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New Research Boosts Our Understanding of the Effective Marginal Tax Rates for the Poor

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New Research Boosts Our Understanding of the Effective Marginal Tax Rates for the Poor 2

Does the American welfare system adequately encourage the
poor to achieve self-sufficiency, or is it a “poverty trap” that locks welfare
beneficiaries into a lifetime of dependency? The question has been debated endlessly
with no clear win for either side. 

In large part, the dispute turns on a concept known as
the effective marginal tax rate (EMTR) faced by poor and
near-poor households. The EMTR is the percentage of any additional earned
income that a household pays in taxes or loses in government benefits. Critics
argue that high EMTRs leave little incentive to work, and even for those who do
work, they mean that their efforts do little to help them to lift their
disposable incomes above the poverty level. What is the point of getting a job
if taxes and benefit reductions are going to eat up 75 percent or more of your
earnings, even without figuring in expenses like child care, commuting, or work
clothes? Supporters of the existing welfare system argue that punitively high
EMTRs are rare. They emphasize that the current welfare system, despite its
flaws, does raise millions of families out of poverty.

Recent research revives the longstanding debate over EMTRs.
This commentary reviews studies that suggest that despite some changes for the
better, critical segments of the low-income population, especially those with
incomes close to and just above the poverty line, continue to face weak work
incentives. Simply expanding eligibility for existing welfare programs will not
fix the problem. As explained in the conclusion, a more effective approach to
mitigating the poverty trap would be to cash out and consolidate current
welfare programs, replacing them with a combination of universal income
supports, universal child benefits, and wage subsidies for the lowest-paid
workers.

Background: The hypothetical-household approach
One source of past disagreements over poverty and work
incentives has been what we can call a hypothetical-household approach to
calculating effective marginal tax rates. That approach begins by listing
specific benefits that a hypothetical household might receive and taxes that it
might pay as income changes. Suppose, for example, that a certain household
receives food stamps, subject to a benefit-reduction rate of 24 percent;
receives cash benefits, subject to a benefit-reduction rate of 30 percent; and
pays a 7 percent payroll tax. The EMTR for that household would be the sum of
the various marginal rates, in this case, 24+30+7=61 percent. After benefit reductions
and taxes, net income would increase by only $39 for each $100 earned. 
A 2015 study from the Congressional
Budget Office illustrates the hypothetical-household approach. Figure
1, which is based on supplemental data from the CBO study, applies to a
hypothetical family of one parent and one child living in Pennsylvania in 2016.
The household participates in the Earned Income Tax Credit (EITC), Temporary
Assistance for Needy Families (TANF), SNAP (formerly food stamps), Medicaid,
the Children’s Health Insurance Program (CHIP), and, as its income rises beyond
the Medicaid level, ACA cost-sharing subsidies for health insurance. The example
also takes payroll and income taxes into account. The figure shows how the
household’s disposable income after taxes and transfers would vary as its
earned income changes.
New Research Boosts Our Understanding of the Effective Marginal Tax Rates for the Poor 3
For this household, the EMTR is lowest in a range from 31 to
54 percent of the federal poverty level (FPL). In fact, the rate is actually a
negative 33 percent in that range, meaning that disposable income increases, on
average, by $1.33 for each extra dollar earned. The boost in income is due to
the bonus that the EITC gives to the lowest-paid workers. 
The highest EMTRs and the weakest work incentives occur in a
range from 115 to 127 percent of the poverty level. In that range, the
household has reached the phaseout range of the EITC and is also subjected to
substantial benefit reductions for other programs. The EMTR is 80 percent, and
the family gains only 20 cents in disposable income for each dollar
earned. 
Defenders of the current welfare system dismiss the
importance of such hypotheticals. For example, Isaac
Shapiro and colleagues from the Center for Budget and Policy
Priorities (CBPP) maintain that extreme EMTRs are worst-case scenarios that
apply to only a small fraction of households who receive an unusual combination
of government benefits. Even then, they apply only in certain narrow income
ranges. By their calculations, fewer than 3 percent of families with incomes
below 150 percent of the poverty line are subject to EMTRs as high as 80
percent.
Who is right here? New research that overcomes the
limitations of the hypothetical-household model provides some answers.
The real-household approach
The new body of research shifts the focus from hypothetical
households receiving an assumed set of programs to real households and the
programs they actually participate in. Studies based on the real-household
approach
 acknowledge that poor households vary in many ways:
  • Characteristics
    like the number of children and state of residence that determine the
    programs for which they qualify.
  • The
    degree to which they actually participate in those programs.
  • Their
    earnings and other factors that determine the benefits they receive from
    the programs in which they participate.
The real-household approach both recognizes these variations
and accounts for the number of families that fall into each category.
A series of marginal tax
rate briefs published by the Department of Health and Human Services
in 2019 illustrates the real-household approach. For example, the second brief
in the series focused on 24 million households with children, whose incomes
were less than 200 percent of the poverty line. Among its findings:
  • Median
    EMTRs increased with income, starting at -22 percent for those with
    incomes less than 24 percent of the federal poverty level (FPL) and
    peaking at 51 percent for those with incomes of 100 to 124 percent of FPL.
  • There
    was wide variation in the combinations of programs for various households.
    For example, the most common combination, SNAP + EITC + Child Tax Credits
    (CTC) + Medicaid/CHIP, accounted for just 12.5 percent of poor households
    with children. 
  • Different
    combinations of programs produced different median EMTRs. For example, the
    most common combination for poor households with children produced a
    median EMTR of 42 percent. Adding housing benefits to that combination
    raised the EMTR to 63 percent, but that combination applied to only 1.6
    percent of such households.
These findings are an improvement over the
hypothetical-household model. They support the contention that we should be
cautious about drawing conclusions from examples based on relatively rare
combinations of program participation. However, they leave a lot unsaid. The
HHS results only whet our appetite for information about the full distribution
of EMTRs above and below the medians, the effects of other benefit and tax
programs not included in the studies, and the variations in EMTRs from state to
state. 
Extending the real-household approach 
Another study, published even more recently, sheds light on
all these matters. That study comes from David
Altig, Alan Auerbach, Laurence Kotlikoff, Elias Ilin, and Victor Ye. Like
the HHS researchers, Altig et al. follow a real-household approach.  They
take into account the observed frequency with which households of various
structures participate in specific welfare programs. However, they go beyond
the HHS studies in three important respects:
  • They
    consider a larger number of benefit programs and taxes, including premium
    subsidies under the ACA, a significant omission from the HHS studies. The
    complete list is given in Figure 2.
  • They
    explore the dispersion of EMTRs within household types as well as their mean
    and median values.
  • They
    calculate both current-year EMTRs, which show how income changes affect
    taxes and benefits in a given year, and lifetime EMTRs that reflect how an
    increase in current-year income affects net taxes in the future.
New Research Boosts Our Understanding of the Effective Marginal Tax Rates for the Poor 4
The EMTRs are computed using a previously developed model
that the authors call The
Fiscal Analyzer.  The analyzer is described as “a life-cycle,
consumption-smoothing tool that incorporates borrowing constraints and all
major federal and state fiscal policies.” The data fed into it come from the
Fed’s 2016 Survey
of Consumer Finances, which includes information on balance sheets, incomes
(including government benefits received), pensions, and demographic
characteristics for a random sample of households.  
Altig et al. calculate current-year EMTRs for an assumed
$1,000 addition to current-year income. The current-year EMTR is the change in
net taxes (that is, the change in taxes paid minus the change in benefits
received) in the current year divided by the change in income. The calculation
of lifetime EMTRs is more complex. The first step is to estimate how the extra
$1,000 of current-year income will affect lifetime taxes and resources,
including the effects of saving on future income, wealth, and taxes paid, as
well as the effect those changes in future income and wealth will have on
future benefits received. The second step is to calculate the present values of
those future taxes and resources. Finally, the lifetime EMTR is calculated as
the change in the present value of net taxes — including taxes paid in the
current year — divided by the change in current-year income.
If the household does not consume its entire income each
year, any current-year saving increases future income and wealth, leading to
what the authors call “double taxation.” By that term, they mean that the
household pays taxes on its income in the year it is earned and pays additional
taxes or experiences reduced benefits in future years due to its accumulated
savings. Because of double taxation, lifetime EMTRs are always greater than
current-year EMTRs.
Median EMTRs vary remarkably little across income quintiles
when calculated using this approach. As Figure 3 shows, the distribution of
EMTRs is slightly U-shaped, with lower values for the second, third, and fourth
income quintiles than for the first or fifth. The U-shape is more pronounced for
lifetime than for current-year EMTRs. For both the lifetime and current-year
cases, however, EMTRs are lower for the top 1 percent of all U.S. households
than for the top 5 percent. The bars in both parts of the graph average EMTRs
across all age groups in a given income group.
New Research Boosts Our Understanding of the Effective Marginal Tax Rates for the Poor 5
For present purposes, one of the most striking findings of
the Altig study is the wide dispersion of EMTRs within the lowest 20 percent of
the population. That quintile is critically important for any discussion of
poverty policy. As of 2019, it consisted of households with incomes less than
$26,840, thereby including all officially poor households with four or fewer
members – 91 percent of all poor households. The quintile also includes some
non-poor households with three or fewer members.
Figure 4 divides EMTRs into percentiles within the
lowest-income quintile. It shows that a quarter of  these lowest-quintile
households face current-year EMTRs higher than 59 percent. For them, taxes and
benefit reductions wipe out three-fifths or more of any income earned in the
current year. 
What is more, any saving by such households is penalized.
Unless the household spends its entire income in the year it is received,
double taxation takes a further bite from lifetime income. The lifetime EMTR is
74 percent for the highest-taxed segment of these households. When double
taxation is considered, at least three-quarters  of any extra income
earned by this group in the current year is sooner or later clawed back either
through taxes or benefit reductions.

New Research Boosts Our Understanding of the Effective Marginal Tax Rates for the Poor 6
For the calculation of short-term work incentives, the
current-year EMTR is probably the more important rate. However, when it comes
to the broader concept of a poverty trap, lifetime EMTRs also play a role. A
high lifetime EMTR means that even people who work year after year at low-wage
jobs, and save whatever they can, will find it harder over time to work their
way permanently out of poverty.
Note that for both the current-year and lifetime measures,
the mean EMTR is greater than the median. That reflects the fact that poor
households in the high-EMTR tail of the distribution face “cliff effects,”
meaning that they lose certain benefits all at once when they reach a certain
earnings threshold. 
In addition to the controversy over how widespread high
EMTRs are, there is a further controversy over whether high EMTRs really
matter. Altig et al. are careful to avoid that issue. “We seek to understand
Americans’ work disincentives, not the response to those disincentives, a task
we leave for future research,” they write. I agree that labor market behavior
is a complex issue, too much so to treat fully here. At the same time, though,
it is too important to leave without making a few points, which I hope to
follow up on in future commentaries.
Shapiro and his CBPP colleagues take the position that EMTRs
don’t make much difference. Citing a 2011 article by Yonatan
Ben-Shalom, Robert Moffitt, and John Karl Scholz, written for the Oxford
Handbook of the Economics of Poverty, they write that “the behavioral response
[to high EMTRs] is small enough, in aggregate, that it has almost no impact on
the substantial degree to which the safety net lifts people out of poverty.”
Ben-Shalom et al. pose the question in a very specific way,
asking how safety-net programs affect low-income families’ behavior relative to
a counterfactual situation in which such programs do not exist at all. They
carefully review research that bears on this question and find little evidence
that the welfare system in aggregate has major effects on work effort. 
However, in a 2016
follow-up, Moffitt adds several important qualifications. He notes that
although work disincentives are relatively small for individual programs, they
can be significant for those who benefit from multiple programs. Although
Moffit doubted that there were enough such families to matter much, the
real-household research reviewed above, not available at the time, suggests
that such cases are far from rare. Secondly, Moffit warns that “work incentives
are more of an issue for families with higher incomes who, when working more,
face both the loss of traditional safety net benefits as well as a phaseout of
[EITC] tax credits.” He concludes that the welfare system as a whole “is doing
very little at the moment to help families help themselves, and this is where
policy could be markedly improved.”
Moffit adds that aggregate behavioral responses to work
disincentives are difficult to detect statistically because other determinants
of whether a low-income family works swamp the effects of EMTRs. I certainly
agree. Improving our knowledge of how EMTRs are distributed across real
households, as recent research has done, is one step toward reducing the
statistical noise. Still,  many other factors also cause variations in the
way individuals respond to the incentives and disincentives inherent in welfare
programs.
The availability of jobs, which varies from place to place
and with the state of the business cycle, is obviously one such factor. Also,
as I have emphasized repeatedly in discussions of work
requirements for noncash welfare and guaranteed
jobs proposals, in boom or bust, many of the poor fall into the category of
“hard-to-employ.” These include not only people with little education or job
training, but also those with criminal records, unstable housing, substance
abuse issues, family situations that interfere with regular work schedules,
borderline mental and physical conditions that fall short of actual disability,
and other problems that make it hard to hold a job. Many such people do
repeatedly seek and find work, but their spells of employment are irregular and
often end on a sour note. It is little wonder that small, or even large,
variations in EMTRs have limited effect on their labor-market participation. It
is no surprise that the many hard-to-employ persons in the welfare population
muddle the results of statistical studies.
Statistical results aside, what really bothers me about high
EMTRs is the perverse selectivity with which they reach the highest levels for
the very people who are most likely to respond to labor-market incentives.
Hypothetical- and real-household studies agree that people with incomes from
zero to half of the poverty level – people who work only part-time or only
intermediately, and at low-wage jobs with minimal chance of advancement –
typically face EMTRs that are low or even negative. But if you show enough
stick-to-it-iveness to work full-time at a minimum wage job, or to hold a
steady part-time job at twice the minimum wage, you hit a dead zone. There,
taxes and benefit reductions take the largest possible bite out of anything you
would earn by working extra hours, or seeking a promotion, or making the change
to a different job that might have short-term inconveniences, but would achieve
long-term rewards. To me, piling penalty-rate EMTRs of 60, 70, and even 80
percent on exactly these people – those on the verge of achieving real
self-sufficiency but not quite there yet – is the very essence of the poverty
trap.
It is also worth noting that the relatively low EMTRs that
many households face are due not to good design of existing welfare programs,
but rather, to the failure or inability of many ostensibly eligible families to
enroll in them. That is partly due to the fact that childless households have
limited access to the largest income-support program, the EITC. But eligibility
is not the whole story. It is estimated that
at least 20 percent  of families that are eligible for the program do not
actually participate. 
Nonparticipation is an even bigger problem for some other
programs. For example, the Urban
Institute found that only a quarter of all families that were eligible
for TANF in 2016 participated – a rate that had fallen by more than 40
percentage points since the program’s first full year of operation in 1997.
Reasons for nonparticipation ranged from difficulty in navigating the welfare
bureaucracy to strict enforcement of work requirements to drug testing. Section
8 housing vouchers are also notoriously hard to get, even for qualifying
families. A guide from the nonprofit journalism group ProPublica details
the difficulties people encounter with waiting lists, documentation, and
finding an apartment once a voucher is in hand. 

Advocates for the poor regularly lament these high
nonparticipation rates, and rightly so. If TANF and housing vouchers were
actually accessible to all who met the formal eligibility requirements, and if
EITC were open to childless households, those programs would lift far more
people to a decent standard of living. But ironically, without other reforms,
wider participation in existing welfare programs would significantly increase
the number of households facing punitively high EMTRs. It would reduce measured
poverty, but at the same time, it would make it even harder for low-wage
working families to make those crucial transitions from poverty to permanent
self-sufficiency, and 

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then on to the middle class. 
Can anything be done about the poverty trap? Should we even
try? 
Shapiro and the CBPP group do not paint a very optimistic
picture of the potential for change. As they put it, 
there are really only two options [for] lowering marginal
tax rates. One is to phase out benefits more slowly as earnings rise; this
reduces marginal tax rates for those currently in the phase-out range. 
But it also extends benefits farther up the income scale and increases costs
considerably, a tradeoff that many policymakers may not want to make.  The
second option is to shrink (or even eliminate) benefits for people in poverty
so they have less of a benefit to phase out, and thus lose less as benefits are
phased down. This reduces marginal tax rates, but it pushes the poor families
into — or deeper into — poverty and increases hardship, and thus may harm
children in these families.  In effect, the second option would “help” the
poor by making them worse off.
In my view, however, there is a third way. Whether or not it
represents a choice that policymakers are ready to make today or tomorrow, it
deserves to be placed on the table as a desirable goal toward which to work.
The third way to fight the poverty trap is neither to
increase nor to reduce benefits within the existing system, but rather, to
defragment that system and then to rebuild it. As Moffit points out, the most
daunting EMTRs are not due to high benefit-reduction rates in any individual
program. Rather, they are attributable  to the perverse interactions of
multiple programs, each uncoordinated with the others, giving rise to
overlapping phase-out ranges, and sometimes to abrupt eligibility cliffs.
That being the case, the path to successful reform should
begin by cashing out in-kind programs that cater to specific needs like food,
housing, winter heating, telephone, internet, and the like. Those should then
be consolidated with existing cash assistance programs such as TANF to achieve
what I call a system of Integrated
Cash Assistance
 (ICA). ICA, together with some separate program to
guarantee universal
affordable access to healthcare, would become the twin pillars of a new,
comprehensive social safety net. 
Within the ICA, cash benefits would be subject to a single
income-dependent schedule free of overlapping phaseout zones and cliffs. The
punitively high EMTRs that many poor households face today, especially those at
the critical margin between dependency and self-sufficiency, would be a thing
of the past.
ICA is a concept, not a rigid formula. There would be
considerable room for flexibility in designing the ICA benefit schedule.
Subject to the usual exigencies of negotiation and coalition-building, the
schedule could include:
  • An
    unconditional minimum benefit regardless of labor-market status.
  • Wage
    supplements for low-wage workers similar to the phase-in range of the
    EITC.
  • A
    gradual phaseout of benefits beginning at some point beyond the poverty
    level, similar to a negative income tax.
  • Equal
    benefits for people regardless of age, or if preferred, a separate benefit
    schedule for children.
Could we afford it? That is the wrong question. ICA has no
inherent price tag. Its cost, like the details of its benefit schedule, would
be subject to political decisions. 
As a starting point for discussion, I have described a
baseline ICA that would cost no more than what is now spent on the various
income-support programs it would replace. Such a baseline ICA would provide a
minimum benefit roughly equal to half the FPL – an income level that the Census
Bureau calls “deep poverty” – and would include modest wage subsidies and child
allowances. It would provide stronger work incentives over its entire range
than those faced by low-income households today. Despite its modest minimum
benefit, it would raise a considerably higher fraction of low-income households
out of poverty than does the current welfare system.
When we look at our current welfare system honestly in the
light of the latest research, the picture is not a pretty one, but we should
not give way to despair. There are better alternatives, if we are willing to
work toward them. Even if we cannot get there in a single leap, incremental
changes that are consistent with an overall ICA-like vision can move us in the right
direction.

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