Would Obama’s tax plan actually raise taxes on the poor and the middle-class?

“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 …

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. …

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. …

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.
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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 and Alan D. Viard, “The Folly of Obama’s Tax Plan” , The American: A Magazine of Ideas (8 August 2008).

http://www.american.com/archive/2008/august-08-08/the-folly-of-obama2019s-tax-plan


Alex Brill is with the American Enterprise Institute. He was a former senior adviser and chief economist to the Committee on Ways and Means of the U.S. House of Representatives, and served on the staff of the President's Council of Economic Advisers. Mr. Viard is also with the American Enterprise Institute. Prior to joining AEI, Alan Viard was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He has also worked for the Treasury Department’s Office of Tax Analysis, the White House’s Council of Economic Advisers, and the Joint Committee on Taxation of the U.S. Congress.

The American tax code is so convoluted that I do not believe anyone really understands it or could defend it. Fiddling with it to make it “better” has become a hopeless exercise because any proposal to change it becomes a political exercise subject to all the irrationalities introduced by special interests. Nonetheless, Americans, especially Presidential candidates, insist on trying.

We can learn something about the complexity of the U.S. tax code from the efforts of the Presidential candidates to change the it in directions they regard as more equitable or more efficient. I am sure Barack Obama wants to shift taxes from lower income to higher income groups, and his full proposal, not discussed here, would likely do that. In the first instance, this simply means Obama wants the SHARE of tax revenues paid by lower income groups to be reduced and the SHARE paid by higher income groups to increase.

I will go further than this: I would guess he wants the AVERAGE tax burden of, perhaps even the ACTUAL AMOUNT of taxes paid by, lower income groups reduced, and his tax proposals will probably accomplish this, assuming the political process enacted it exactly as he proposed it. So far, so good.

What Brill and Viard focus on, however, are MARGINAL tax rates, the rate paid on any additional dollar earned. Now we enter an area where maintaining equity is difficult -- read impossible -- once one makes any exception to the strict application of dollar-for-dollar taxation. This is not what Obama wants to do. Rather, he wants to give “tax breaks” for this and that to low income groups. When you give tax breaks -- especially tax breaks intended to lower the actual amount of taxes paid -- you introduce tremendous marginal tax rate distortions when the tax breaks are phased out. In other words, when the tax break ends, any addition income earned is taxed at a very high rate, at least for a time.

This is important because economic theory suggests that most decision-making is made on the margin, not on the average. We do not decide whether to work harder on the basis of the average tax rate we pay but the marginal rate. We compare the addition effort we must make against the additional income we might receive. Similarly, we decide whether to save and invest on the basis of the additional spare income we have available for this purpose, not on our average income, and we compare against the income we are likely to receive were we to put funds to use, not against the income we have received from our previous investments.

According to Brill and Viard’s analysis Obama’s tax proposals are full of special tax breaks, and therefore full of marginal tax distortions. The marginal tax rates shown in the chart above for lower income groups are very high. If you add state income taxes and the Social Security contributions the full marginal tax rate under Obama’s proposal is probably well above 50 per cent of their income. It is fair to say that Obama’s proposal represents a large tax increase on poor Americans, at least in terms of the loss of any additional income they might earn from working.

Before we call Obama’s tax proposals equitable and helpful to the poor and lower income groups, it would be wise to remember E. R. A. Seligman’s words on the economics of taxation:

“The problem of the incidence of taxation is one of the most neglected, as it is one of the most complicated, subjects in economic science. It has indeed been treated by many writers; but frequently been marked by what Parieu calls the ‘simplicity of ignorance.’ Yet no topic in public finance is more important; for, in every system of taxation, the cardinal point is its influence on the community. Without a correct analysis of the incidence of a tax, no proper opinion can be formed as to its actual effect or justice.”

Let me suggest that lacking “a correct analysis of the incidence of” Obama’s proposal, “no proper opinion can be formed as to its actual effect or justice”. The same would be true of McCain’s.

Thanks to Greg Mankiw for the pointer.