On The Cover/Top Stories
When Work Doesn’t Pay For The Middle Class
Janet Novack and Stephane Fitch 10.05.09, 12:00 AM ET
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.
With their older son in his freshman year at Colgate and their middle son a high school senior eyeing similarly pricey schools, Denver residents Randy S. and Valerie Lewis decided she’d have to go back to work after 17 years as a stay-at-home mom. Valerie, 46, is applying for local teaching jobs paying $35,000. If she lands one, taxes will eat up $15,000 and the need-based aid they’d be eligible for will decline by $10,000, figures college finance consultant Troy Onink, who runs Stratagee.com.
That leaves the Lewises $10,000 ahead if she works. “It makes sense to go back to work, but it’s frustrating looking at the number,” says Valerie, who would have preferred to stay home a few years longer, since her youngest son is 12. Randy, 45, is a former commercial real estate broker who is in the process of launching a real estate investment fund. He’s frustrated that the money he socked away in custodial accounts for his kids wiped out any chance of aid for their eldest son’s first year. “We got totally skunked,” he says.
The Obama Administration’s $75 billion Making Home Affordable loan modification program aims to stave off foreclosures by pushing down the interest rate on mortgages owned or guaranteed by Fannie Mae and Freddie Mac so that monthly housing costs don’t exceed 31% of a family’s gross. Relief is for five years, and interest savings don’t have to be repaid. Applicants have a big incentive to fall a little bit behind on their payments to wangle a refi. (Honor your promises? That’s so out of date.) The process can take months, and while it’s under way it is imperative for homeowners to keep their income within a certain range. Once the new rate is locked in, they are free to earn more.
“I almost understand why some people stay on welfare,” says Karen, a 59-year-old Bellevue, Wash. self-employed house cleaner. As a matter of “personal pride” she’s been applying for better paying, hotel head-housekeeper jobs, even though that could endanger her pending bid to have the interest rate on her condo reduced.
The mortgage refi program will presumably end when the foreclosure crisis does. Not, however, the new system for college loan repayments. The program, passed by Congress in 2007 and launched this past July, will probably be around for a long while. Graduates electing this option face up to 25 years of income-based payments that act like an additional 15% marginal tax.
A health care overhaul, if it happens this year, seems likely to include income-based subsidies for the uninsured that go up to three or four times the poverty level–that’s $66,000 or $88,000 for a family of four. In Massachusetts, which adopted a universal care scheme in 2006, a 50-year-old childless Boston couple with an income of $43,700 and no employer-provided health insurance can pick from four Commonwealth Care plans costing them $232 to $299 a month. The same couple earning $44,000 would have to turn to Commonwealth Choice, where the cheapest plan, with a high deductible, runs $732 a month.
Massachusetts also provides premium subsidies so laid-off workers can pay for insurance through their former employers’ health plans under a federal provision known as Cobra. In addition, February’s federal stimulus included temporary Cobra subsidies for couples with an income of up to $290,000 and singles earning up to $145,000.
Three kids, two lawyers, one income: Jennifer and David Atkins with (from left) Jason, 3, Sharon, 5, and Marshall, 1.
David Atkins, a 42-year-old Westwood, Mass. MIT grad, nonpracticing lawyer and father of three, was laid off from his tech manager’s job at a young Internet firm last December. In May, when he took a contract job managing a state Web site, he gave up combined state and federal subsidies that paid 93% of his $1,313-a-month Cobra premium. (He also gave up $728 a week in unemployment benefits.) Atkins’ new health plan, with a much higher deductible, costs him $950 a month. He took the job because he likes to work and wants to keep his skills sharp. But he concedes that the net economic benefit, at least in the short term, isn’t compelling.
As Atkins mastered the arcane details of the Cobra subsidies, he blogged tips for laid-off Massachusetts residents seeking to stay insured. Among them: If you get freelance work, don’t lie about it–that’s a crime–but schedule your work “strategically” so that you can collect unemployment one or more week each month and remain eligible for the insurance subsidy.
Some phaseouts, particularly on the benefit side, are unavoidable given Americans’ divisions over the size of the social welfare state. Subsidy phaseouts wouldn’t exist if the U.S. provided everyone with a basic health insurance plan and then raised taxes to pay for it. But there’s no political consensus for that, any more than there is for allowing poorer folks to go without health care.
Still, much of what’s going on here–particularly in the tax code–is a blatant shell game. Congress gives with one hand and takes with the other. A half-century ago the personal and dependent exemptions were the main way the federal government helped families with children. Since then the exemption’s value has eroded and it has been taken away from millions of families stuck in the alternative minimum tax–the shadow tax system originally designed to make sure rich folks with exotic shelters paid at least some tax.
Instead of providing a big universal exemption, Congress has created a grab bag of family-friendly-sounding tax goodies, almost all with income-based clawbacks. Both liberals and conservatives have bought into this–the former because it concentrates relief at the bottom of the income scale and the latter because it helps hold down the advertised top marginal rates, says Steuerle.
How does all this affect taxpayer behavior? Studies show that certain groups–such as the second earner in a couple–do weigh marginal rates in deciding how much to work.
David Atkins’ wife, Jennifer, 39, a lawyer, decided to stay home after their first child was born. She compared her aftertax take with the high cost of quality day care and concluded, “I didn’t want to work just to pay somebody else to raise my children for me.” When they were both working, the couple’s income approached $200,000–meaning they earned too much to get the child credits or any deduction for the interest on Jennifer’s $65,000 in college and law school loans.
“Don’t think the American public is stupid,” says Cheryl Morse, a tax practitioner in eastern Massachusetts with both middle- income and affluent clients. “People call me and say, ‘What’s the most I can earn before I lose the earned income tax credit?’ [They] may not understand marginal rates, but they’re shocked when they lose the college or child credits. You hear all the time, ‘The harder I work, the more they take away from me.'”
Rosanne Altshuler, codirector of the Urban-Brookings Tax Policy Center, worries that all the tax gotchas could “erode confidence in the system, and that could lead to a bigger compliance problem.”
In 2007, after the oldest of her three sons started college, Kristin Lavieri of Litchfield, Conn. went back to work full-time. She and her husband lost the college tax credit for their son. “To me, taking away that tax credit is a slap in the face. You pay so much for school,” she says. Aside from the plight of parents, there’s another point to Lavieri’s story: She’s a tax accountant at Weinstein & Anastasio in Hamden. “Even with the knowledge that I have, I got stuck,” she says. “What’s happening to the other folks who don’t have the insider knowledge that I do?”
People may not up and quit when they lose a credit or benefit. But over time, says Steuerle, attitudes and expectations change. For years an “earnings test” caused Social Security recipients younger than 70 to lose $1 of benefits for every $2 they earned over a certain amount. In reality this penalty wasn’t so bad, since those who had their checks docked for working received higher benefits later on. But retirees viewed it as an unfair tax on work. In 2000 Congress eliminated the test for recipients who have reached their full retirement age (now 66). As word got out, attitudes about working at older ages changed and work by seniors increased–good thing since the boomers will need to work even longer.
Desiree Segura, 23, expects to graduate from Oregon State University next June with a degree in ethnic studies and $40,000 in federal student loans. A student government senator, she flirted with going to law school but has decided instead to seek a job at the U.S. Students Association or a similar group. “The ussa is mobilizing their constituency to fight for themselves,” enthuses Segura. She couldn’t afford to make lobbying for college kids a full-time job if she had to make the full $435-a-month payments on her federal debts, so she plans to opt for the income-based repayment. Under that option she will be required to pay only 15% of her gross above 150% of the poverty threshold–meaning, as of 2009, above $16,245. If she earns $2,000 a month, she’ll pay $97. The unpaid interest will add to what she owes, but she won’t be charged interest on that interest. Any time her income rises, her monthly payment will, too.
Should Segura embark on a more lucrative career? Or take a second job as a waitress, to pay down the debt faster? The economy would be better off if she did. But she would be wise to make liquidating the debt a low priority. If she winds up in a public sector or nonprofit job for at least ten years, any remaining debt is wiped out.