Statutory and effective tax rates: Part 1

Article Highlights

  • Wage and income taxes impose work disincentives, but the manner in which they discourage work has caused confusion.

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  • Looking at the effective tax rate reveals that many views about the effect of taxes on work incentives are unfounded.

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  • It may be desirable to focus on reducing other distortions posed by the tax system instead of focusing on disincentives.

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Statutory and effective tax rates: Part 1

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Although it is well known that wage taxes and income taxes impose work disincentives, the manner in which different tax systems discourage work has been the subject of considerable confusion. A common misperception, expressed by commentators across the ideological spectrum, views work disincentives as depending solely on the statutory tax rates imposed on wages. This misconception leads to the fallacy that it is possible to significantly reduce work disincentives without encountering any revenue or distributional trade-offs by lowering statutory income tax rates and offsetting the revenue loss through base broadening.

In reality, a tax system's work disincentives depend on effective marginal tax rates, which can differ significantly from statutory tax rates. The effective marginal tax rate on an individual's work is the net increase in tax payments that she incurs by working to earn and consume an additional dollar. The relevant tax payments include any taxes explicitly imposed on the additional dollar of wages but are not limited to those taxes. The correct calculation of the effective tax rate also reflects any taxes imposed on, or any tax savings generated by, the consumption financed by the additional dollar of wages. For example, any excise taxes or general consumption taxes imposed on the expenditures financed by the dollar of wages increase the effective tax rate and enhance the work disincentive. Conversely, tax savings generated by income tax deductions or credits for expenditures financed by the dollar of wages reduce the effective tax rate and diminish the work disincentive.

Looking at the effective tax rate reveals that many commonly expressed views about the effect of taxes on work incentives are unfounded. Notably, a revenue-neutral and distributionally neutral income tax reform that broadens the tax base and lowers statutory tax rates will leave work disincentives roughly unchanged. The correct analysis reveals that there are no easy ways to significantly reduce work disincentives. Although work disincentives can be significantly reduced by lowering the overall level of taxation or by making the tax system less progressive, each of these options poses distributional trade-offs. It may therefore be desirable to focus on reducing other distortions posed by the tax system, such as the bias in favor of owneroccupied housing and fringe benefits.

In this article, which is the first part of a two-article series, I draw out these points in a hypothetical economy with no passage of time. The economy considered here features no choices about when to work or consume and has no saving or capital accumulation. In the forthcoming second article, I will broaden the analysis to consider an economy in which time passes. As will be seen, the same basic principles continue to apply, but there are several additional implications to consider.

Alan Viard is a resident scholar at AEI.

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About the Author


Alan D.
  • Alan D. Viard is a resident scholar at the American Enterprise Institute (AEI), where he studies federal tax and budget policy.

    Prior to joining AEI, Viard was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He has also been a visiting scholar at the US Department of the Treasury's Office of Tax Analysis, a senior economist at the White House's Council of Economic Advisers, and a staff economist at the Joint Committee on Taxation of the US Congress. While at AEI, Viard has also taught public finance at Georgetown University’s Public Policy Institute. Earlier in his career, Viard spent time in Japan as a visiting scholar at Osaka University’s Institute of Social and Economic Research.

    A prolific writer, Viard is a frequent contributor to AEI’s “On the Margin” column in Tax Notes and was nominated for Tax Notes’s 2009 Tax Person of the Year. He has also testified before Congress, and his work has been featured in a wide range of publications, including Room for Debate in The New York Times,, Bloomberg, NPR’s Planet Money, and The Hill. Viard is the coauthor of “Progressive Consumption Taxation: The X Tax Revisited” (2012) and “The Real Tax Burden: Beyond Dollars and Cents” (2011), and the editor of “Tax Policy Lessons from the 2000s” (2009).

    Viard received his Ph.D. in economics from Harvard University and a B.A. in economics from Yale University. He also completed the first year of the J.D. program at the University of Chicago Law School, where he qualified for law review and was awarded the Joseph Henry Beale prize for legal research and writing.
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