In the current negotiations to raise government revenues, politicians on both sides of the aisle seem to be pushing for phase-outs of deductions and credits rather than raising marginal tax rates. Somehow they seem to think that eliminating phase-outs will not raise marginal tax rates. That is not true. Phaseouts are simply a backdoor method of increasing marginal tax rates. The problem is that phaseouts increase marginal tax rates in a manner that most would consider unfair. Specifically, phaseouts raise the marginal tax rate on the middle class while keeping marginal tax rates lower for the very rich.
That’s not what people have in mind when they call for tax fairness. Most Americans would prefer a flat or progressive tax system. A phase-out of a deduction might sound progressive, but it is actually a regressive marginal tax system. Within the income range where the deductions are phased out the marginal tax rate rises, and at higher income levels when the phase-out is complete, it falls.
To see this, suppose that there is a flat 20 percent rate with various deductions capped at $50,000. If you earn $150,000 you owe $20,000 in taxes, (20% x $150,000-50,000). If you earn $250,000 you’d owe $40,000, (20% x $250,000-50,000). For both, an extra $1,000 of income means $200 more in taxes-the 20% marginal tax rate. Now suppose that the $50,000 deduction is phased out at a rate of 5% per $1,000 beginning with those earning more than $150,000 (that is, the deduction falls by $50 for every thousand dollars earned over $150,000). With this phase-out rate, the deductions will be totally phased out at an income of $250,000. Now consider the marginal tax rate of someone earning between $150,000 and $250,000 compared to the marginal tax rate of someone earning more than $250,000. He or she will be paying the equivalent of a marginal tax rate of 25%–when he earns another $1000 he pays 20% ($200) in marginal tax, and 5% ($50) in what might be called phase-out marginal tax. Any person earning more than $250,000 only pays a 20% marginal tax rate. So in that range the tax system becomes regressive. That’s not my, and what I think are most people’s, view of what society wants in its tax system.
What’s a better alternative? To be honest about what you are doing. Increasing tax revenues through tax reform requires an increase in the marginal tax rate on someone. There is no way around it, so don’t pretend you’re not raising marginal tax rates when you are. If a deduction makes sense, then keep the deduction, and institute higher overall marginal tax rates. If the deduction doesn’t make sense, then dump it totally; don’t phase it out under the pretence of not increasing marginal tax rates. Because with phase-outs you are increasing marginal tax rates, but you are doing it in a regressive fashion:
First Published: November 30, 2012