Income Tax Issues: How do phaseouts of tax provisions affect taxpayers?
Many provisions in the tax code are phased out (that is, their value is reduced as income rises) for higher-income taxpayers as a way to target tax benefits on middle- and lower-income households and to limit the loss of revenue. Phaseouts not only claw back these benefits but also increase the marginal tax rate that affected taxpayers face and thus decrease the after-tax gains of earning more income. Some taxpayers have multiple tax provisions phasing out at the same time, compounding the negative effects on their work incentives. More broadly, phaseouts complicate the tax code and make it more difficult for taxpayers to understand the taxes they pay. The table below describes the main phase-ins and phaseouts in the tax code as of 2011.
Phaseouts increase effective tax rates over the range of income in which they apply. Each additional increment of income causes a reduction in the tax benefit, which is equivalent to an increase in the tax on the additional income.
- Phaseouts are structured in various ways and thus have different impacts. Some reduce credits and thus have the same tax effect for all affected taxpayers. Others reduce deductions, in which case their effect depends on the taxpayer's marginal tax rate: the higher the rate, the greater the value of the lost deduction.
- Phaseouts reduce tax benefits at different rates depending on their structure and range.
- Most phaseouts reduce benefits at a constant rate over the full phaseout range; the rate depends on the width of the range. For example, for single tax filers the American Opportunity Tax Credit phases out over a $10,000 range, so its phaseout rate is 1 percent per $100 in additional income. In contrast, the adoption credit phases out over a $40,000 range, so its phaseout rate is one-fourth as fast—just 0.25 percent per $100.
- Some phaseouts, however, reduce benefits by a certain amount for each fixed increment of income. For example, the child credit decreases by $50 for every $1,000 or part of $1,000 in additional income above the phaseout threshold. Whether income exceeds the threshold by $1 or by $999, the credit falls by the same $50.
- Some phaseouts have more pronounced "cliffs," so the benefit drops in large increments when income exceeds the threshold. For example, in 2011, the limit on the deduction for higher education tuition and fees drops from $4,000 to $2,000 for a single tax filer as soon as income exceeds $65,000 and then drops to zero when income tops $80,000.
- Many phaseouts are indexed for inflation so that the phaseout ranges remain fixed in real terms. Phaseouts that are not adjusted for inflation affect more taxpayers over time, as inflation raises nominal incomes and thus lifts more taxpayers above the phaseout thresholds.
- Many phaseouts create significant marriage penalties-or bonuses-because the phaseout range for married couples is less than twice that for single tax filers. Take the phaseout of personal exemptions for example. It is not in effect for 2011 and 2012 but is scheduled to resume in 2013, when it will begin at a projected $261,650 for married couples filing jointly, which is under twice the projected $174,450 threshold for single filers. Consider a couple in which each spouse had income of $150,000. Each spouse would be unaffected by the phaseout if they were single, but they were worse off as joint filers because they lost some of their personal exemptions. The phaseout of itemized deductions (which also does not apply in 2011 or 2012 but is scheduled to resume in 2013) is worse: it will begin at the same $174,450 income level for both single and married tax filers.