Workers need more purchasing power, not less. They need tax breaks, not a heavier burden. If upward mobility is the key to economic prosperity, tax reform is one way to unlock it for millions of working Americans.
One option is border tax reform. Imagine a government giving subsidies to single parents that increase tax rates for extra work. Such is the case of a Japanese single parent who earns $39,981 and faces a marginal tax rate of 57 percent. For a small $599 salary increase, she would face a marginal tax rate of 359 percent. A Japanese parent benefiting from a $5,123 government program could lose 100 percent of that benefit if he or she earns above the income limit.
For this reason, the marginal tax wedge is relevant to understanding how workers benefit (or don’t) from a wage increase once taxes come into play.
While the tax and benefit system can keep low-income, successful working households out of poverty and encourage labor force participation, high marginal tax rates at different income levels can act as barriers to career advancement and discourage people from advancing in their careers.
Very often these high rates are hidden in complex political structures. “Marginal Tax Rates and Economic Opportunity,” a recent study by the Archbridge Institute and Tax Foundation, sheds light on the underlying policies driving the peaks in marginal tax rates faced by workers in several countries.
In 2021, a single parent with two children in the United States faced high marginal tax rates due to the Earned Income Tax Credit, Recovery Rebate Credit, and Medicare taxes. At 76 percent of the median wage and around 95 percent of the median wage, the marginal tax rate for this single parent falls from 52 percent to 34 percent because the EITC ends at this income bracket. If this worker moves up the income ladder and earns $112,688 and his employer increases compensation by only $678, the net pay increase for the worker is only $11. This US worker faced a marginal tax wedge of 98 percent due to the phasing out of cash benefits 2021 RRC approved by the American Rescue Plan Act enacted in response to the COVID-19 pandemic.
Although the EITC can encourage labor participation by certain groups and the RRC has been an important safety net during the economic crisis caused by COVID-19, both measures are imperfect given the potential for the high marginal tax rates they create motivate to reduce the hours worked.
Similarly, a Canadian worker could face marginal tax rates claiming 59 percent of the additional income due to the health premium collected from individuals by the provinces of Quebec, Ontario and British Columbia. The first peak in the marginal tax rate occurs at 65 percent of average wage and about 73 percent of median salary. This could keep some workers in those provinces just below the income threshold that triggers the tax rate spikes. Removing these barriers by introducing a unique and lower rate will allow workers to access higher wages without having to face this barrier.
However, these are not the only countries where workers and single parents with children face high marginal tax rates that could prevent them from earning extra income or working overtime.
Our study shows that the French “contribution d’equilibre générale” and Italian local income taxes lead to spikes in marginal tax rates at certain income levels, causing French and Italian workers to lose up to 93 and 116 percent of their extra income, respectively. Meanwhile, single parents with two children can face a border tax wedge of up to 652 percent in Australia and 359 percent in Japan. These marginal tax wedges are due to policies such as the Family Tax Benefit and Parenting Payment in Australia, or the Educational Allowance and Child Benefit in Japan.
On the other hand, the tax design of Lithuania and Australia for single workers avoids unnecessary tax peaks as observed in Canada and the United States by applying a flat social security contribution and a flat or slightly progressive income tax.
Tax breaks come with trade-offs that policymakers must consider when planning tax system reform. High marginal tax rates can directly affect workers’ decisions to accept a raise, work extra hours, or choose to keep government benefits. In Canada and the United States, the spikes directly affect workers earning below average wages.
Redesigning some of these policies to achieve a more equal variation in marginal tax rates across different income levels would likely increase labor supply and foster unemployment upward mobility of employees. That would unleash economic prosperity at a time when it is most needed.