Effective marginal tax rate

The effective marginal tax rate (EMTR) is the percentage of additional income that a recipient of government welfare pays in taxes or loses in welfare benefits and tax credits. The EMTR is a measure of the benefits cliff, the point where the welfare recipients experience an increase in income, thus crossing the means test threshold and becoming ineligible for welfare, but their additional income is not enough to cover the expenses resulting from loss of the welfare benefits.

Calculating the EMTR is typically very dependent on individual circumstances and involves a consideration of welfare withdrawal rules, income tax laws, low income tax offsets, tax rebates and the individuals tax and welfare status. As such tables showing EMTRs are rarely published. The net effect however is generally a higher effective marginal rate of tax than that suggested by income tax tables.

As a simplistic example, suppose the government provides childcare subsidies worth $10,000 for households whose income is below $50,000 per year. A family that earns $49,000 per year saves $10,000 in childcare costs because of this welfare benefit. However, when the family's income increases to $51,000, they have to pay $10,000 for childcare, leaving them with only $41,000. Despite an increase of $2,000 in earned income, the family is financially worse off, effectively losing $8,000 per year. A 2023 Federal Reserve Bank of Atlanta report provides a realistic example of two families in Washington D.C., each of which includes an adult and a three-year old child. The first family earns $11,000, while the second family earns $65,000. However, the second family pays additional taxes and receives less welfare benefits, suffering from high EMTRs following benefits cliffs, making their effective income same as the first family.

A high EMTR creates a welfare trap that discourages workers from attempting to advance their careers, improve their standard of living, and achieve self-sufficiency.

An example of welfare trap: A person earning $30,000 receives government support that increases their effective income to $80,000. The person hits a benefits cliff at the income of $31,000, losing several welfare benefits and tax credits, making their effective less than $50,000. At an earned income of $45,000, the person hits a bigger cliff, paying additional taxes while losing more benefits, taking the effective income below $40,000.