What is a Tax Wedge?

A tax wedge is the difference between gross income and after-tax income. In economics, it refers to the broader financial effects of a tax on a sector of the market.

Technically speaking, the tax wedge is the sum of personal income tax and employee plus employer social security contributions together with any payroll tax less cash transfers, expressed as a percentage of labor costs (definition from the Organization for Economic Cooperation and Development).

How Does a Tax Wedge Work?

For example, let’s assume that John Doe earns $100,000 in salary this year and must pay a 28% federal tax as well as an 11% state and local tax on the earnings. He nets out at $61,000 for his family after taxes. Now let’s assume the income tax rate rises to 35% at the federal level and 15% at the state and local level. John now takes home only $50,000 of his salary. At that point, he and many others decide that working isn’t worth it; that they can find other ways to keep more of what they earn (or work less but bring home the same amount) via investing, working under the table or drawing government benefits instead.

In turn, the participation in the workforce suffers. Applications for government benefits rise. The workers who remain demand higher salaries from companies just so they can take home enough money after taxes, which in turn causes companies to hire fewer workers (or outsource) so they can afford to pay the ones they have.

Why Does a Tax Wedge Matter?

A tax wedge generates income for governments but it also increases inefficiencies in the market. The bigger a tax wedge is, the bigger the incentive there is to not engage in the activity associated with the tax.