Jumping the Galt

by Eric Martin

I wanted to follow up on my previous post on the irrationality of Americans seeking to keep their incomes below $250,000 for fear of paying a slightly higher marginal rate with a couple of points - and a correction.  As commenter JanieM patiently and repeatedly pointed out in the thread to that post, I was using the wrong rates to apply to income above $250,000.  Daniel Gross provides the goods:

Obama wants to let marginal rates for families with taxable income (not total income, but taxable income) of more than $250,000 revert from 33 percent to 36 percent, and to let the top rate—currently 35 percent on family income above $357,000—revert to 39 percent. (Here are the current tax tables.) There's also talk of capping—not eliminating, but capping—deductions on charitable giving and mortgage interest.

Obama's proposals don't mean the government would steal every penny you make above the $250,000 threshold, or that making more than $250,000 would somehow subject all of your income to higher taxes. Rather, you'd pay 36 cents to the government in income taxes on every dollar over the threshold, rather than 33 cents.

But there's one other point that got lost in the discussion of whether or not it was wise for Americans to begin searching for ways to keep their 2009 income below the given threshold: the rate increases won't take effect until 2011 (the year the Bush cuts were set to expire)!  Which only reinforces my belief that those clients being turned away by the lawyer in the subject article will be better off in the long run.

Comments

[Bob L.]

On the capping of deductions -- This is already part of the income tax law. Beyond a certain fairly high threshold, you have to do a calculation that reduces the amount of itemized deductions that can be taken against income. The reduction is not a percentage of itemized deductions but a percentage of income, so it's the same dollar amount for all people who earn the same amount of adjusted gross income, regardless of the amount of their deductions. This means that it has the effect of an increase in the tax rate.

If, for example, you're in the 36 percent bracket and find your deductions reduced by $10,000, that means your taxable income increases by $10,000 and you pay $3,600 in additional tax. In other words, it's a disguised way of making you pay a higher tax rate than the nominal. Also, there's no ceiling on the reduction other than the obvious one that if your income is high enough, your itemized deductions can fall to zero, no matter what they otherwise would have been.

I don't think the new legislation changes this scheme. It may alter the numbers, but you wind up in the same place -- as income goes up, deductions go down, and effective tax rate is higher than nominal. It would be more honest, and efficient, to stop playing these games and just raise the rate. As it is, the effective rate is higher than meets the eye. But the result is that people think they're losing their deductions, when in fact what's happening is that their tax rate is higher.

In actuality, most of the people who get caught in this deduction give-back earn enough to be covered by the alternative minimum tax, even after the annual legislative "fix," and under the AMT you get the benefit of the full deduction for charitable contributions. But since the top tax rate for the AMT is currently 27 percent, Uncle Sam is actually subsidizing your charitable contributions to the tune of 27 percent, not the 40 percent most people think if the effective rate.

The AMT may yet be adjusted for the upper brackets, but it probably won't be abolished. Unless there's some tinkering with the basic set-up that I haven't spotted, this means that most of the people who get hit with the deduction phase-out won't actually be any worse off than before.

Anyway, it's pleasant to think that people donate to charities for reasons other than tax planning.

[byrningman]

I'm having trouble understanding why this is a relatively widespread 'issue'. How would someone even manage to earn more than $250,000 if they aren't cognitively-proficient enough to grasp the quotidian phenomenon of marginal tax rates?

[russell]

The PEP and Pease limits on deductions, specifically, have been in place since Bush I. They were the compromise he made with Congress to reduce the deficit without 'raising taxes'.

'Read my lips', he said.

As part of Bush II's tax cuts of 2001, they were scheduled to be progressively lifted between 2006 and 2010.

Also as part of Bush II's tax cuts of 2001, they were to be reinstated in 2011 when Bush's cuts expired.

So, at least as far the PEP and Pease limits on deductions are concerned, what Obama appears to be proposing is to basically let Bush I's tax changes expire as originally planned.

[Personal Failure]

I work at a law office that caters to banks and very wealthy business owners, and I have found that building an extremely successful business from nothing does not necessarily require intelligence. We have clients this stupid.

[cleek]

How would someone even manage to earn more than $250,000 if they aren't cognitively-proficient enough to grasp the quotidian phenomenon of marginal tax rates?

it's just ignorance based on the complexity of the system. if you've never done your own taxes, it's pretty easy to not know exactly how things work. and even if you do your own taxes it's easy to miss it : those tables in the tax packets don't really convey the concept of marginal rates. and i don't think i've ever heard the media explain it.

[efgoldman]

Wait a minute!

I make considerably less than $250k, in fact less than $100k, but I still pay what it costs to use the most popular of the on-line tax programs [no commercial endorsement here]. It still costs less than half of what an accountant charges, takes much less time, and is deductible next year. I especially do it because state taxes where I live are hideously complicated.

And *I* understand the difference between basic and marginal tax rates.

FWIW, I'd be very pleased to have to worry about it!

[dmbeaster]

How would someone even manage to earn more than $250,000...

People are willing to believe all sorts of irrational things in order to justify their point of view. Much of conservative thought is about inventing fables as alleged truth in order to stay secure in whatever nonsense they believe.

Conservatives are not unique in doing this, but they do seem to embrace it more readily in my lifetime.

Heck, someone in the last administration (cough, Rove, cough) made a point of bragging about it to Suskind:

The aide said that guys like me were "in what we call the reality-based community," which he defined as people who "believe that solutions emerge from your judicious study of discernible reality." ... "That's not the way the world really works anymore,"...

[Slartibartfast]

and is deductible next year

Uh...it's been deductible since it first came out. "Tax preparation fees", Schedule A, line 22. Although sampling back to 1992, that was line 20.

[Bernard Yomtov]

I'm having trouble understanding why this is a relatively widespread 'issue'. How would someone even manage to earn more than $250,000 if they aren't cognitively-proficient enough to grasp the quotidian phenomenon of marginal tax rates?

These are the same people who don't understand that, in the case of a small business, the $250K number doesn't apply to company revenues but to the profits accruing to an individual owner or partner.

This error/lie was popular during the Presidential campaign.

[baf]

How would someone even manage to earn more than $250,000 if they aren't cognitively-proficient enough to grasp the quotidian phenomenon of marginal tax rates?

The obvious answer is "inheritance". But I don't have figures on what proportion of the over-$250k set this covers.

[Dave W.]

Slart - I think he meant that it is (always) deductible in the following year, not that the tax law is changing to make it newly deductible. Although, since I think it's a miscellaneous deduction subject to the 2% floor, most people don't actually get to deduct it these days unless they have a lot of other miscellaneous deduction.

Meanwhile, the brackets have been generally been part of the instructions for people with incomes past the end of the table for years. See here, and scan down for the phrase "2008 Tax Computation Worksheet—Line 44". I see they have changed the computation to make it computationally simpler but less clear - they used to have you subtract the bottom of the bracket, multiply by your marginal rate, and add back the tax on the bottom-of-bracket income. Now they have you multiply your whole income by the marginal rate, and then subtract a number that equals the amount this overestimates the tax on your below-bracket income. It amounts to the same thing, but it doesn't make the underlying structure as obvious.

Still, anyone with an income over $100,000 who either (1) did their taxes by hand, or (2) worked through this table to check their accountant's/tax program's tax computation should be familiar with the concept.

[Slartibartfast]

Slart - I think he meant that it is (always) deductible in the following year

Ah, I see. Nevermind, then.

Still, anyone with an income over $100,000 who either (1) did their taxes by hand, or (2) worked through this table to check their accountant's/tax program's tax computation should be familiar with the concept.

I haven't been in the over-$100k zone all that long, but I've known for at least a couple of decades about how income tax works. How anyone can pay taxes in the US and be unfamiliar with how our tax structure works is a mystery, but I'm also mystified by people who buy lottery tickets.

[ericblair]

what Obama appears to be proposing is to basically let Bush I's tax changes expire as originally planned.

You mean "expire as 'originally planned'". I'm sure none of these fine economic minds actually intended for the tax cuts to go away: the sunset clause was just to make the numbers look better. Sure enough, when we're just letting the tax laws do what they were written to do, we get the usual Commie Socialist I'm-Going-Galt-I-swear drivel from the usual sources.

Really, they're being hoisted by their own petards, but we're so far into shameless political demagoguing it doesn't matter anymore.

Oh yeah, for everybody who's threatened to go Galt, we're waiting. You've promised for weeks now, and the suspense is just killing us. Really, we'll help you pack.

[von]

Is it wise to cap mortgage deductions in the midst of a housing crisis? Take someone earning 250k with an 800k condo -- not unheard of in several big cities. Capping the deduction might impose a strain.

(And, no, this isn't me. I live in a cheap-ass house and I'm not disclosing my earnings.)

[David Hunt]

So, at least as far the PEP and Pease limits on deductions are concerned, what Obama appears to be proposing is to basically let Bush I's tax changes expire as originally planned.

I would disagree with the use of the word “planned” and suggest the word “stated.” The plan was always to make the cuts permanent. I knew that back all the way when they were doing it. They were only presented as expiring after 2010 to hide the effects on the deficit. No Republican ever actually plans to let any tax cut expire. That would be “raising taxes.”

[David Hunt]

ericblair beat me to point I was making. I’d also like to state that I don’t really believe the lawyer in that article would be doing herself one lick of even short term good, even if the tax law did not work in the system of marginal rates that we’ve been discussing. I haven’t looked at the article since it came out, but I got the impression that she was in practice by herself. I’m only in a small city/big town but I do taxes for a living and I’ve got a few lawyers as clients. They just don’t make that much money. They have revenues that high, but once you deduct out all their business expenses, their income (revenues less expense) doesn’t leave them even worrying about that. Plus any tax preparer worth a damn would tell her she’s insane.

I originally figured that she was simply incapable of figuring out how the Income Tax actually worked. I changed my mind, however. I realized that she was a lawyer and her lips were moving. I don’t think she ever had the intention to actually cut back on her work. I think that she was simply making noise about this wild thing that she was going to do (wink, wink) to call attention to how bad the new tax structure is (nudge, nudge) that she would be better off not working (say no more, say no more)! It makes for a sensational story and generates ink for her, but ABC was never going to follow up to see if she did it.

[Dennis]

The effect of reducing one's income to below $250k in order to avoid a small marginal tax rate change is rather self-defeating. It reminds me of something someone once said about withholding forgiveness: it's like taking poison and expecting the other person to die.

[bedtimeforbonzo]

"How anyone can pay taxes in the US and be unfamiliar with how our tax structure works is a mystery, but I'm also mystified by people who buy lottery tickets."

Slart: I agree with your first point. As to your latter observation, I must confess to buying a lottery ticket every time I fill up the gas tank: For $1, it's a chance to dream -- and heaven helps us, if I win -- I certainly won't go Galt.

[hilzoy]

Slarti: like someone else said, inheritance explains a lot.

I have never, ever, ever understood the conservative attachment to overturning the estate tax. (Though I do get the attachment of lobbyists for the wealthy.) I do see why one would want to provide incentives to effort that was successful in a greater-than-250k way, and if we didn't need to, you know, fund the federal government, I wouldn't just see the point; I'd be convinced.

But kids who just inherited their wealth? Who have, for the most part, already gotten any number of huge advantages from it (education, etc.) that they didn't earn either? Why on earth should anyone make their ability to inherit even more money a priority?

Feh.

[Troy]

ever understood the conservative attachment to overturning the estate tax

it's part of their war on the redistributive state -- fighting for the normative morality of their minarchist comrades-at-arms: everyone should have access to the governmental services, justice, and economic opportunity they can afford, and not one drop more.

Why on earth should anyone make their ability to inherit even more money a priority?

All taxes are theft in their world; the bigger the tax the bigger the theft.

[Matthew Ernest]

'The obvious answer is "inheritance".'

Inheritance is not earned and is therefore not subject to income tax, so the change in marginal rate is not directly relevant. It is only relevant if an inheritance in a previous year lead to some opportunity for an increase in earned income in a latter year.

(As an aside, the federal exclusion for estates is $2 million for 2008, increasing to $3.5 million in 2009.)

[Christophe]

Inheritance is not earned and is therefore not subject to income tax, so the change in marginal rate is not directly relevant.

No, but the income from the inherited assets is taxed.