Statutory vs. Effective marginal tax rates

As you've probably noticed, I have been posting a number of VITA workbook taxpayer scenarios on this blog. I'll be posting a few more. I'll also be posting a few "celebrity taxpayer" scenarios, namely those of politicians who have made their tax returns public, including Sarah and Todd Palin, Joe and Jill Biden, and Barack and Michelle Obama.

We will be looking at their statutory and effective marginal tax rates, as well as their effective average tax rates.

This post is about statutory vs. effective marginal tax rates, which are key for economic decision-making.

Basically, a marginal tax rate answers the question: if my income goes up by a thousand dollars, how much will my tax bill go up? (Or, alternatively, how much of that thousand dollars do I actually get to keep, after taking the tax increase into account.)

There are two ways to answer that question: the statutory answer (i.e., the tax law states quite precisely how the tax on line 44 of the 1040 will respond to a thousand dollar increase in the taxable income on line 43) or the real bottom line answer, which we call the effective marginal income rate.

The two graphs below give some idea of how much those two concepts can differ.



The graph above comes from Chapter 18 of Jonathan Gruber's Public Finance and Public Policy textbook, which we used in my fall term public finance class. It shows the statutory marginal tax rates, and looks nice, neat, and tidy--and progressive. Here is a link to a complete listing of the statutory marginal tax rates for all filing statuses, both current and historical (going back to the 1940s.)

The economic reality of taxation, however, is about far more than the statutory rates, due to the many intersecting complications of the tax code. The graph below comes from an article by Urban Institute economist Greg Leiserson, showing the effective marginal tax rates on working families.



But even this graph just scratches the surface of the complexity in the tax code. To keep the analysis simple, the graph above assumes all income comes from wages and considers only a limited number of credits and deductions. As soon as we start to look at other kinds of income, credits, and deductions, there are even more possibilities for marginal tax rates all over the map.

For example, consider the VITA workbook case study of Odessa Parks, whose circumstances are typical of many VITA/AARP clients. Her datapoint is off the charts above: at an income of $35,000, her effective marginal federal income tax rate is a whopping 67%. If we add in her payroll taxes (Social Security & Medicare) as well, the combined effective federal income and payroll marginal tax rate goes to 82%.

And wait, there's more! If we assume she's a New York State resident, her effective state marginal tax rate is an additional 18%.

The bottom line: for a taxpayer like Odessa Parks, a thousand dollar raise could easily make zero impact on her after-tax income, because her effective marginal tax rate is so high. Statutory marginal tax rates are only part of the story. You need to look at the entire tax situation to figure out exactly how much of that raise a taxpayer can keep.