Marginal Taxes and Work Incentives

Greg Mankiw, writing in yesterday's NYT, provides us with a clear example of how President Obama's proposed higher tax rates will affect his incentives to work. Using his example, I'll argue that the president's plan will also affect most everyone's incentive to work.

Although he doesn't explicitly say so, Mankiw suggests that those who believe the president when he says that the top tax rate "would just go back to where they were under President Clinton," are being duped. Mankiw shows us how the math under the new plan is much different than proposed. Factoring in the reinstatement of a stealth provision phasing out itemized deductions, along with the introduction of the new Medicare taxes provided by the healthcare law, top earners will now pay close to 45 percent of their income in taxes, not an insignificant increase from Clinton-era tax rates. Adding to that the proposed increases in capital gains, dividends, and estate taxes, along with state and local taxes, top earners can face a 90 percent total marginal tax rate.

That bears repeating. The new tax proposals offered by President Obama will force top earners to pay considerably more marginal taxes -- some up to a 90 percent total marginal tax rate. Put another way, if you make 250K a year or more, under the president's plan, for every extra dollar in income you earn, up to 90 cents can be taxed.

With projected increases in federal spending driven by Social Security and to a greater extent, the new healthcare law, will taxing the top 2 percent of earners up to 90 percent of their extra income be enough? The short answer is no. Top earners do not provide nearly enough revenue to close the gap in federal spending. So that means most everyone, including the broad middle class, will face substantially higher real and marginal taxes. But don't take my word for it; let the title to a David Leonhardt piece convince you: "Like Medicare? Then Taxes Must Rise."

And here's where work incentives come into play. Faced with higher real and marginal tax rates, Mankiw turns down a lot of opportunities to work more. There's just no incentive for him to exert extra effort when doing so would provide almost no extra benefit to him and his family. He puts it this way: with a 90 percent total marginal tax rate, "is it any wonder that I turn down most of the money-making opportunities I am offered?"

Any wonder, indeed. But as we've discovered, it's not only top earners who will face perverse work incentives. Higher federal spending in the future means higher real and marginal tax rates for everyone. And this raises another question: will we wonder why no one will want to work more?