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How to Fairly Tax Families

Monday, April 14, 2014

Based on fairness concerns, there’s a strong case for making the tax system more marriage neutral by shifting to individual rather than family-based taxation, and for providing increased support to low-income individuals without children.

In his 2015 budget proposal, President Obama called for expanding the Earned Income Tax Credit (EITC) for workers without children. Currently, that program heavily favors parents relative to nonparents. It also gives rise to large marriage penalties, which some observers have proposed eliminating on the grounds that marriage should not be punished. Another proposal to change the way we tax families came, last fall, from Senator Mike Lee of Utah, who unveiled a tax reform plan that would dramatically reduce taxes on parents relative to nonparents. Defending this underlying principle, Reihan Salam has argued, “By shifting the tax burden from parents to nonparents, we will help give America’s children a better start in life, and we will help correct a simple injustice” stemming from the fact that we all benefit from the work parents do in raising the next generation.

This diversity of proposals illustrates how tricky it is to figure out the right way to tax families. Based on fairness concerns, though, there’s a strong case for making the tax system more marriage neutral by shifting to individual rather than family-based taxation, and for providing increased support to low-income individuals without children.

One approach to thinking about the right tax treatment of families sets fairness aside and examines the spillover effects of marriage and childbearing. If these decisions have spillover benefits to society, they should be encouraged through subsidies. If they have spillover costs, they should be discouraged through taxes. Marriage may have spillover benefits because all members of society are better off with stable families: Children help to relieve the burden created by the pay-as-you-go Social Security and Medicare programs, in which contributions from younger generations are used to pay benefits to older generations. A child may grow up to be the next Steve Jobs or Albert Einstein, making contributions that far exceed the monetary compensation they or their parents receive. (Of course, a child may also grow up to be the next serial killer, but one hopes that the upside potential is greater.) On the other hand, additional children may cause spillover environmental harms.

Because the work decisions of secondary earners are particularly responsive to take-home pay, lowering their tax rates by switching to individual-based taxation would significantly increase economic output.

Many of these spillover effects are difficult to quantify. Fortunately, that doesn’t really matter from a tax policy perspective because marriage and childbearing decisions don’t appear to respond to tax incentives very much. For example, one study found that a $1,000 increase in the marriage penalty reduces the probability of marriage by only 0.4 percentage points. Another study found that expansions in the EITC — which favors families with children — had only a small effect on fertility. Given the size of these effects, the stakes involved in getting the economic incentives exactly right are relatively low.

Instead, policy makers should give greater weight to fairness. As Aspen Gorry and I have argued, family-based taxation, which the United States currently uses, creates important fairness concerns. Consider four single individuals: Jack, who earns $50,000, Jill, who earns nothing, Hansel, who earns $25,000, and Gretel, who earns $25,000. Under a family-based tax system in which each couple or single person pays nothing on the first $10,000 of income and a 10 percent tax on the rest, Jack pays $4,000, Jill pays nothing, and Hansel and Gretel each pay $1,500. Now suppose Jack and Jill get married, and Hansel and Gretel get married. After marriage, both couples pay $4,000 in taxes on a family income of $50,000. While Jack and Jill’s total tax burden doesn’t change with marriage, Hansel and Gretel end up with a marriage penalty of $1,000. Policy makers could provide marriage penalty relief by increasing the exemption to $20,000 for married couples. Then, both couples would pay $3,000 after marriage, wiping out Hansel and Gretel’s marriage penalty but giving Jack and Jill a marriage bonus of $1,000.

We can eliminate both marriage bonuses and penalties by taxing people on their individual incomes even after marriage. Some may argue that this system creates inequality between our two hypothetical couples: Jack and Jill pay $4,000 while Hansel and Gretel pay only $3,000, although both families have identical total incomes. The big advantage, though, is that individual-based taxation takes the government out of personal decisions about marriage and living arrangements. That view is particularly appealing today given the increase in the number of nontraditional families — cohabiting couples have almost doubled as a share of all households since 1990. Since these couples are taxed as individuals, maybe legally married couples should also be taxed that way.

The big advantage is that individual-based taxation takes the government out of personal decisions about marriage and living arrangements.

Another benefit is that individual-based taxation reduces tax rates on secondary earners. Under a family-based tax system, secondary earners pay the same tax on an additional dollar of earnings as primary earners, even if their earnings are very low. In the previous example, if Jill gets a part-time job that pays $5,000, the family-based tax system would levy a 10 percent tax on that income because Jill is married to Jack. In contrast, under an individual tax system, Jill would pay no tax because her income is below the $10,000 exemption. Because the work decisions of secondary earners are especially responsive to take-home pay, lowering their tax rates by switching to individual-based taxation would significantly increase economic output.

It’s particularly hard to determine the fair tax treatment of children. Supporters of Senator Lee’s tax plan argue that tax breaks for children are desirable because they relieve the financial burden on struggling parents. But, others have pointed out that the current tax system already heavily favors children, and that it is in fact low-income nonparents who are in bad shape. For example, my AEI colleague Kevin Hassett has shown that while the tax burden on low-income parents has fallen considerably in recent decades, it has remained relatively constant for low-income nonparents. So it’s not surprising that observers on both the right and the left have expressed support for expanding the EITC for nonparents.

The appropriate tax treatment of families and children is a difficult policy issue. Because marriage and childbearing decisions don’t appear to respond much to tax incentives, policy makers should emphasize fairness concerns. Americans clearly hold differing opinions on how to fairly tax married couples relative to singles and parents relative to nonparents. But there’s a reasonable case to be made for shifting from family-based to individual taxation and for lowering the relative tax burden on low-income nonparents.

Sita Nataraj Slavov is a resident scholar at the American Enterprise Institute.

FURTHER READING: Slavov also writes “The Penalties of Our Tax Code” and “Let’s Raise Taxes on the Middle Class.” Josh Good contends “War on Poverty Needs New Strategy.” Alex Brill contributes “Understanding Tax Fairness (and Why the Buffett Rule Is A Distraction).”

Image by Dianna Ingram / Bergman Group

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