Election-Year Tax Politics: Keeping the Debate Accurate

With the major parties' presidential nominees now known, the world's attention turns to the overwrought parlor game of projecting/guessing what will happen if one or the other is elected. Too often, which is to say almost always, these discussions miss some basic features of American political institutions, most importantly that presidents don't impose their pre-existing preferences on a perfectly receptive system. Thinking about Obama and McCain only makes sense in the context of a Congress that what will almost certainly feature bigger Democratic majorities in 2009.

Apart from the basic concepts of Poly Sigh 101, discussions of tax policy in particular often miss another basic but important point: income tax rates are marginal. Let's see how recognition of this simple fact can change the way a potential policy change is perceived.

In the most recent BusinessWeek, Jane Sasseen riffs on potential changes in federal tax law in the aftermath of the 2008 elections, in particular those provisions affecting upper-middle-class (or lower-upper-class, depending on your perspective) taxpayers (i.e., BusinessWeek's subscriber base). Here's a classic example (emphasis added in bold):

 The soaring deficit, along with the fact that the Bush tax cuts expire at the end of 2010, provide much of the impetus for the coming fight over high-end taxes. If Washington doesn't act, tax rates on income, capital gains, dividends, and other areas will return to the higher rates in effect before the cuts were enacted in 2001 and 2003. Senator John McCain (R-Ariz.), the presumptive GOP Presidential nominee, has said he would extend the cuts for everyone, while Obama says he'll maintain them for all but the wealthiest. If Obama wins, some taxes could go up as soon as 2009.

By "wealthiest" Obama means married couples earning more than $250,000; for a single taxpayer, the equivalent income would be roughly $200,000. Today, taxpayers making that much fall into the top two federal income tax brackets, paying rates of 33% or 35%. Their rates would revert to the 36% and 39.6% top rates used in 2000. The same households would also see a bump up in the rates they pay on capital gains and dividends, both of which now stand at 15%.

BW readers unschooled in marginal tax rates might read this to say that affluent households' total tax bills would rise from 33% or 35% to 36% or 39.6%, respectively. But that's not the case. Instead, only that portion of a household's income over a certain point (the dividing line between brackets; north, say, of $250k) would be taxed at the higher rate.

Let's take Sasseen's example of the Hammer family, where the doctor/lawyer combo of Howard and Hope reportedly earn $300,000 a year. Now, let's assume that half of their $3,000 monthly mortgage payment is deductible interest. Let's further assume that after they take various other deductions (for their kids, charitable contributions, 401k contributions, &c.), they report $260,000 in taxable income.* Under the Obama plan--which, again, will surely be sublimated into something different in the legislative process--only the last $10,000 of their income would be subject to a higher marginal tax rate. In other words, a family with a quarter-million dollars in annual taxable income would see their federal income tax bill rise by $300 or $400 per year.

Naturally, taxpayers with much higher incomes would pay more tax, but again, only on their marginal dollars. And yes, we realize that Obama's program involves changes to capital gains and dividend tax rates. But our point here isn't to defend Obama's program, or any other program. It's to shed some light on an important feature of income tax law, which is that households' effective tax rates are much lower than their highest marginal rates. It's a distinction with an enormous programmatic--to say nothing of political--difference.

A recurring theme in Sasseen's piece is that households between the 96th and 98th percentiles (those reporting incomes between $200,000 and $500,000) would experience non-trivial hardship if their taxes were to rise. We think Sasseen's point about the cost of living varying widely across the country is absolutely spot-on. But we hope The Stanford Group's Anne Mathias had her tongue planted firmly in her cheek when she told Sasseen that the next couple years "will be a very bad time to be rich." Ummm...compared to what? It's this sort of attitude that leaves working- and middle-class Americans yelling "Cry me a river!" at the copies of BusinessWeek they pick up in the waiting rooms of their friendly neighborhood HMOs.**

Raising taxes on affluent households may or may not be a good idea. And if it's a good idea in the abstract (good, that is, relative to the alternatives, which are (a) more long-term debt for all of us, (b) big cuts in current government spending, or (c) both), reasonable people can and will disagree about what concrete form any revenue-raising should take.

We'd like to see better fiscal discipline out of Washington, and we'd like to see it start on the spending side of the equation. But whatever debates we need to have about the revenue side, let's make them precise and informative, not breathless and misleading.

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* It's probably less than $260k, but we're trying to be conservative here in order to make a general point.

** To see this in action, scan a few of the comments submitted to BusinessWeek.com in response to Sasseen's piece. Here's one example: "Oh my God, I can't believe this article. The families cited in this article may not be rich, but they are not middle class either. They are way upper class. Our income is about half of what the families in this article earn, and we live in the expensive SF Bay Area, and have no problems living comfortably. We also had no problems with the higher tax rates when they were in effect. There is something wrong when people earning $ 300,000 a year can't make ends meet. Try explaining that to families making the median of $ 48,000 a year. Your article reinforces the stereotype of business magazines that live in an alternative universe that centers around Manhattan."

Sources

Jane Sasseen, "Taxing the 'Not-So-Rich' Rich," BusinessWeek, June 5, 2008

Tim Harford, "A Secret Tax on Teenagers," Slate, May 31, 2008

Comments

[willynill]

Yes, income tax rates are marginal, but so is the decision to hire an extra worker; the marginal worker doesn't get hired because the extra dollar of profit isn't "worth it" because of higher tax rates. Don't you see: raising taxes on the wealthy hurts low-income workers!