Wednesday, November 28, 2012
New York Times: Congressional Proposal Could Create ‘Bubble’ in Tax Code, by Nate Silver:
The coming Congressional debate over fiscal policy is sure to feature a wide array of proposals, some of which would hit certain taxpayers harder than others. But one idea being floated by Congressional negotiators, as described in an article by The New York Times’s Jonathan Weisman on Thursday, is hard to defend from the standpoint of rational public policy making. Its arithmetic could require that the 300,000th dollar of income was taxed at a rate of about 50% -- even while the three millionth dollar of income, or the three billionth, was taxed at a lower 35% rate instead.
The math behind these calculations is not all that complicated. It’s just a matter of understanding how marginal tax rates work.
Take an American who earns $400,000 a year in taxable income. (This is roughly the threshold at which a taxpayer reaches the top 1% of households.) The top marginal federal income tax rate is now 35%, and kicks in at earnings above $388,350. Someone making $400,000 is above the $388,350 threshold. Does this mean that she’d be taxed at a 35% rate on all $400,000 of income, meaning that she’d owe the government $140,000?
Not under current law. Instead, only a small fraction of the taxpayer’s income – the $11,650 she earns after she’s already reached $388,350 – is taxed at the top 35% rate. This is because the tax rates are applied on a marginal basis. ...[U]nder [the] proposal, the taxpayer making $400,000 would in fact pay 35 percent in overall income taxes and would owe $140,000 — about $23,000 more than she does currently. ...
The question is when the government would collect the additional $23,000 of taxes. [T]he taxpayer would owe about $117,000 in taxes if she made $399,999, but $140,000 if she made $400,000 instead. Thus, that one additional dollar of income would cost the taxpayer about $23,000 in taxes. ... For example, the taxpayer might be asked to pay additional taxes on the $150,000 of earnings between $250,000 and $400,000. To collect the extra $23,000, the government would need to tax this income at a rate of about 15 % — in addition to the marginal tax rates that are already applied under current law, which now range between 33 and 35%.Thus, the taxpayer would owe close to 50% in federal income taxes on earnings between $250,000 and $400,000. ...
There is still a perversity introduced by this proposal. Specifically, after the taxpayer had hit her 400,000th dollar of income, her marginal tax rate would then decline. Rather than owing 50 cents for each dollar earned, she’d be back to a 35% rate instead. ... This is what’s known as a “tax bubble”: when someone earning less income might be taxed at a higher marginal rate than someone making more.
It’s also a question of whether the tax increase would make the tax code more efficient or less so. One might favor a flatter schedule of marginal tax rates or a steeper one. All taxes have the potential to discourage work. But smoother increases in marginal tax rates, as under current law, create less economic friction, and fewer deadweight losses, then those with a number of peaks and valleys. It is hard to see the economic rationale for creating a bubble in the middle of the tax code.
(Hat Tip: Ed Kleinbard.)