How Taxes and Transfers Affect the Work Incentives of People With Low and Moderate Income

Posted by
Shannon Mok
March 17, 2017

While testifying at Congressional hearings in February, CBO’s Director was asked a number of questions about how federal taxes and benefits affect people’s incentive to work. Because answers during hearings must be brief, CBO is providing some additional information in this blog post.

When workers’ earnings rise but their after-tax income rises less—because of increases in their income and payroll taxes or declines in their benefits from government programs—their incentive to work typically declines. The percentage of an additional dollar of a person’s earnings that is unavailable for such reasons is called the marginal tax rate.

In part, income and payroll tax rates determine marginal tax rates. But other features of the tax system do too, and so do some benefit programs. Certain deductions and tax credits reduce the taxes that eligible taxpayers owe and increase their after-tax income—but those provisions, if the amounts are based on the recipient’s income, also contribute to marginal tax rates. Those rates are similarly affected by programs providing cash and in-kind benefits, referred to as means-tested transfers, that target assistance to people of reduced means. The rate at which those benefits phase out with increasing income is also part of the marginal tax rate that workers face.

What Marginal Tax Rates Do Low- and Moderate-Income Workers Face?

In a 2015 report, CBO found that low- and moderate-income workers—those with income below 450 percent of federal poverty guidelines (commonly known as the federal poverty level, or FPL)—would face, on average, a marginal tax rate of 31 percent in 2016. That estimate takes into account federal and state individual income taxes, federal payroll taxes, and the phaseout of two transfer programs—benefits from the Supplemental Nutrition Assistance Program (SNAP, formerly the Food Stamp program) and the cost-sharing subsidies for health insurance provided under the Affordable Care Act. The estimate includes the effects of refundable tax credits—including the earned income tax credit, the additional child tax credit, and the premium assistance tax credit—that are part of the individual income tax. (Refundable tax credits are those that can result in a payment from the government if the total amount of the credits exceeds the amount of income taxes owed.) On average, statutory rates—the rates set in law that apply to the last dollar of earnings—for federal payroll taxes and for the federal income tax will have the largest effect on marginal tax rates. Marginal tax rates will vary greatly by earnings and among individuals with the same amount of earnings because of the tax credits and government benefits that they receive, with greater variation in the rates for people at lower income levels than at higher income levels (see the figure below).

How Do Marginal Tax Rates Affect Incentives to Work?

When deciding how much to work, people consider not only the higher earnings from working more hours but also the resulting difference in after-tax income—which is market income plus government transfers minus taxes. For example, increases in statutory tax rates have two opposing effects among people already working:

  • The substitution effect, in which marginal tax rates increase. People tend to work fewer hours because other uses of their time become relatively more attractive, and
  • The income effect, in which after-tax income drops from what people would have otherwise earned. People tend to work more hours because having less after-tax income requires additional work to maintain the same standard of living.

On balance, the first effect appears to be greater than the second, according to CBO’s assessment of relevant research. Increases in marginal tax rates, on net, decrease the supply of labor by causing people already in the labor force to work less.

The effects on labor supply are not uniform, however. Groups of workers respond differently to changes in taxes and transfers. For example, married women have historically worked less when marginal tax rates rose than have working-age men, on average.

Some changes in government benefits can generate both substitution and income effects that push labor supply in the same direction. As income rises, phasing out a benefit (such as SNAP) increases the marginal tax rate and reduces the incentive to work. SNAP also effectively increases the after-tax income of its recipients—even as the benefit phases out—further discouraging work.

Shannon Mok is an analyst in CBO’s Tax Analysis Division.