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Incentives to stay poor

February 16, 2012

The state legislature seems to be racing to increase Iowa's earned income tax credit as part of an emerging grand bargain to lower commercial property taxes. The Iowa Senate has passed a bill to increase the refundable credit to 20% of the federal credit by 2014. It currently is 7% of the federal credit.

While the legislation may be well-intended, it worsens a perverse side effect of the EITC: it increases the penalty for the working poor to improve their lot. The EITC phases out as income increases. When you take the phase-out into account, the marginal tax rate -- the effective rate on each additional dollar of income earned -- goes through the roof.

Using a standard income tax projection software, I figured the marginal tax rate of a single taxpayer with three children and self-employment income. I used self-employment income to capture the payroll tax effects of additional earnings that are hidden for wage earners. The results are charted below:

Click to enlarge

The federal marginal tax rate reaches 48%. The Iowa marginal rate rises as high as 10.04%. Considering the highest federal and Iowa regular tax rates for high-income earners are 35% and 8.98%, that's a real handicap on the working poor trying to improve their lot. It 's a big unintended incentive to the poor to keep their income low.

The situation gets even worse if you take into account other means-tested welfare benefits. The loss of these benefits can cause marginal tax rates for the working poor to exceed 100%.

It would be nice if the legislature would consider the disincentives they create for emerging from poverty. Unfortunately, giving away money is enough for them to campaign on.

Related: Can you cut taxes for people who don't pay taxes?

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