What will your tax rate be this year--15%, 28%, 31%, 36%, or 39.6%? The answer: maybe none of the above. Those are the official rates in the Internal Revenue Service tax tables. But about 33 million Americans will actually pay much higher effective marginal rates.
That's the stunning conclusion of a Feb. 3 study by the congressional Joint Committee on Taxation. The reason: Over the past 15 years, Congress has enacted 23 different tax credits and deductions that phase out as income rises. True, some of these breaks benefit taxpayers who can take full advantage of them. But as they disappear, they begin to have a perverse effect: The tax on the last dollar you earn can rise sharply as the value of your tax benefit falls.
The wealthy are whacked as their personal exemptions and itemized deductions are gradually eliminated. Some 4.5 million high-income taxpayers get hit by hidden rates as their income rises and deductions such as medical expenses, mortgage interest, and state taxes disappear. That means a taxpayer with a top rate of 39.6% really gets clipped for nearly 41%. But the real victims are low-wage families with kids, who lose tax credits as their earnings rise, and middle-class retirees, who are taxed on Social Security benefits if they work.
ANTI-WORK. Lawmakers say all these phase-outs make the code fairer. In truth, they are a quiet way to raise revenue without hiking published rates. And they add complexity to the tax code and discourage hard work and saving. "It's a rotten way to run a railroad," says Robert S. McIntyre, director of Citizens for Tax Justice, a liberal think tank.
Consider this simple example: Say the tax rate for income up to $1,000 is 15%. That means Jane Taxpayer forks over $15 on every $100 she earns. But if Jane is eligible for a 10% credit, her tax is really $5--an effective rate of only 5%. Now suppose Jane's tax credit declines by one percentage point for each dollar she earns over $100. So when she earns $101, her tax jumps from $5 to $6.06, and her take-home pay drops from $95 to $94.94. Thus, her marginal rate on that additional dollar is over 100%, a powerful disincentive to work for an extra buck.
Perhaps the cruelest real-world example is the mother pushed off welfare. To ease the transition, she is eligible for the Earned Income Tax Credit to supplement her pay. The EITC allows a working mother with two kids to get an annual payout of about $2,500--as long as her income remains below $12,000. But once her income exceeds that level, the EITC and a child-care credit slowly disappear, causing taxes to shoot up. The Joint Committee reports that a mother of two who earns $25,000 pays an effective marginal rate of 38.5%, not counting payroll taxes. That's nearly the same rate as that of a married couple earning $300,000.
For some former welfare moms, it can be absurd. Take an unmarried mother who does just what the family values folks want--gets married and gets a job. Now, she and her husband average about $6.50 an hour, or a combined $27,000 a year. An Urban Institute study estimates she will give back 100% of what she earns in the form of higher taxes and lost benefits. Bottom line: She's no better off economically than when she was single and on assistance.
Last year, nearly every tax break enacted by Congress came with tax code sleight-of-hand. Even crazier, all these benefits phase out at different income levels, so you've got to run a separate set of numbers every time you get hit.
These hidden rates are unfair, complicated, and anti-work. Yet Congress--abetted by the President--can't resist sneaking them into the tax code. No wonder the public is so disgusted with the games Washington plays.