Marginal Tax rates, and unintended consequences

2016 March 23
tags:
by Daniel Lakeland

Imagine a scenario that must play out millions of times in the US, especially here in CA where salaries and cost of living are both relatively high. A family has two skilled adults, a man and a woman, with two children. Each adult is capable of earning say $100k to make things easy to calculate. For example, perhaps the man is a lawyer and the woman is a CPA.

Now, the children are youngish, and for a year or so the woman has been staying home with one of the children, and is now thinking about starting up her CPA business as an LLC or whatever. The specifics don't matter.

So, current family income is around $100k, and this places marginal tax rates on income at 25%. To start up an LLC doing taxes as a CPA requires that the marginal income pay 25% federal, 15% self-employment, 9% CA state tax, and on everything you take home and spend, you'll pay 9% sales tax. So, adding it all up you're talking about 58% marginal tax rate. (actually a little higher, because at 151k the marginal rate jumps to 28% federal, but you may be able to deduct some of the self-employment. the point is, it's definitely in the neighborhood of 58 +- 5% or so).

So, this person has to make the choice, stay home and work at home doing cleaning, after school care, taking care of the finances, getting the car fixed when it's broken, shopping, arranging family vacations and soforth... Or go back to work for the business and earn paid income.

How much is the unpaid work worth? Well, lots of people ask this kind of question and have various issues with quantifying it, but quoting here: https://en.wikipedia.org/wiki/Valuation_of_Nonmarket_Housework suggests that the unpaid home work in the US amounts to on the order of $11.6 Trillion or $73,000/person. Now, some of this work is done even if you're employed, on weekends, evenings, etc. So let's suppose the portion given up by going to work full time is say 75% or $54,000. (I'd argue this is the least well known variable, and that it depends a lot on what people actually choose to do with their home time. But let's put it between say 45 and 65k for this educated person who has access to resources from her partner's salary).

At a marginal tax rate of around 60%, the new job needs to pay 54,000/(1-0.6) = $135,000 to make this tradeoff make any sense (and maybe more, because the tax rate increases).

So, this person stays home, doing relatively easy stuff, maybe working a few hours here and there, but certainly not trying hard to make this CPA job a full time business. The world has say $(100-54=46),000 less overall services provided, but the family saves $6,000 in value relative to working full time to earn $100k and then paying all that tax and hiring someone to do the house-work, and the flexibility and reduced stress she experiences is pretty valuable in an intangible but very significant way (much easier to go to the gym if you set your own schedule for example).

How does this make sense? Income tax is just a broken idea. The reason we have income tax is that 100 years ago or so it was infeasible to collect taxes any other way, but WWI required significant resources. Computerized transaction accounting etc didn't exist. To capture the tax money required inducing businesses to be tax collectors. Today, we're in a different world.

 

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