The voices of Tax Policy Center's researchers and staff
Suppose that a taxpayer earns an additional dollar of income. How much tax would she owe on that dollar? A natural way to answer this question would be to look up the taxpayer’s statutory tax rate – the rate corresponding to her tax bracket and filing status.
But that approach often gives the wrong answer and can mislead not only taxpayers but policymakers. Many tax preferences are phased in or out according to income, and as a result, those who earn extra income may face either a hidden tax or a subsidy as their tax benefits change in value. For example, for those in the phase-in range of the earned income credit earning an extra dollar increases the credit and reduces their tax liability, driving their actual rate below their statutory rate. But once they make enough so the EITC begins to phase out, the opposite happens and the rate they actually pay climbs.
Altogether, half of taxpayers in 2009 face actual tax rates on additional earnings that differ substantially from their statutory rates. The tax on that last dollar – what economists call the effective marginal tax rate – is higher than the statutory rate for 32 percent of taxpayers and lower for almost 18 percent. Moreover, the difference between the two rates can be huge. For taxpayers whose effective rate is higher, the average discrepancy is almost 6 percentage points. For those with lower effective rates, the difference averages 11 percentage points (we pointed out these differences in this week’s Tax Fact column in Tax Notes).
This distinction between effective and marginal rates sounds like the kind of technical mumbo-jumbo only economists can love, but it is a very big deal. It changes – or at least it should change – the way lawmakers look at how tax policy affects economic behavior. Take, for instance, President Obama’s proposal to restore some of the pre-Bush tax rates. Simply looking at the change in the statutory rates may not tell a very accurate story. The effective marginal tax rate is what should shape incentives to work, save, and comply with the tax system.
Although differences between effective and statutory rates are significant for all groups, the discrepancy is especially striking for those subject to the Alternative Minimum Tax (AMT). More than 80 percent of AMT taxpayers face an effective rate above their statutory rate because they gradually lose the full benefit of their personal exemptions. The statutory rates for the AMT are 26 and 28 percent. But the phaseout of the personal exemptions raises the effective marginal rate to 32.5 and 35 percent. So while the AMT is an unpleasant surprise for many, this higher effective rate is the real shock. AMT taxpayers making between $200,000 and $500,000 (about two-thirds of all AMT taxpayers in 2009), are socked, on average, with a whopping effective rate of 34 percent. Ouch.
Yet many don’t even know it. Statutory and effective rates differ so haphazardly that most taxpayers probably have no idea how much tax they owe on an additional dollar of income. What does this say about our current tax system? First, the phase-in and phase-outs of provisions really do bite. Second, in case you needed more proof that our current system is complex, here you have it. Finally, it suggests that many individuals are making decisions based on incorrect notions about the tax consequences of their behavior.
People lose confidence in a system that leaves them in a fog about the tax rates they face. And considering that we are going to have to rely on this revenue-raising structure more than ever in the coming years, that it not a good thing at all.
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