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The Folly of Obama’s Tax Plan

Friday, August 8, 2008

Senator Obama’s proposed ‘tax cuts for the middle class’ are actually marginal rate hikes in disguise.

Senator Barack Obama declared recently that he wants to “reform our tax code so that it rewards work and not just wealth.” We think that is a great goal if it means a simple tax system with low marginal tax rates. Unfortunately, a close inspection of Obama’s proposals reveals something disquieting: he would raise marginal tax rates for many middle-income taxpayers, a bad move for anyone seeking to promote economic growth. 

Although Obama is offering a new series of tax breaks, they undermine rather than improve economic incentives. First, whether or not you get those breaks will depend on your income. In Washington, taking away tax breaks as families work harder to make more money is called a “phase-out.” Economists have a different name for it—we call it a tax. Reducing a person’s tax credit as his income goes up also reduces his incentive to earn more income. 

Second, Obama would make some credits refundable for families with credits bigger than their tax liability, which would also have the nefarious effect of raising marginal tax rates. For example, consider a worker in the 10 percent bracket with $1,000 of tax liability before credits who claims $1,200 in credits. The tax impact of earning an extra $100 depends on whether the credit is refundable. If it’s not refundable, there’s no tax penalty on earning the extra $100 because the worker’s tax liability stays at zero. But if the credit is refundable, earning the extra money pushes the tax up from negative $200 to negative $190—that’s a 10 percent penalty on earning income. 

Although Obama is offering a new series of tax breaks, they undermine rather than improve economic incentives.

The solid line in the nearby chart illustrates the effective marginal tax rate under Obama’s tax proposals (based on the authoritative “Preliminary Analysis of the 2008 Presidential Candidates’ Tax Plans,” published by the Brookings Institution/Urban Institute’s Tax Policy Center). These are the marginal rates in 2009 for a two-earner couple with two children—a college freshman and a 12-year-old receiving after-school care—under some specific assumptions. For comparison, the dotted line on the chart illustrates the effective tax rates under current law. The rates shown in the chart are not spelled out in the tax code; they are the result of giving and taking away tax breaks as the household’s income changes. 

As the chart shows, Obama’s give-and-take tax policy results in marginal tax rates of 34 percent to 39 percent in the $31,000 to $45,000 income range for this family. That’s an increase of 13 percentage points or more from the current rates. 

What accounts for the higher rates? First, Obama expands the maximum child and dependent care credit for families with one young child from $1,050 to $1,500 and phases down the credit over a longer income range, from $30,000 to $58,000. Throughout this income range, the credit is phasing out at a rate of $30 per $1,000 of income, thus raising the effective tax rate by 3 percentage points. Obama also makes certain credits refundable, which introduces a tax penalty of 10 percent or 15 percent, depending on the income bracket. 

While Obama has publicly embraced a tax rate of 40 percent for couples earning over $350,000, his tax policies would result in a staggering 45 percent effective marginal rate in the $110,000 to $120,000 income range for this family. That is 11 percentage points higher than under current law. 

FS_Obama_Tax.jpgThe culprit in this case is Obama’s proposed reform of the Hope Scholarship Tax Credit for college tuition, which he would rename the “American Opportunity Tax Credit.” He would increase the credit’s maximum value from $1,800 to $4,000 while still phasing out the credit over the same income range, $100,000 to $120,000. The larger phase-out would boost the penalty on work from 9 percentage points to 20 percentage points. 

Although Senator John McCain would not eliminate the existing phase-outs, he would avoid adding new ones, with one small and temporary exception. While McCain has proposed increasing the personal exemption for children, he would make it immediately available only to lower-income taxpayers. Until the bigger exemption is offered to everyone in 2016, some households would face an additional effective marginal tax rate of about 2 percentage points. 

To be sure, Obama’s proposals would not tarnish an otherwise pristine tax code. As the chart shows, the U.S. tax code is already littered with phase-ins and phase-outs. For that matter, it’s hard to know how much phase-outs actually discourage people from earning additional income. Because the phase-outs are so hard to decipher, many Americans may ignore them when making their work and saving decisions. Of course, those people are still burdened by the long and frustrating IRS worksheets required to compute the value of their tax credits; and creating a more confusing tax code certainly does not make for good government. 

While both candidates will reduce their tax plans to clever sound bites, voters should consider how those plans would affect incentives to earn income. Unfortunately, Senator Obama’s proposed “tax cuts for the middle class” are actually marginal rate hikes in disguise.

Alex Brill is a research fellow and Alan D. Viard is a resident scholar at the American Enterprise Institute.

Image by Corbis.

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