The marginal tax rate is the rate
on the last dollar of income earned. This is very different from
the average tax rate, which is the total tax paid as a
percentage of total income earned. In 2003, for example, the
United States imposed a 35 percent tax on every dollar of
taxable income above $155,975 earned by a married taxpayer
filing separately. But that tax bracket applied only to earnings
above that $155,975 threshold; income below that cutoff
point would still be taxed at rates of 10 percent on the first
$7,000, 15 percent on the next $14,400, and so on. Depending on
deductions, a taxpayer might pay a relatively modest average
tax on total earnings, yet nonetheless face a 28–35 percent
marginal tax on any activities that could push income
higher—such as extra effort,
education,
entrepreneurship, or
investment. Marginal decisions (such as extra effort
or investment) depend mainly on marginal incentives (extra
income, after taxes).
The seemingly arcane topic of marginal tax rates became the central
theme of a revolution in economic policy that swept the globe during
the last two decades of the twentieth century, with more than fifty
nations significantly reducing their highest marginal tax rates on
individual income (most of which are shown in
Table 1). Tax rates on corporate income (not shown) were also
reduced in most cases (e.g., to 12.5 percent in Ireland).
Table 1 also shows, however, that a handful of countries did
comparatively little to reduce the highest, most damaging tax
rates—notably, most of Western Europe, Scandinavia, Canada, and
Japan.
Why did so many other countries so dramatically reduce marginal tax
rates? Perhaps they were influenced by new economic analysis and
evidence from optimal tax theorists, new growth economics (see
economic growth), and
supply-side economics. But the sheer force of example may
well have been more persuasive. Political authorities saw that other
national governments fared better by having tax collectors claim a
medium share of a rapidly growing economy (a low marginal tax)
rather than trying to extract a large share of a stagnant economy (a
high average tax). East Asia, Ireland, Russia, and India are a few
of the economies that began expanding impressively after their
governments sharply reduced marginal tax rates.
*. Hong Kong’s maximum tax (the “standard rate”) has normally been 15 percent, effectively capping the marginal rate at high income levels (in exchange for no personal exemptions). | |||
**. The highest U.S. tax rate of 39.6 percent after 1993 was reduced to 38.6 percent in 2002 and to 35 percent in 2003. | |||
1979 | 1990 | 2002 | |
Argentina | 45 | 30 | 35 |
Australia | 62 | 48 | 47 |
Austria | 62 | 50 | 50 |
Belgium | 76 | 55 | 52 |
Bolivia | 48 | 10 | 13 |
Botswana | 75 | 50 | 25 |
Brazil | 55 | 25 | 28 |
Canada (Ontario) | 58 | 47 | 46 |
Chile | 60 | 50 | 43 |
Colombia | 56 | 30 | 35 |
Denmark | 73 | 68 | 59 |
Egypt | 80 | 65 | 40 |
Finland | 71 | 43 | 37 |
France | 60 | 52 | 50 |
Germany | 56 | 53 | 49 |
Greece | 60 | 50 | 40 |
Guatemala | 40 | 34 | 31 |
Hong Kong | 25* | 25 | 16 |
Hungary | 60 | 50 | 40 |
India | 60 | 50 | 30 |
Indonesia | 50 | 35 | 35 |
Iran | 90 | 75 | 35 |
Ireland | 65 | 56 | 42 |
Israel | 66 | 48 | 50 |
Italy | 72 | 50 | 52 |
Jamaica | 58 | 33 | 25 |
Japan | 75 | 50 | 50 |
South Korea | 89 | 50 | 36 |
Malaysia | 60 | 45 | 28 |
Mauritius | 50 | 35 | 25 |
Mexico | 55 | 35 | 40 |
Netherlands | 72 | 60 | 52 |
New Zealand | 60 | 33 | 39 |
Norway | 75 | 54 | 48 |
Pakistan | 55 | 45 | 35 |
Philippines | 70 | 35 | 32 |
Portugal | 84 | 40 | 40 |
Puerto Rico | 79 | 43 | 33 |
Russia | NA | 60 | 13 |
Singapore | 55 | 33 | 26 |
Spain | 66 | 56 | 48 |
Sweden | 87 | 65 | 56 |
Thailand | 60 | 55 | 37 |
Trinidad and Tobago | 70 | 35 | 35 |
Turkey | 75 | 50 | 45 |
United Kingdom | 83 | 40 | 40 |
United States | 70 | 33 | 39** |
Source: PricewaterhouseCoopers; International Bureau of Fiscal Documentation. |
Economic Growth by Robert J. Barro and Xavier Sala-i-Martin
(MIT Press, 2004, p. 514) lists among the world’s twenty
fastest-growing economies Taiwan, Singapore, South Korea, Hong Kong,
Botswana, Thailand, Ireland, Malayasia, Portugal, Mauritius, and
Indonesia. As
Table 1 shows, all these countries
either had low marginal tax rates to begin with (Hong Kong) or cut
their highest marginal tax rates in half between 1979 and 2002
(Botswana, Mauritius, Singapore, Portugal, etc.). This might be
dismissed as a remarkable coincidence were it not for a plethora of
economic studies demonstrating several ways in which high marginal
tax rates can adversely affect economic performance.
Numerous studies, ably surveyed by Karabegovic et. al. (2004), have
found that high marginal tax rates reduce people’s willingness to
work up to their potential, to take entrepreneurial risks, and to
create and expand a new business: “The evidence from economic
research indicates that … high and increasing marginal taxes have
serious negative consequences on economic growth, labor supply, and
capital formation” (p. 15).
Federal Reserve Bank of Minneapolis senior adviser
Edward Prescott, corecipient of the 2004 Nobel Prize in
economics, found that the “low labor supplies in Germany, France,
and Italy are due to high [marginal] tax rates” (Prescott 2004, p.
7). He noted that adult labor force participation in France has
fallen about 30 percent below that of the United States, which
accounts for the comparably higher U.S. living standards.
Even in the United States, marginal tax rates are really higher than
statutory rates suggest. In a study aptly titled “Does It Pay to
Work?” Jagadeesh Gokhale et al. (2002) include state and local
taxes, the marginal impact of losing government benefits (such as
Medicaid and food stamps) if income rises, the progressive nature of
Social Security benefits (which are least generous to
those who work the most), and the phasing out of deductions and
exemptions as income rises. They conclude that even “those with
earnings that exceed 1.5 times the minimum wage face marginal net
taxes on full-time work above 50 percent” (Abstract). At higher
incomes, the estimated federal, state, and local marginal tax rate
is about 56–57 percent. Marginal tax rates are higher still,
however, in countries where statutory rates are higher.
Lifetime family work effort and entrepreneurship are not the only
things affected. Nobel laureate
Robert Lucas emphasized the deleterious effect on
economic growth of high tax rates on capital. Philip Trostel focused
on the impact on
human capital, finding that high marginal tax rates on
labor income reduce the lifetime reward from investing time and
money in education. There are evidently many channels through which
high marginal tax rates may discourage additions to personal income,
and thus also discourage marginal additions to national output
(i.e., economic growth). As the variety among these studies
suggests, each separate effect of high marginal tax rates is
typically examined separately, which makes the overall economic
distortions and disincentives appear less significant than if they
were all combined.
Despite widespread reduction of marginal tax rates throughout the
world, there remains considerable misunderstanding about what
marginal tax rates are and why they matter. The common practice of
measuring tax receipts as a percentage of GDP, for example, is too
static. It ignores the destructive effects of tax avoidance on tax
revenues, the numerator of that ratio, and on the growth of GDP, the
denominator. A sizable portion of productive activity may cease,
move abroad, or vanish into inefficient little “informal”
enterprises. And just as so-called tax havens attract foreign
investment and immigrants, countries in which the combined marginal
impact of taxes and benefits is to punish success and reward
indolence often face “capital flight” and a “brain drain.”
OECD in Figures (2003) shows total taxes as 45.3 percent of
GDP in France, compared with 29.6 percent in the United States. But
it would be a mistake to conclude that the higher average tax burden
in France is a result of that country’s more steeply graduated
income tax. French income tax rates claim half of any extra dollar
at incomes roughly equivalent to $100,000 in the United States, and
exceed the highest U.S. tax rates at even middling income levels.
Yet these high individual income taxes account for only 18 percent
of revenues in France, about 8.2 percent of GDP, while much lower
individual income tax rates in the United States account for 42.4
percent of total tax receipts, or 12.5 percent of GDP. Countries
such as France and Sweden do not collect high revenues from high
marginal tax rates, but from flat rate taxes on the payrolls and
consumer spending of people with low and middle incomes. Revenues
are also high relative to GDP partly because private GDP (the tax
base) has grown unusually slowly, not because tax revenues have
grown particularly fast.
People react to tax incentives for the same reason they react to
price incentives. Supply (of effort and investment) and demand (for
government transfer payments) respond to marginal incentives. To
increase income, people may have to study more, accept added risks
and responsibilities, relocate, work late or take work home, tackle
the dangers of starting a new business or investing in one, and so
on. People earn more by producing more. Because it is easier to earn
less than to earn more, marginal incentives matter.
To the extent to which a country’s tax system punishes added
income with high marginal tax rates, it must also punish added
output—that is, economic growth.
Further Reading
Gokhale, Jagadeesh, Laurence Kotlikoff, and Alexi Sluchynsky.
“Does It Pay to Work?” NBER Working Paper no. w9096. National
Bureau of Economic Research, Cambridge, Mass., 2002. Online at:
http://www.nber.org/papers/w9096.
Karabegovic, Amelia, Niels Veldhuis, Jason Clemens, and Keith
Godin. “Do Tax Rates Matter?” Fraser Forum, July 2004.
Online at:
http://www.fraserinstitute.ca/admin/books/chapterfiles/July04ffkarabeg.pdf#.
Lucas, Robert E. Jr. “Supply-Side Economics: An Analytical
Review.” Oxford Economic Papers 42 (April 1990): 293–316.
Online at:
http://ideas.repec.org/a/oup/oxecpp/v42y1990i2p293–316.html.
Prescott, Edward C. “Why Do Americans Work So Much More than
Europeans?” Federal Reserve Bank of Minneapolis Quarterly
Review (July 2004). Online at:
http://minneapolisfed.org/research/qr/qr2811.pdf.
Reynolds, Alan. “Crises and Recoveries: Multinational Failures
and National Success.” Cato Journal 23 (Spring/Summer
2003): 101–113. Online at:
http://www.cato.org/pubs/journal/cj23n1/cj23n1–11.pdf.
Reynolds, Alan. “The Fiscal-Monetary Policy Mix.” Cato
Journal 21 (Fall 2001): 263–275. Online at:
http://www.cato.org/pubs/journal/cj21n2/cj21n2-11.pdf.
Reynolds, Alan. “International Comparisons of Taxes and
Government Spending.” In Stephen E. Easton and Michael A.
Walker, eds., Rating Global Economic Freedom. Vancouver:
Fraser Institute, 1992. Pp. 361–388. Online at:
http://oldfraser.lexi.net/publications/books/rating_econ_free/.
Reynolds, Alan. “Tax Reform in Lithuania and Around the World.”
Lithuanian Free Market Institute, no. 6, 1997. Online at:
http://www.freema.org/NewsLetter/tax.budget/1997.6.treform.phtml.
Reynolds, Alan. “Workforce 2005: The Future of Jobs in the
United States and Europe.” In OECD Societies in Transition:
The Future of Work and Leisure. Paris: OECD, 1994. Pp.
47–80. Online at:
http://www.oecd.org/dataoecd/26/32/17780767.pdf.
Trostel, Philip A. “The Effect of Taxation on Human Capital.”
Journal of Political Economy 101 (1993): 327–350. Online at:
http://econpapers.hhs.se/article/ucpjpolec/v_3A101_3Ay_3A1993_3Ai_3A2_3Ap_3A327-50.htm.