Effective Marginal Tax Rates on Labor Income

Effective Marginal Tax Rates on Labor Income, 

November 2005,

U.S. Congressional Budget Office

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Factors That Affect Marginal Tax Rates

Many factors interact to determine how much of an additional dollar of earnings a taxpayer gets to keep. Provisions of income tax law obviously play an important role. But a taxpayer’s personal circumstances play an equally large part. Federal payroll taxes, state income taxes, and the rules of federal benefit programs can also affect a taxpayer’s effective marginal rate on earnings.  ... 

... Anything that affects taxable income can alter the marginal tax rate: 

• income (whether from the taxpayer’s earnings, a spouse’s earnings, or other sources),
•  itemized deductions (such as interest payments on a mortgage or charitable contributions), 
• number of children (which determines the number of personal exemptions and eligibility for several credits), and 
• filing status (since, as shown in Figure 1, statutory tax rates apply at different income levels depending on whether a taxpayer files as single, head of household, or married).

1. Individual Income Taxes

Many provisions in the individual income tax system also affect a taxpayer’s marginal tax rate. In addition to the statutory rate brackets, many deductions and credits apply only over specific income ranges (see Table 1). As noted above, the phasing in and out of those items can

cause taxpayers’ effective marginal rate to differ from their statutory rate. Since various deductions and credits phase out over similar income ranges, taxpayers in those ranges can face multiple phaseouts on top of their statutory rate.  

In the case of many deductions or exclusions from income, the allowed amount gradually phases out over an income range, so as a taxpayer earns more, allowable deductions shrink and taxable income rises faster than earnings.

...

6. Payroll Taxes

Most income from wages and self-employment is subject to payroll taxes that help fund Social Security’s Old-Age, Survivors, and Disability Insurance (OASDI) programs and Medicare’s Hospital Insurance (HI) program. Employers and employees each pay an OASDI tax of 6.2

percent on earnings up to a certain amount ($90,000 in 2005) and a 1.45 percent HI tax on all earnings. Public finance theorists generally agree that the employer’s share of those taxes is passed on to workers in the form of lower wages. CBO follows that assumption and treats payroll

taxes as if employees paid both shares.

Because Social Security taxes are linked to benefits, including them in a calculation of marginal tax rates is problematic. On one hand, payroll taxes involuntarily reduce the return from working just as an income tax does, and as such they should affect people’s decisions about how much to work. On the other hand, earning more and thus paying more in Social Security taxes (up to the taxable maximum) will eventually entitle workers to higher Social Security benefits. The net effect—the true “tax”—is the portion of the OASDI tax not offset in the future by increased benefits. CBO has not attempted to divide the tax into its gross and net components; instead, for simplicity, this paper presents marginal tax rates with and without payroll taxes.

The proper treatment of the HI tax is less ambiguous. Under the Medicare program, once workers have earned credit for 40 quarters of contributions, they are eligible to

start receiving benefits at age 65. In 2005, workers receive a credit for each $920 in earnings and can accumulate up to four credits per year. Because workers receive no benefit for earnings above $3,680 per year, any amount beyond that can be viewed as a pure tax. Once workers have accumulated 40 quarters, any additional HI tax paid over their lifetime does not affect benefits. Thus, the HI portion of payroll taxes is much closer to a pure tax than the OASDI portion is.

Payroll taxes raise the effective marginal rate by approximately the combined employee and employer statutory payroll tax rate (see Figure 5). Because the OASDI tax is capped, the effect of payroll taxes is larger for low- and middle-income earners than for high-income earners.

Box 1. Including the Employer’s Share of Payroll Taxes in Calculations of Marginal Tax Rates

The Congressional Budget Office (CBO) assumes that employees bear the burden of both their and their employers’ shares of Social Security and Medicare payroll taxes (because research suggests that employers pass on their share of those taxes to workers in the form of reduced wages). Consistency with that assumption requires calculating the marginal payroll tax rate on an additional dollar of compensation measured before the payment of the employer’s payroll

taxes. The employee, of course, actually pays income and payroll taxes on income measured after the employer’s share of payroll taxes has been paid.

Suppose an employer pays a worker $13,934 in cash wages. Both the employer and the employee must pay $1,066 in payroll taxes (7.65 percent of $13,934), and the employee, who is in the 10 percent statutory bracket, must pay $573 in federal income taxes (after various deductions). The employee’s share of payroll taxes is deducted from cash wages, but the employer’s share is in addition to those wages, making the pretax amount of compensation

$15,000 (see the table at right). If the employer spent an additional $1,000 to compensate the

worker, cash wages would rise by only $929 because the employer would have to set aside $71 to pay its share of payroll taxes. The employee would also pay an additional $71 in payroll taxes and $93 in federal income taxes. From that extra $1,000 of compensation, therefore, the federal government would receive $235 in taxes—thus, the worker’s marginal tax rate would be 23.5 percent. That rate is less than the sum of all of the applicable tax rates (7.65 + 7.65 + 10 =

25.3 percent) because those rates are applied after the employer’s share of payroll taxes has been deducted.

Computing marginal tax rates with respect to pretax compensation alters the marginal income tax rate as well as the marginal payroll tax rate. In the example above, although the employee is in the 10 percent tax bracket, his or her marginal income tax rate is 9.3 percent. When this paper discusses a marginal rate that includes payroll taxes, the rate is computed with respect

to pretax compensation. That approach is consistent with CBO’s assumption that the employee

bears the full burden of payroll taxes. However, when the analysis considers individual income taxes in isolation, the marginal rate is computed with respect to wages received after payroll taxes have been paid.

That formulation aligns effective marginal rates with the rates specified in income tax law.