What pay rise?

I work with a bunch of economists. Now is the time of year we have performance reviews and negotiate pay rises and promotions. But no one has yet discussed the fact that high effective marginal tax rates (EMTR) greatly reduce the real take-home benefits of a pay rise.

(EMTR is an estimate of the change in take home income after tax, and after accounting for reduced welfare payments)

An EMTR higher than 50% is very common in Australia for low and middle income earners, and any push for greater middle class welfare will simply increase this perverse tax incentive.

For example, you get a pay rise approximating CPI of 4%.  Your average tax rate is 25% (meaning you get 75% of your gross pay in the hand) and your EMTR is 50% (meaning that you only get 50c out of every extra dollar of your gross salary). In this case you actually have a pay reduction in real terms. 

You take home pay only increased 2.7% (but the government net tax portion of your income has increased by 8%).

In the above example for your take home pay to keep pace with CPI you need an 6% pay rise.  If you are a lower income earner whose cost of living increases typically exceed CPI, you will need an even higher pay rise just to break even.

High effective marginal tax rates might be a contributing factor in the rise of middle class welfare.  High EMTRs mean that employers payroll costs must grow at a rate much faster than CPI just for employees to break even.  If these type of pay rises are not supported by the real growth of the economy governments may increase welfare to maintain standards of living.  This further increases EMTRs in a reinforcing cycle.

An additional point is that the significant impacts of effective marginal tax rates on changes in take home pay is generally ignored when comparing changes in gross household incomes to the cost of living, or the cost of housing.

In sum, one major economic problem with high EMTRs is that your employer faces a 4% increase in the cost of employing you for a 2.7% increase in your net pay.