Public Policy Taxes

Health Insurance Subsidies (a.k.a Higher Marginal Tax Rates)

The health reform bills currently propose introduce health insurance subsidies for individuals who do not qualify for health insurance provided by the government.  The goal of these subsidies is to make health insurance more affordable for the lower and middle class. The subsidies gradually decrease for higher income levels.

In “Obama’s Prescription for Low-Wage Workers,” Michael Cannon notes that one also can see these subsidies as increasing the marginal tax rate.  For instance, let us John makes $16,000 and has a 25% income tax rate.  Under the new health reform bill, John would also receive a subsidy to purchase health insurance.  Let us assume the subsidy is $5000.  Thus, his after tax income is $17,000 [(1-.25)*16,000+5000].

What happens if John has the option to work at a new job that pays him $20,000?  Of course, he will earn more income but his health insurance subsidy will also decrease.  If the health insurance subsidy decreases to $3,500, then his after tax income in your new job is now $18,500 [(1-.25)*20,000+4000].  Although John’s gross income increased by $4000 when taking the new job, his after tax income only increased by $1500.  This is in a marginal tax rate of 62.5%.  In fact, Mr. Cannon’s research finds that mandates and subsidies impose effective marginal tax rates on low-wage workers “averaging between 53 and 74 percent.”  When marginal tax rates are high, extra hours worked lead to a smaller increase in after-tax income.  Thus, the labor supply decreases.

One thing Mr. Cannon ignores, however, is the current Medicaid poverty trap.  Poor individuals are eligible for Medicaid.  However, if they get a better job paying them more money, they may lose their Medicaid eligibility.  Poor individuals may refuse to take better paying jobs to keep their Medicaid coverage.

Once the subsidies are implemented, however, poor individuals will be more likely to take a better-paying job since they can receive subsidies to buy private health insurance even if they lose their Medicaid coverage.  The high marginal tax rates are more likely to affect the labor supply of the lower-middle class and middle class individuals.  These individuals are in the same scenarios as John is above.  Higher pre-tax earnings will not necessarily translate into significantly larger after-tax earnings.  I predict that the higher marginal tax rates Mr. Cannon mentions will decrease the labor supply most for individuals in the middle class.

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