Food stamps, unemployment insurance, and other subsidies to persons who are unemployed and otherwise with low incomes, have recently been made more generous and available in more situations. Did extra transfers help prevent a deeper recession, or did it amplify and prolong it? Economists cannot fully answer these questions without examining the incentives of persons receiving the transfers. The purpose of this paper is to quantify the number of people who recently had essentially no short-term financial reward from working, and how that number might have been different if safety net program rules had been made more generous, or if they had remained what they were in 2007.
American economists often discuss the unemployment insurance (hereafter, UI) system and its moral hazards as if the penalty for accepting a new job were about 50 percent of compensation, which would suggest that the financial reward to working would be positive and significant in all but a few rare circumstances. At the same time it is commonly noted that the average weekly unemployment benefit of about $300 barely exceeds the compensation from a full-time minimum wage job, and for this reason alone UI is almost always inferior to a real paycheck. These claims are incorrect because they ignore payroll taxes, income taxes, and other safety net programs. The tax arithmetic suggests that many UI participants would, even under 2007 rules and even ignoring all safety net programs aside from UI and the personal income tax, keep about 30 percent – and maybe as little as ten percent – of the compensation generated by accepting a new above-minimum-wage job because taxes typically took as much of the reward from working as foregone unemployment benefits did. These thin margins essentially disappeared under the American Recovery and Reinvestment Act of 2009 (hereafter, ARRA).
Even when helping the poor is a primary policy motivation and the wage elasticity of labor supply is low, optimal tax theory frowns on labor income tax rates that equal or exceed one hundred percent (as long as work is not socially harmful) because at a one hundred percent rate there is no longer a tradeoff between efficiency and government revenue. From a positive point of view, economists expect that employment rates will be low, if not zero, in groups of people who are aware that they receive no financial reward from working. These are a couple of more reasons to quantify the prevalence of marginal tax rates that are near or exceed one hundred percent.
The paper begins with a brief overview of the major safety net programs affecting the financial reward to working. The first quantitative results are 2009 marginal tax rates and their components for some of the more common tax situations encountered by American workers and their families. The rates are calculated for three scenarios: actual benefit and tax rules, benefit and tax rules as they would have been if they had not been changed since 2007, and benefit and tax rules as they might have been in a bigger stimulus. The following section considers the rich and complicated variety of possible tax situations in order to arrive at estimates of the number of household heads and spouses with little or no financial reward to accepting a new job. A “demand shocks and job search gambles” section shows how job acceptance rewards are nonlinear in the amount of a job offer, and the final section concludes.
Before the recession began, going from unemployment back to work did not pay that well for someone eligible for unemployment benefits, but almost always paid a little something, with at least twenty percent of compensation from a job going toward enhancing the new employee’s disposable income above what it was during the spell. Despite its inclusion of a “making work pay” tax credit and its expansion of the “earned income tax credit,” the ARRA increased marginal tax or “job acceptance penalty” rates for the vast majority of the unemployed and essentially erased the short-term financial benefits from working for two to three million non-elderly and unemployed household heads and spouses. About five million had their job acceptance penalty rates increased above 80 percent by the ARRA.
Layoffs have also long been subsidized by unemployment insurance and other safety net programs, but again typically public treasuries would pay for less than 90 percent of the compensation lost from a layoff, while employer and employee had to absorb the rest. When the ARRA was in full force, over three million workers could be laid off with a subsidy of 90 percent or more, and another five million with a subsidy rate of 80 to 89 percent. A bigger stimulus would have put as many as 30 million workers in that situation.
To the degree that unemployment responds to the financial incentives for working, the ARRA and other programs assisting the unemployed interact with demand shocks in determining the number unemployed: an adverse demand shock increases unemployment more under the ARRA than it would if the same demand shock were experienced under 2007 tax and subsidy rules.
None of these results hinge on the increase of the duration of unemployment benefits from 26 to 99 weeks, which was achieved by legislation separate from the ARRA
(United States Department of Labor 2011). I count each unemployed person only when they are laid off; the results here reflect the level of benefits delivered by tax and subsidy programs to unemployed persons beginning to receive UI. UI and other program eligibility rule changes are not considered in this paper but are important for quantifying changes in marginal tax rates between 2007 and 2009, and comparing such changes across demographic groups.
My findings of large, even confiscatory, job acceptance penalty rates are not the result of “cliffs” in transfer program formulas in which many dollars of benefits are lost for earning a particular marginal dollar
(Yelowitz 1995) because I look at the consequence of more “discrete” decisions of accepting a job, or initiating a layoff, that change calendar year income by thousands of dollars. Instead, my large rates reflect the combination of tax and subsidy rules, especially unemployment insurance. Not surprisingly, my rate estimates exceed those of previous studies of transfer program marginal tax rates that omit unemployment insurance (Holt and Romich 2007) and exceed those of previous studies of unemployment insurance that ignored taxes (Chetty 2008). But taxes, unemployment insurance, and other transfer programs have recently contributed significantly to the living standards of the poor and unemployed (Sherman 2011), so we cannot have a full understanding of the magnitude of marginal tax rates without considering the safety net broadly.
I have likely somewhat under-estimated the number of people with marginal tax rates in excess of one hundred percent because I have omitted a number of other possible sources of implicit taxes. They include other means-tested cash assistance programs such as Disability Insurance, TANF and Supplemental Security Income; means-tested housing subsidies; means-tested tuition assistance; and means-tested energy assistance programs. They also include court-enforced wage garnishment associated with the collection of delinquent consumer, tax, and child support debts.
At the same time that incentives to retain and accept jobs were erased for millions, millions were laid off from their jobs and remained unemployed for an extended duration. I estimate that 2.3 million additional non-elderly household heads and spouses were laid off in 2009 than would have been laid off if the 2000-2007 average number of layoffs had persisted through 2009. The number of unemployed household heads and spouses were about 5 million greater than normal. In other words, the extraordinary numbers of persons laid off and unemployed are of roughly the same magnitude as the numbers of persons having their incentives essentially erased by the ARRA. The fact that more persons would have had incentives erased if the ARRA had been more generous to the unemployed suggests that it is possible that a bigger stimulus would have resulted in more unemployment than the actual stimulus did.
It is beyond the scope of this paper to quantify the impacts that the large penalties for work from the ARRA (or other legislation) had on the labor market for people laid off during the recent recession. Nor do I attempt to determine whether increasing marginal tax rates beyond 100 percent matters more or less than increasing them beyond, say, 70 percent. But even before obtaining such estimates we should not expect that a labor market would function normally while the private benefit to working was zero or negative. For this reason, the arithmetic presented in this paper is indeed unpleasant, and disturbingly similar to discredited welfare program rules of the distant past. As James Tobin put it in 1965,
“[A 100 percent tax rate] does just that, causing needless waste and demoralization. This application of the means test is bad economics as well as bad sociology. It is almost as if our present programs of public assistance had been consciously contrived to perpetuate the conditions they are supposed to alleviate.”
(Tobin 1965, 890)
(2008) estimates the U.S. UI replacement rate as 50 percent for the purposes of demonstrating that it might be slightly less than optimal. See also Fujita (2010).
 Behavior in the neighborhood of 100 percent tax rates would be especially interesting if it were true that (a) when tax rates are lower and more typical of their historical values, the amount of unemployment were insensitive to the amount of the UI benefits and (b) unemployment would be high if unemployment paid better than working. To see this, try drawing a graph of the relationship between unemployment and the size of UI benefits that satisfies the properties (a) and (b): it must turn or jump sharply toward high unemployment as the benefit approaches the amount of pay from working.