How do phaseouts of tax provisions affect taxpayers?
Many preferences in the tax code phase out for high-income taxpayers—their value falls as income rises. Phaseouts narrow the focus of tax benefits to low- and middle-income households while limiting revenue costs, but raise marginal tax rates for affected taxpayers.
Many preferences in the tax code are phased out (meaning 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, however, not only claw back these benefits from the more affluent, they also increase the effective marginal tax rate these taxpayers face, decreasing the after-tax gains of earning more income.
Some taxpayers are affected by multiple tax provisions phasing out at the same time, compounding the negative impact on their earning incentives. More broadly, phaseouts complicate the tax code and make it more difficult for taxpayers to understand the taxes they pay.
How Do Phaseouts Work?
Phaseouts are structured in different ways and thus have different effects. Some reduce credits and thus have the same impact on all affected taxpayers. Others reduce deductions, in which case their quantitative impact depends on the taxpayer’s marginal tax rate: the higher the tax rate, the greater the value of the lost deduction.
Phaseouts reduce tax benefits at different rates depending on their structure and range (table 1). Most phaseouts reduce benefits at a constant rate over an income range; that rate depends on the width of the range. For example, for single tax filers, the American Opportunity Tax Credit phases out evenly 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 specified amount for each fixed increment of income. For example, the child tax 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, so earning a few more dollars could make a taxpayer worse off.
Some phaseouts have more pronounced cliffs, so the benefit drops in large increments when income exceeds the threshold. For example, in 201, the limit on the deduction for higher education tuition and fees drops from $4,000 to $2,000 for a single tax filer if income exceeds $65,000 by even $1, and then drops to zero when income tops $80,000. Again, just a few dollars of additional income could leave a taxpayer whose income is near the cliff much worse off.
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.
How Phaseouts Create Marriage Penalties and Bonuses
Many phaseouts create significant marriage penalties—or bonuses—because the phaseout range for married couples is less than twice that for single tax filers. For example, in 2017 the phaseout of personal exemptions begins at $313,800 for married couples filing jointly, less than twice the $261, 500 threshold for single filers. Consider a couple in which each spouse has income of $200,000. The phaseout would not affect either spouse if they were not married—each would have income under the single threshold—but as joint filers they lose 70 percent of their combined $8,100 personal exemptions, increasing their taxable income by nearly $5,700.
Phaseouts can also create marriage bonuses, reducing a couple’s combined tax bill. For example, if one spouse has $300,000 of income and the other spouse has none, their combined income would be under the $313,800 threshold for reducing exemptions for joint filers in 2017. If they were single, the high-earning spouse would lose 32 percent of her personal exemption, which would increase her taxable income by nearly $1,300.
Phaseouts also impose marriage penalties on low-income families, and those penalties are often a larger percentage of their income than the marriage penalties caused by phaseouts for higher-income taxpayers.
In 2016, a single mother who earns $17,450 and has one child pays no income tax and receives two refundable credits—a $1,000 child tax credit (CTC) and a $3,373 earned income tax credit (EITC) (table 2). If she marries a man making $40,000—whose 2016 income tax as a single person would be $3,984—she would lose all of her EITC (the couple’s income would cause the credit to phase out completely) but would retain her CTC. Losing the EITC means that the couple would pay $2,978 in income tax when married, compared with receiving a net payment of $354 (her $4,349 combined credit minus his $3,995 tax) if they remained single. That difference is a marriage penalty of $3,332, or 5.8 percent of the couple’s adjusted gross income.
 The married couple’s bonus would be even larger because, having no income, the nonearner could not benefit from the personal exemption. Filing jointly, the couple would get the full value of both spouses’ exemptions.
 In 2016, a single mother with one child begins paying income tax (before credits) when her income exceeds $17,450—the sum of her $9,350 standard deduction for a head of household and personal exemptions for herself and her child totaling $8,100.
Internal Revenue Service. Your Federal Income Tax, Publication 17.
———. The Earned Income Credit, Publication 596.
———. Child Tax Credit, Publication 972.
———. Child and Dependent Care Expenses, Publication 503.
———. Tax Benefits for Education, Publication 970.
———. Individual Retirement Arrangements (IRAs), Publication 590.
Urban-Brookings Tax Policy Center. Marriage Penalty Calculator.
Gale, William G. 2001. Tax Simplification: Issues and Options. Testimony before the House Committee on Ways and Means, Washington, DC, July 17.