Their chart illustrates one of the difficult tradeoffs that politicians have to make when designing tax relief intended for the “middle class” or the poor. These tax relief provisions are typically structured as a credit that “phases out” above a certain income. For example: the “child tax credit” is a $1000 credit per child available to families* making less than $110,000 per year**. Above 110,000 per year, the credit is slowly taken back at a rate of $50 per $1000 that your income exceeds $110,000.
That means that a family that earns $130,000 and has a child pays $1000 more in taxes (in addition to the regular income tax) than a family that earns $110,000 and has a child. Economists call this an increase in the marginal tax rate.*** Higher marginal tax rates have the downside of discouraging people from earning additional income. The American summarized the additional marginal (income) tax rates in the Obama plan in the figure shown at right.
I think this might be a misleading analysis, in that we’re only shown a portion of the income scale (what’s going on above $125,000 in income, or below $25,000?), and we’re not given the total taxes paid at each income (it would be less misleading to publish the “Suits Index” for the change). There’s also the problem of selecting your test case to make your intended point strongest. In this case, the selected family has a young child and a college student. Both children make the family eligible for large tax credits that phase out in the income range shown. I also found this statement interesting:
Obama also makes certain credits refundable, which introduces a tax penalty of 10 percent or 15 percent, depending on the income bracket.
It takes a certain leap of logic to imply that a tax credit that has been made refundable (meaning that you can get it even if you don’t earn enough to pay any tax) is somehow a “tax penalty”. Since the authors are resident scholars at the conservative American Enterprise Institute, I would expect this kind of distortion, as I’ve seen it before from them.
These provisions are an interesting tradeoff for politicians. The tradeoff is between keeping the total fiscal impact of a provision small, and keeping the marginal rates low and at higher income. For instance, what if the Child Tax Credit was given only to people making less than 20,000 per year, and was completely phased out at $22,000. That means that people trying to decide to work a little harder and earn $22,000 instead of $20,000 would be facing a marginal rate of 50%, and they’d only get $1000 (actually less) of the increase in their income because of the loss of the child tax credit. However, such a credit would not be as large a fiscal impact because far fewer people with children earn less than $20,000 than $110,000 per year.
Now compare the current tax credit with one that phases out between an income of $2 million and $3 million. This tax credit would be quite expensive, because practically everyone earns more than $1 million****, so almost everyone with a qualifying child would have their taxes reduced by $1000^. The marginal tax rate increase is small, only 0.1%, and hits only people making between $1 and $2 million, so the incentives to work have been reduced drastically.
As shown above, it’s a tradeoff, between keeping the budget from busting and making sure that there are adequate incentives to work. I think it’s good to keep in mind that the high marginal rates in Obama’s plan reflect that these represent large tax benefits granted to lower income taxpayers, and that relative to current law, everyone making less than the phase-out income will be paying less in tax than before. Sure, you face a higher marginal tax because the credits are being phased out, but you have more money in your pocket than before, and that’s nothing to frown at.
*”married filing jointly” status
**Modified AGI, which usually means total income before deductions
***If you’re curious, you can detect when this is happening to you when you do your taxes. Just look for places in the calculation where you’re subtracting some amount from your AGI or your taxable income, then multiplying the result by some fraction. In this case, you subtract $110,000 from your AGI, then multiplying the result by 0.05.
****See this chart, footnote (3). 99% of tax filers have less than $620,000 in income.
^Except for those families not earning enough to pay income tax, because the child tax credit is not refundable. For them, there is the “additional child tax credit, which is smaller and not discussed here.