Cumulative Tax Rates on the Working Poor: Evidence of a Continuing Poverty Wall
Suyderhoud, Jack P., Loudat, Thomas A., Pollock, Richard L., Journal of Economic Issues
The persistence of poverty in the United States remains an analytical and political issue |Sawhill 1988~. "Welfare" programs' contribution to this persistence likewise has been the subject of heated political exchanges and less impassioned but no less relevant academic study. The economic literature has addressed this issue by examining the extent to which transfer payments reduce incentives for the poor to supply labor, earn income, and thereby alleviate their poverty. These so-called "work disincentives" have received much attention, especially within the context of the Aid to Families with Dependent Children (AFDC) program.
Work disincentives have two theoretical forms. First, an income effect exists since the receipt of public assistance (e.g., AFDC) increases the recipient's capability to "purchase" leisure and thus reduce the supply of labor. Second, increased wage earnings reduce welfare benefits and increase tax liabilities and other work-related expenses. The collective impact of these is to introduce a price effect that reduces net disposable income from working and creates a work disincentive.
Northrop |1991, 1021-22~ and Jencks and Edin |1990, 41-44~ recognize that incremental returns to work may not be adequate to induce recipients to leave AFDC rolls. Northrop argues that this is not a cause of poverty, but merely reflects the economy's failure to provide sufficient rewards for work. We agree but add a related facet to this complex issue. This is the "tax" structure of public assistance programs, particularly AFDC. What is the structure of these "taxes"? Does it penalize those who try to replace public assistance with earned income? The answers to these questions are the focus of this paper.
In developing our analysis, we first define the nature of the "tax" faced by AFDC recipients. We review the relevant literature and point out shortcomings in previously used definitions and measures of the "tax." These shortcomings have led to significant understatement of the AFDC "tax" and its work disincentive effects. We also illustrate how the so-called "welfare reform" of the 1980s increased work disincentives.(1) Finally, we show how the interaction between the tax system and the AFDC program creates marginal tax rates that penalize the work efforts of the poor. We find that even without considering work-related expenses and other public assistance programs, the returns to work for AFDC recipients are so low that effective marginal tax rates are above those considered oppressive to middle- and high-income taxpayers.
The Cumulative Tax Concept
The earnings "tax" for AFDC recipients can be characterized as a "cumulative tax," an amalgam of two "taxes" as earnings increase: positive income and payroll taxes, and an implicit "tax" taking the form of public assistance benefit reductions. Marginal discretionary income for the working poor is determined by how taxes, AFDC benefits, and work-related expenses change in response to higher earnings from increased work effort. We define the relevant "cumulative tax rate" (CTR) as the sum of the marginal positive tax rate (PTR) and the AFDC effective benefit reduction rate (BRR).
In the interest of specificity, our measure of the CTR focusses on the full "tax" impact of one welfare program, AFDC, in one state, Hawaii, for the years 1985 and 1989. However, the concepts and methodology we develop have relevance for more definitive and comparable measures for all transfer programs in all states. Furthermore, they can assist in the evaluation and design of welfare programs and tax policies affecting the working poor so that they result in less onerous cumulative tax rates.
We measure the 1985 and 1989 cumulative tax rates to compare work disincentives for two different time periods. The 1985 rate reflects the 1981 Omnibus Budget Reconciliation Act (OBRA) rule changes but not the 1986 Tax Reform Act (TRA) and the 1988 Family Support Act (FSA) modifications. …