Marginal Tax Rates and the Welfare State

Discussions of the welfare state often miss a key issue: marginal tax rates.

People often discuss programs that have universal coverage, which have high payroll taxes.  But there is little justification for universal coverage, which normally crowds out the private industry in that area (such as annuities instead of Social Security).

Once one moves to means tested programs like Medicaid, it is possible to believe that the tax rates on the poor can be lower because the program is not being provided to everyone.  But the effective tax rates on means tested programs can be quite large.  The poor person must decide whether it makes sense for them to work more to secure income, even though that will cause them to lose benefits.   Sadly, it is often rational for them to not work (or to work off the books).   Greg Mankiw reports on work done at the Urban Institute on the subject:

we calculate the effective average marginal tax rate if this household increases its income from $10,000 to $40,000. That is, how much of the additional $30,000 of earnings is lost to government through direct taxes or loss of benefits? The average marginal tax rate in the first bar of Table 3, 29 percent, is based simply on federal and state direct taxes, including Social Security and the EITC. The rate rises appreciably as the family enrolls in additional transfer programs in bars 2 and 3. For a family enrolled in all the more universal non-wait-listed programs like SNAP, Medicaid, and SCHIP, the average effective marginal tax rate could be 55 percent. Enrolling the family in additional waitlisted programs, like housing assistance and TANF, ratchets the rate up above 80 percent….

Such programs are a recipe for creating a permanent underclass.

But cutting such programs is somehow seen as an “attack on the poor.”

Update: I changed “the key issue” in the first sentence to “a key issue.”  I had intended to refer to the effect of means tested programs on the poor.  In my view, marginal tax rates are the key issue there.  But the language did not convey that, so the change was necessary.