Sometimes you don’t know what to believe. Consider the possible consequences for moderate-income households if all of Barack Obama’s tax proposals are adopted. Some say most such households would pay less income tax. Others argue such households would face substantially higher marginal tax rates than under current law. Who is right?
The answer is that both can be right at the same time. The dollar amount of taxes owed by most households with incomes of less than $100,000 would drop under the Obama plan. This is largely due to a slew of new “funded” or “refundable” tax credits. (By funded or refundable, economists mean that you would get a check for the amount of the credit even if you don’t owe any taxes.)
One is a $1,000-per-couple “make work pay” credit. Then there is a $4,000 credit for college tuition and a savings tax credit of up to $500. There is an expansion of the existing Earned Income Tax Credit and a larger child-care credit. These credits would reduce taxes owed for many households and would produce a “refund” payment for some people who would owe nothing under existing law.
But the credits are “means-tested.” In other words, they apply if your income is below some specified level but get phased out as your income increases. So as you earn more, you not only may owe more from existing tax rates, but you will see some or all of these new credits disappear. So the effective bite out of another dollar earned may be higher than now, even if total tax paid remains lower.
A paper by the American Enterprise Institute based on research at the Tax Policy Center, a joint effort of the Urban Institute and the Brookings Institution, argues that couples with two children in the $31,000 to $45,000 income range would pay income taxes equaling 34 cents to 39 cents out of each additional dollar earned, versus 21 cents now.
Historically, this was a severe problem with welfare programs. As your income rose, you progressively lost eligibility for welfare benefits, food stamps and, at some point, Medicaid. The effective marginal tax rate exceeded 100 percent in some cases. In other words, for every additional dollar earned, you lost more than a dollar in benefits. Many liberals as well as conservatives saw this as a disincentive to work. Obama’s critics argue that his phasing out tax credits would create similar perverse incentives.
Conventional introductory microeconomic theory solidly supports this conclusion. But Obama’s economists have some defenses.
First, real-world tax liabilities are complex. The same Tax Institute that did the research from which critics argue used a sophisticated simulation model found that 43 percent of households in the $30,000 to $40,000 income range would see a decrease in their marginal rate, 32 percent would see no change and only 25 percent would see an increase. Across all income ranges, 61 percent would face a lower marginal rate, 24 percent no change and 15 percent a higher marginal rate. So the worst-case predictions of the AEI study don’t apply to many households.
Many skeptics think the whole issue will be moot as fiscal pressures from the ongoing economic crisis would prevent enactment of Obama’s proposals in any case.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.