Marginal Tax Rates on Labor Income Under the Democratic House Ways and Means Child Tax Credit Proposal

February 17, 2021

The coronavirus relief legislation passed out of the House Ways and Means Committee last week would significantly expand the child tax credit (CTC) for 2021, from its current $2,000 maximum to a fully refundable $3,600 for children 6 and under and $3,000 for children over 6. Monthly payments would be provided based on income tax returns on file with the Internal Revenue Service (IRS) for 2019 or 2020.

The changes would increase the benefits that lower-income households receive by making the CTC fully refundable and eliminating the phase-in with earned income. While overall benefits would increase, eliminating the phase-in would also affect marginal tax rates. Marginal tax rates on labor income measure the effective tax rate that applies to earning one more dollar of income and can differ from statutory individual income tax rates due to phase-ins and phaseouts of various tax provisions as well as payroll taxes and other taxes on income.

Examining marginal tax rates can help show the incentives that workers face and how policies influence labor supply. We can see how the tax code would treat an additional dollar of income earned under the expanded child tax credit compared to current law.

Take, for example, a household with married taxpayers filing jointly and two children under 6. Under the proposal, their maximum CTC of $4,000 under current law would rise to a maximum of $7,200 under the Democratic proposal. The overall benefit would significantly increase. But under the proposal, households would see an increase in marginal tax rates because the CTC no longer phases in and because of the phaseout of the larger CTC benefit.

Under current law, the credit phases in with earned income above $2,500 at a 15 percent rate, which reduces marginal tax rates by 15 percentage points over the phase-in range. Because the newly proposed credit provides the full amount immediately to households, it no longer has a phase-in and therefore no longer reduces marginal tax rates for lower-income households (see Figure 1). The result is higher marginal tax rates over the current law phase-in range.

The Democratic proposal would also increase marginal tax rates for households at higher income levels by phasing out the extra benefit that the proposal provides over current law. The extra credit provided under the proposal (in the current example, an extra $3,200 above the current law amount of $4,000) would begin phasing out at $150,000 in income at a 5 percent rate until it reaches the amount that would be provided under current law, to preserve existing CTC benefits. The phaseout of the extra amount increases marginal tax rates by 5 percentage points compared to current law (see Figure 1).

Democrats House Ways and Means covid proposal would increase marignal tax rates while receiving larger child tax credit benefits. Democrats child tax credit plan

Marginal tax rates would change in a similar way for other filers. For example, a single parent with one child under 6 (a head of household filer) would be eligible for a maximum $2,000 CTC under current law compared to $3,600 under the Democratic proposal. Like the previous example, marginal tax rates would be higher because the CTC no longer phases in and because of the phaseout of the additional CTC benefit.

Democratic House Ways and Means covid proposal would increase marginal tax rates for some head of household filers. Democrats child tax credit plan

The proposed expansion of credits is only for 2021 and would not be a permanent policy change. Other proposals, like Senator Mitt Romney’s (R-UT) Family Security Act, would permanently expand the child tax credit. It is likely that any temporary expansion would create pressure for an extension or permanence, however. Some argue that the increases in marginal tax rates created by removing the phase-ins would reduce work incentives and potentially negate the positive effects of larger benefits; but the magnitude of the effect is debated. Comparing both the total amount of benefits and the changes in marginal tax rates under each proposal can inform policymakers of potential trade-offs as they work to reform child- and work-related benefits.

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A 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.

The Internal Revenue Service (IRS) is part of the U.S. Department of the Treasury and is responsible for enforcing and administering federal tax laws, processing tax returns, performing audits, and offering assistance for American taxpayers.

A payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue.

The federal child tax credit (CTC) is a partially refundable credit that allows low- and moderate-income families to reduce their tax liability dollar-for-dollar by up to $2,000 for each qualifying child. The credit phases out depending on the modified adjusted gross income amounts for single filers or joint filers.

The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax.

A tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly.