Taxes aren't really my thing, but I can't help passing along this anecdote about my mom:
My mom is 67 and ostensibly retired. She taught elementary/middle school for several decades and specialized in teaching children with reading disabilities. (She has a masters' degree in education.) When she retired, she decided to supplement her income by teaching children with severe learning disabilities. She took an intensive course in dyslexia and hung out out her shingle.
She now has 10 students. Some are severely dyslexic, which means they will need years of therapy. She's always been a great teacher and is evidently doing a good job now, because she's constantly getting asked to take on new kids.
She charges $25-$30 an hour or something like that, which is the going rate for this kind of therapy. But each session takes a lot of preparation, so her effective rate of compensation is closer to $15/hour.
Still, that's pretty good money for a retired person, right?
But hold on. Thanks to her social security benefits and a slightly better teacher's penson, she has just edged up into the 25% marginal tax bracket. She also has to pay 15% self-employment tax -- to pay for her benefits when she retires.
A 40% marginal tax rate.
It's worse than that, though. Because she makes more than the social security administration thinks is prudent, she must now pay taxes on $4,000 of her social security benefits. Altogether, she has a 50% marginal tax rate on her teaching income. Her effective rate of compensation is somewhere around $7/hour.
She was surprised by her tax bill. She's done the calculation. She doesn't want to work 15-20 hours per week for $7-$8/hour; after all, she's supposed to be retired. So next year she plans to scale back to the five students with the most serious problems. It's not worth it financially to do any of this, she said, but she feels like these five really need her.
When economists talk about the deadweight loss from taxes, this is what they mean. No one benefits when my mom scales back from 10 hours to 5 hours -- she loses out, five of her students lose out, and the government won't see one thin dime from the 5 sessions that would have been.
There's always been a lot of handwringing from some about the distortionary effects of high marginal tax rates for the wealthy, but I've always thought the high marginal tax rates for the lower-income distort the market even worse. (Not to mention the unfairness of it all -- I make a lot more than my mom, but my marginal tax rate is much lower.) The 15% self-employment tax is crippling to those who want to go out on their own. And I can't think of a more boneheaded retirement system than one that forces the retired to be even more reliant on meager social security payments.
Addendum. I ought to say something about my idea of a fair tax system. Here it is:
(1) Eliminate the social security/employment tax. Period.
(2) Eliminate taxation based on family income.
(3) Give every taxpayer a standard $20,000 deduction, with progressive marginal tax rates after that. (Combined with (1), someone making $20,000 or less would pay no federal tax.)
(4) Eliminate the mortgage interest deduction.
(5) Impose a carbon tax, which would generate a huge amount of revenue, allowing reductions in income taxes, while pricing the externality generated by carbon use.
(6) Include employer-provided health care benefits in taxable income.
(7) Restrain the growth of social security somehow, perhaps by bumping up the retirement age by a year and reducing the COLA. But don't count social security benefits when calculating income for the retired; i.e., soften the blow by letting them supplement their income without penalty.
Like I said at the beginning, I'm no tax wonk. I don't know whether this would be feasible. I'm sure it's not policitally feasible. It certainly seems fairer to me, though.
