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Why Care About Marginal Tax Rates?

1 min readBy: Andrew Chamberlain

The Congressional Budget Office released a new study of marginal effective taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. rates on labor income yesterday (PDF here). Why should we care about marginal tax rates? Here’s one answer from their executive summary:

Higher marginal rates tend to cause more behavioral changes than lower rates do, leading to larger inefficiencies. Taxes on activities about which people are very flexible in how much of them to pursue will tend to create greater distortions than taxes on activities about which people have less discretion. And taxes that affect broad aspects of the economy—such as how much work is done—can have the greatest distortionary impact…

One interesting section of the paper explores what will happen to marginal tax rates if the 2001, 2002 and 2003 Bush tax cuts are allowed to expire in coming years. From the perspective of economic efficiency, it’s not good news:

If tax provisions enacted in 2001, 2003, and 2004 expire as scheduled over the next five years, marginal rates will increase across most of the income distribution. Compared with a fully phased-in version of existing law, expiration would raise effective marginal tax rates by an average of almost 3 percentage points. Roughly half of taxpayers would face higher marginal rates…

Here’s a chart of effective marginal tax rates on labor, by income percentile, under current law and after the expiration of the Bush tax cuts (click to enlarge).

Read the full study here (PDF).