0 | $2,132 | $0 | $4,272 | $4,401 | $15,728 | 59.65% |
| $7,260 | $105 | $450 | $0 | $2,904 | $0 | $4,272 | $3,822 | $17,703 | -2.35% |
| $9,720 | $141 | $603 | $0 | $3,888 | $0 | $3,682 | $3,084 | $19,630 | 21.65% |
| $12,690 | $184 | $787 | $0 | $3,888 | $0 | $2,969 | $2,193 | $20,769 | 61.65% |
| $21,917 | $318 | $1,359 | $0 | $1,945 | $0 | $754 | $0 | $22,939 | 76.48% |
| $25,060 | $363 | $1,554 | $471 | $1,283 | $0 | $0 | $0 | $23,954 | 67.71% |
| $31,152 | $452 | $1,931 | $1,385 | $0 | $0 | $0 | $0 | $27,384 | 43.71% |
| $50,000 | $725 | $3,100 | $4,213 | $0 | $0 | $0 | $0 | $41,963 | 22.65% |
| $80,400 | $1,166 | $4,985 | $13,530 | $0 | $0 | $0 | $0 | $60,720 | 38.30% |
| $100,000 | $1,450 | $4,985 | $19,018 | $0 | $0 | $0 | $0 | $74,548 | 29.45% |
There are a number of interesting facts made clear by this table: Most important is that our system is not progressive. Some of the highest "marginal tax rates" apply to low income families. This is the "Catch-22" of the welfare system which creates "career" recipients. It is a strong disincentive to seeking employment, or to increasing productivity.
Also note how some different programs offset each other. Look at what happens between annual incomes of $1,440 and $5,330. This is the range over which the TANF benefits are phased out. But look at the Earned Income Credit (EIC). This benefit is being phased in. Why do we need two separate programs that work against each other?
There is a point where it is much worse than is shown by these numbers. The Medicaid benefit is not included in this table. The problem with the Medicaid program is that it is all or nothing. There is a point where the family is eligible, but if they make one more dollar, they are ineligible. In Texas, this is a recognized problem and families are given a transition period after they become ineligible, but there is still a point where the income level starts that period and this benefit will go away. Note that Medicaid in this situation is only for the children.
This table actually understates the lack of progressivity. Due to the complex provisions of our tax code, those with more resources often find ways to pay tax on less than the amounts used in these calculations. These calculations are based upon using the standard deduction with no amounts set aside on a Section 125 Plan or a retirement plan. Those that use these devices to reduce their taxes may pay tax at an even lower rate.
This table also provides an important consideration for the debate on the minimum wage. Proponents of increasing the minimum wage often argue that an increase is necessary to help poor families. But does it? The recent proposal to increase the minimum wage from the current $5.15 to $6.15 would increase the annual income from $10,712 (for 2080 hours) to $12,792. But look at the tax rates. The government takes back most of this in taxes and reduced benefits. This $2,080 increase in earnings only achieves a $777 increase in net income. The sad thing is that the people (other than the government itself) who benefit most are those who are not on any form of assistance and do not earn enough to pay income taxes — probably middle-class teenagers working part time. They do not need it! A higher minimum wage just makes it harder for them to get jobs. Increasing the minimum wage may sound good, but it is misguided if the purpose is to help the poor families.
NOTE: For this table, we picked Texas as an illustration simply because it is home. It is not the state least encouraging to the poor. Daniel N. Shaviro has found that other states may so tax and decrease benefits that this family would have $2,540 less to spend if the earned income would increase from $10,000 per year to $25,000 per year.1
NOTE: The rates and limits used in calculating this table are from 2001.
Conclusion
There are a wide variety of programs, each with its own rules and regulations on eligibility, and each with its own forms and bureaucracy, that work at cross purposes and significantly reduce the incentive to be productive.
Chart Income Levels
Many of the income levels in the chart were chosen because rules changed at that income level:
|
Annual Income |
|
|
$0 |
No income, start phasing in EIC and phasing out Rent Subsidy as soon as any income is earned |
|
$1,440 |
TANF phase-out starts |
|
$2,000 |
|
|
$4,000 |
|
|
$5,330 |
TANF phase-out complete |
|
$7,260 |
Food stamp phase-out begins |
|
$9,720 |
EIC reaches maximum |
|
$12,690 |
EIC phase-out starts |
|
$21,917 |
FIT liability starts |
|
$25,060 |
Food stamp phase-out complete |
|
$31,152 |
EIC phase-out complete |
|
$50,000 |
|
|
$80,400 |
Social Security maximum |
|
$100,000 |
Bibliography
A newer and more comprehensive study of this type can be found at Marginal Net Taxation of Americans
Another article on the level of disincentives may be found at John Cochrane's blog