Asymmetrical Information - Megan McArdle

11.20.12

Should People Who Make $250,000 a Year Worry About Obama's Tax Proposals?

There are more wrinkles in the tax code than you think

Kevin Drum and Dave Weigel take off after rich people who don't understand that they only pay marginal tax rates on the extra dollars they earn above taxation thresholds.  "This isn't true, of course. Obama is only proposing to raise tax rates on income over $250,000, so if your income goes up to $251,000, you only pay the higher rate on the extra $1,000. The tax bill on your first $250,000 stays exactly the same."

Their analysis is basically sound, except for the fact that it is not quite true.  They have forgotten to look at deduction phaseouts, surtaxes, and the AMT, which are not taxes on marginal income.*

No matter what you have heard on the internet, there are in fact a lot of sizeable marginal inflection points for high earners.  There are the Pease deduction phaseouts, temporarily abated by the Bush tax cuts but scheduled to go back into effect in 2013, which can eliminate up to 80% of deductions for couples who make more than about $175,000 (the number is indexed for inflation, so it changes every year): your deductions are reduced by 3% of the amount by which your income exceeds the threshhold.  The student loan interest deduction phases out at $150,000 ($75,000 for singles).  And a lot of tax-free savings opportunities disappear: educational savings accounts and IRAs have income limits, so your ability to use them starts phasing out in the low-six-figure income range.  So do various educational and child tax credits.  These things obviously aren't a huge deal for people who make $1,000,000 a year but they can be a huge tax hit for couples in the $150,000 to $300,000 range.  Come 2013, they will be an even bigger hit.

And we haven't even discussed the AMT, which virtually eliminates deductions for couples who make the mistake of doing things like buying a house, having children, or living in a high tax state.  

To be sure, there are a bunch of people who confuse marginal with effective tax rates, and their error should be gently pointed out.  But it is hard to correct the errors of others while simultaneously making a fairly sizeable error of your own.  So I've put together a handy graphic showing you what income levels trigger deduction phaseouts or surtaxes.  The red line shows you where the phaseout is complete--i.e., where the deduction completely disappears.    

So for example, a married couple filing jointly in 2013 with two kids at home and one in college who go from making $100,000 to $125,000 loses a $2,000 child tax credit and $1800 worth of HOPE credit, an increase of almost 4% in their effective--not marginal--tax rate. The marginal tax rate on their extra earnings is 15.2% just from deduction losses; that comes on top of the 28% they'll be paying the federal government in income taxes, and whatever state income tax they owe.  

A couple who goes from $150,000 to $185,000 loses tuition deductibility and the ability to contribute to an IRA.  They also become eligible for the AMT, and if they aren't hit by the AMT, they will get hit by the Pease deduction phaseout.  (If they're filing in 2012, they don't get hit by the deduction phaseout, but do lose the Opportunity Tax Credit, to the tune of $2500). Exactly how much they lose will depend on their deductions, but it's thousands of dollars, representing a substantial increase in their effective--again, not their marginal--tax rate.  And if the Bush tax cuts expire, they'll also be facing a 3% tax hike on about half of their annual income, another effective increase of 1.5%.  

A couple that goes from $180,000 to $251,000, meanwhile, loses access to Coverdell Education Savings Accounts and the adoption tax credit, loses $2250 worth of deductions under the Pease rules, almost certainly pays AMT, and has any investment income hit with a 3.8% surtax.  Under Obama's plan, it's true that the top marginal tax rate will only affect about $1,000 worth of their income.  But the other tax law changes that have occurred (or will) under his administration make for a sizeable increase in their overall tax burden.  At the margin, this couple is probably better off earning the extra money.  But there will couples who will not be--and a number of couples who will have to think hard about whether it wouldn't be better to cut back on the high-stress job.  

This is not necessarily an argument against increasing those taxes; I favor letting all the Bush tax rates expire because we don't seem to have any plans to cut spending to match the revenue that those tax rates bring in.  But it isn't true that this is simply trivial for all but the superrich.

Indeed, this graph really should include the EITC, which as I've written elsewhere, effectively creates a high marginal tax rate for the poor.  But the phaseout is calculated based on the number of children you have, which means that there's no way to cleanly display it on the same graph as everything else.  Anyway, just keep in mind that there's a big tax hit for poor people who make more money, too.  

* This article originally contained an example about the 3.8% investment surtax which was incorrect, so I've removed it. I misread a source, and thought that the investment surtax applied to all investment income, when actually there's a fairly complicated formula that should keep this from happening.  I apologize for the error.