Not all tax cuts are the same. The question isn’t just how much money taxpayers get to keep or are given, but the impact that taxes have on how hard people work. Tax plans that try to help the poor can sometimes become traps, making it difficult for the poor to climb out of poverty.
One approach is to lower the marginal tax rate, the percentage taken for each additional dollar they earn. The other is to increase tax deductions and credits, and to phase them out as people’s income increases.
Take something such as the Earned Income Tax Credit, a program designed to help guarantee the poor a certain level of income. The desire to help the poor is understandable, but it also creates its own problems. Giving more money to people, the poorer they are, also means that the more income these poor individuals make, the more government assistance is taken away from them. Just as higher taxes discourage work, the loss of a significant portion of one’s deductions and credits will also discourage work.
John McCain’s proposals have top marginal income tax rates of 35 percent for individuals and 25 percent for corporations, while Barack Obama’s plan has rates of 39.6 and 35 percent respectively. But the official marginal tax rate isn’t the rate that people actually pay, because they also lose tax breaks as their income rises.
While Obama would directly increase the marginal income tax rate on families making more than $250,000 per year and raise the rates on capital gains and dividends, he has a whole set of new and expanded tax breaks for the poor, retirees, students, homeowners and new farmers. All these tax breaks phase out with higher incomes, producing high effective marginal tax rates for those with low incomes as well as for people making between $100,000 and $120,000.
The effects of these phase-outs are dramatic. Alex Brill and Alan Viard, at the American Enterprise Institute, show that a two-earner couple with two children (one of whom is in college) can face a 34 percent marginal tax rate when they earn $31,000, with the tax rate rising to 39 percent when their family income reaches $45,000. And families making $110,000 to $120,000 may have to think twice about making more money with the federal income tax alone taking almost half of each additional dollar they make.
Families making other levels of incomes will also face higher marginal income taxes, but these are just the most egregious examples.
The Tax Foundation points out that when Obama’s plans to increase Medicare and Social Security taxes for higher-income individuals are included, one "gets to a nearly 50 percent (federal) tax rate."
The dramatic increases in marginal tax rates are not too surprising, considering who Obama’s economic advisers are. For example, Austan Goolsbee claims that the 9 percentage point increase in income tax rates imposed on the wealthy by President Clinton in 1993 produced "probably closer to zero" effect on their level of work.
This past Thursday Goolsbee and Jason Furman had an op-ed in the Wall Street Journal claiming that the top tax rates in Obama’s plan would not exceed "their 1990s levels of 36% and 39.6%" even when "including the exemption and deduction phase-outs," and that all other brackets would remain unchanged. Yet, this is obviously false given that the marginal tax rates of 36 percent and 39.6 percent would be hit even if there were absolutely no phase-outs in the tax code.
There are already plenty of phase-outs in the current tax code causing these hidden increases in marginal tax rates. McCain may not plan on fixing existing tax rate spikes, but, with one small exception, at least he avoids adding new ones. The exception is an increase in the personal exemption for children that will temporarily be offered only to the poor. But even this small bump in marginal rates will be temporary, as the exemption will be extended to everyone in 2016.
During the primaries Obama often spoke about the inequities in the tax system, with wealthy individuals not paying their fair share. He is willing to double the capital gains tax rate just “for purposes of fairness.” President Bush’s tax reforms are a particularly favorite whipping boy for Obama.
Yet, one is hard-pressed to see the wealthy not paying their share of taxes or Bush’s reforms increasing inequality. In 2006, the top 50 percent of taxpayers made seven times the income of the bottom 50 percent, but they paid 32.4 times as much in taxes. Does anyone really believe that those in the top 50 percent got even seven times the benefits from government that those in the bottom 50 percent received?
When Bush became president in 2001, the top 1 percent of taxpayers paid about 34 percent of all income taxes. By 2006, their share had risen to 40 percent. Meanwhile, the share of income taxes paid by the bottom 50 percent had declined from 4 to 3 percent.
What Bush can legitimately be blamed for is using the old discredited Keynesian notions of stimulating spending to justify tax cuts. But the reason why this won’t work is that the resources have to come from someplace. Three options are open: either the government raises taxes, borrows, or prints up money. Everyone understands how taxes merely redistribute the money. But printing up money and borrowing are no different. Printing money devalues the money held by others. Borrowing takes money from those who otherwise would have used it to do everything from investing to buying houses or cars.
Ronald Reagan understood that one wanted to cut marginal tax rates to encourage work and increase the country's total wealth. When Reagan signed the 1986 tax reform act he noted that "progressive nature of the tax struck at the heart of the economic life of the individual, punishing that special effort and extra hard work that has always been the driving force of our economy. . . . taxation fell most cruelly on the poor, making a difficult climb up from poverty even harder. . . ."
Obama’s proposals will make an already complex tax system even more Byzantine. Yet his desire to help out people may discourage people’s desire to improve their own lives and make them ever more dependent on the government for help.
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