Obama is trying to raise income tax rates without having to admit it.
Reportedly, the vast majority of his proposed tax hike is a phase-out of itemized deductions for people earning over $250,000. This is simply a rate hike by another name.
Let me explain.
I’m making a point that revolves around the distinction between marginal rate and effective rate.
Today, if you make a $250,000 salary, you are likely in the 33% tax bracket. That means your marginal rate is 33%, but your effective rate is far lower. For instance, you might pay $20,000 in mortgage interest, and give $10,000 to charity, and claim a $3,700 personal exemption. Subtract that $33,700 from your income, and your taxable income is $216,300.
On the first $8,500 of that, you only pay 10%. On the next $26,000, you pay 15%. On the next approximately $50k, your rate is 25%. Then it’s 28% on the next $90k.
After $174,400 in taxable income, the 33% rate kicks in. So, our imaginary taxpayer with $250k in income, and $216,300 in taxable income, pays $56,276 in income taxes. Divide that by his income of $250k, and his effective tax rate is 22.5%.
But every dollar he earns gets taxed at 33%. So his marginal tax rate is 33%. As he earns more — or if you were to eliminate one of his deductions — his effective rate climbs closer to 33%, but his marginal rate stays the same (at 33%) until he hits the top bracket (when he’s making over $379,000).
But when you phase out deductions, you actually add to his marginal rate. I don’t have the details yet on how the rate is phased out, but whatever the specifics, this model works:
Say that Obama proposes that every $10k in income over $250k loses you 10% of your itemized deduction. Then if our fictional taxpayer boosts his income to $260,000, his deductions go from $30k down to $27k (even though his charity plus his mortgage interest still equal $30k). That adds $3,000 in taxable income, which is taxed at 33%.
So that extra $10k in income increased his tax burden by $3,333.33 (his tax rate times the marginal income) PLUS $1,000 (his tax rate times the reduction in his deduction). That means that earning $10k cost him $4,333.33. Every $10k he earns will be taxed at that 43% until either he reaches a new bracket, or until his deduction is 0%.
In other words, his new income tax rate is now 43%. This is a rate hike by another name.
This matters because of the incentive effects. Eliminating tax deductions makes people poorer, which is bad. Raising rates (explicitly or sneakly) makes people poorer and reduces their incentive to earn — doubly bad.
— ADDENDUM: Of course, if you don’t give to charity and don’t have a mortgage, then you don’t incur this hike.
