What are Effective Marginal Tax Rates?

This post is by PaulL, a regular commentor and occasional contributor.   It is the second post in a series on the financial incentives to work and the impacts of our tax and transfer system on household formation.  The index to all posts in the series can be found here.

When we talk about incentives to work what matters is the impact on the next dollar – the impact at the margin.  People care about the impact of the change from their previous situation.  I wasn’t working and now I am.  How much extra money do I get than I had before?  I was working 20 hours a week, now I’m working 24 hours.  How much extra money do I get?

At a headline level the lowest marginal tax rate in NZ is 14%.  So if I work four extra hours at minimum wage, I should get $21.20 x 4 hours x 86% = $73 cash in the hand.  Easy, right?

But remember that I’m getting a benefit.  I may be getting an accommodation supplement.  I may be getting childcare support, and I get tax credits via working for families.  All those government programmes have some form of threshold and abatement rate.

If I work an extra hour I get $21.20 gross income.  

• I lose $3 to tax.  
• If I’m over the $160 weekly income threshold, my jobseeker benefit will also be reduced by 70 cents in the dollar. I lose another $14 in benefit reduction.
• I may also have accommodation supplement.  If I cross the earning threshold I’ll lose 25 cents in the dollar. 
• If I’m a parent I’m probably getting Family Tax Credit.  I’ll lose 27 cents in the dollar if my household income is more than $33,000 per annum. 
• If I’m not getting a main benefit I may get In Work Tax Credit, and I’ll lose 27 cents in the dollar on that
• If I’m a sole parent I’ll be getting a subsidy on my childcare. That has income thresholds at $840 a week, $1,250 a week, $1,400 and $1,500 a week, each of which reduce the amount paid.

An effective marginal tax rate (EMTR) adds all that together.  It says “if you earn an extra dollar of income, after we take all the government programmes you receive into account, how does it change your household income?” 

For many people on a full or partial benefit in NZ their effective marginal tax rate is 83% or more.  Even worse, at some specific income thresholds, the tax rate approaches 100%. This is massively higher than the 39% tax rate facing the top end of town.

The effective marginal tax rate only considers the government programmes – the tax and transfer system.  Incentives to work are impacted by more than just the tax and transfer system.  If I go to work I have to get there somehow – maybe I drive, maybe I take the bus.  I may need to buy lunch, or at least make and take my lunch.  I may need appropriate clothing that I wouldn’t otherwise own.  I have direct financial costs when I go to work. Not all of my income is now available for me to spend.  Someone making a decision to get a job considers their full costs – how will their usable income be different.  If their job has $20 a day of transport costs, that’s part of their consideration.

For a sole parent going to work there’s also childcare to consider. If you’re lucky you have family who can help, for many of the people most in need their family aren’t there to support them. You get childcare subsidy, but often it doesn’t cover the full costs of the child care.

All of that ignores another obvious impact – I’m now at work instead of doing whatever else I want.  It’s not enough for going to work to balance out roughly even. If I’m going to spend time at work I need to get quite a few dollars in the hand for each hour of my time.

In summary, calculating an effective marginal tax rate is a way to see the entirety of the impacts of government programme abatement, and understand how much of an extra dollar that a person earns is clawed back by the government.

The rest of this series will explore effective marginal tax rates in NZ for people with different household circumstances.  

The rest of this specific post will dive into a bit more detail on the effective marginal tax rate literature.  If you’re not into reading lots of detail, now is when you stop reading this post, and wait for the next post in the series.

The international literature has a lot of analysis of effective marginal tax rates.  This study from the USA is focused on the ‘marriage penalty’ that exists in the US tax and transfer system, in which people are worse off if they get married.  Later posts in this series will look at impacts of the tax and transfer system on household formation (aka does it make financial sense to move in together?)

There is also a NZ literature.  The best I’ve found is this paper from Patrick Nolan when at the productivity commission from 2018 that comes to similar calculations to those I have.  Around page 15 it shows graphs of the EMTRs facing example families, and on page 20 it contains this comment:

nonetheless, for all beneficiaries, once full abatement of the main benefit begins there are few incentives to work until income is sufficient to exit the benefit

Patrick also provided a similar paper to policy quarterly from Vic University.  Patrick is now at Treasury, and provided this link to the source code for the Treasury created “income explorer”, and a link to a hosted version of that code (which wasn’t operational when I accessed it).  Both of those are open source and not subject to as rigorous vetting as the internal Treasury models. The commitment from Treasury to make this material available to the public is commendable, albeit it would be nice if it were a bit more easily consumed.

There’s a 2010 paper from MSD on the impacts of Working for Families on EMTRs.  

The MSD paper notes that 17% of beneficiary families faced marginal tax rates of higher than 75%, and 2% higher than 100%.  That was a reduction from pre-Working for Families.  Similarly they observe that 7% of non-beneficiary families faced EMTRs higher than 75%. The paper calculates EMTR only for the next dollar of income, in my opinion that may underestimate the impacts of high EMTRs on people who are near to thresholds (but not exactly at the threshold).

Working documents for tax and transfer legislation often include discussion of EMTRs.  As an example, this document from MSD on the 2021 changes to Working for Families thresholds.  

Patrick Nolan, now at Treasury, also wrote this excellent paper in the early 2000s.  The analysis is interesting, however the target audience is academic/bureaucratic, and as such it is more a statement of what is than a recommendation on what to do.  The tax and transfer system has changed substantially since the 2003 data used in that analysis, with consequent changes in incentives.

I also found this OIA, relating to a tax package in 2017, in which the finance minister (presumably Bill English) was seeking a tax and transfer package that “increased work incentives.”  Clearly at that point in time the government was interested in addressing EMTRs.  The package proposed had relatively little impact on EMTRs and a large fiscal cost ($2B per annum).  I note that MSD don’t appear to have actually answered the question asked – they’ve more answered the question “if you were going to spend $2B, where would you spend it”, rather than “how do I change the tax and transfer system to improve work incentives.”

Overall there is quite a bit of material available, much of it rather dense and academic.  Patrick Nolan at Treasury was very helpful in pointing to this material (much of it written by him), his helping me find the material doesn’t in any way imply endorsement of what I’ve written (Treasury is an apolitical organisation).  Eric Crampton was helpful in pointing me to Patrick as the knower of all things.

In upcoming posts I’ll draw on this material to illustrate examples of EMTRs that face various households in NZ, and use that to illustrate the quite weak incentives for an economically rational person to work additional hours, or to seek additional hourly pay.