When Work Doesn't Pay For The Middle Class

Judith Lederman would like to find another $120,000-a-year job. But Casey, her high school senior daughter, will qualify for $19,000 a year more in college financial aid if mom has to settle for half that salary.

Eighteen months after being laid off, Judith Lederman, a 50-year-old divorcee who lives in Scarsdale, N.Y., is ready to consider jobs paying half the $120,000 she earned as a publicity manager at Lord & Taylor. That's mostly because she's desperate, but it also makes sense when you consider how this country punishes work effort. While the first $60,000 of her income would be lightly taxed, the next $60,000 would be hit with what is in effect a 79% tax rate. Given a choice between a part-time or easy job paying $60,000 and a demanding, stress-ridden job paying $120,000, Lederman would be wise to take the former. In the tougher job she would be contributing twice as much to the economy. But she wouldn't be doing herself much good. It would make more sense to take it easy and spend more time with her high school senior daughter, Casey.

How did a middle-class single mom wind up with a 79% marginal tax rate? At $120,000 she would pay $16,500 a year more in federal and state taxes, wouldn't qualify for the five-year $12,000-a-year cut in her mortgage payments she's applying for and would be eligible for $19,000 a year less in need-based college financial aid.

For decades there has been debate about how to help the poor without discouraging work, saving or marriage. Yet with almost no notice just such disincentives have crept up the income ladder, observes economist C. Eugene Steuerle, a former Treasury official and expert on the taxation of families. At first blush it would be hard to argue with anything that might help Lederman get back on her feet. Mortgage relief? The voters clamored for it. Scholarships for less-prosperous students? Everyone wants poor kids to get the same chances in life as rich ones. Add up all these good intentions, though, and you get some perverse incentives.

Work isn't the only middle-class virtue that is getting punished. The system penalizes savings, too--not just through taxes, but also through programs that reward debtors, the profligate and college families that show up at the financial aid office with empty pockets. Yet another series of tax and benefit rules penalizes marriage.

"This is a big social experiment. We really don't know what the long-term effect of all these incentives is going to be," Steuerle says.

There are now more than two dozen federal tax breaks, including seven created or expanded by February's $787 billion stimulus, that disappear (often simultaneously) as income rises. As her adjusted gross income climbs from $60,000 to $90,000, a single parent could lose some or all of the $1,000 per child credit, the $2,500 per college student credit, the $400 Making Work Pay credit and the $8,000 first-time home buyer credit, as well as deductions for contributions to an individual retirement account and for interest paid on a student loan. Such gotchas can push up the marginal federal income tax rate--that is, the tax on the next $1 earned--far beyond the top 35% rate imposed on rich folks. For a mom with a $30,000 income, the phaseout of the earned income credit and loss of a federal Pell college grant can produce a 40%-plus marginal rate, without counting Social Security and Medicare taxes.

Built into the earned income credit and some other tax benefits are marriage penalties, whereby couples lose some advantage they'd get separately. A single taxpayer has more of his Social Security benefits taxed when his income (calculated a special way, just for this provision) reaches $34,000; a couple when their combined income hits $44,000. Harry, a widower with $30,000 of income, and Louise, a widow with $30,000, live in sin. They would be saps to get a marriage license.

As tax grab-backs have grown, so, too, have nontax benefits middle-class folks can lose as their incomes rise. These benefit phaseouts act and quack like taxes. "It's economics 101," says MIT professor James Poterba, president of the National Bureau of Economic Research. "Look at what happens to my family resources if I earn another dollar: I pay more in taxes and I lose some benefits. It places a combined burden."

Need-based college financial aid is a blend of government subsidies and the well-established practice by colleges of charging what the traffic will bear. Before they can get aid, parents are expected to devote 47% of aftertax income (above a modest level) and 5.6% of nonretirement-account savings to college costs each year. Some savings held in a student's name get whacked for 20% a year.

At most schools the 47% rate can hit a family with as little as $65,000 in income. A few rich universities cut the poor and even the middle class more slack. A family earning $65,000 whose kid gets into Princeton will have to kick in maybe $2,000, and the contribution rate rises gently from there. Still, by $150,000 in income or so, parents are back to that 47% aid tax.

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