The current debate on tax reform features familiar framing from policymakers on all sides, the familiar sound bites of “the rich should pay their fair share” or “we need tax cuts for the middle class.” In reality, those two statements are two sides of the same coin; if tax policy is revenue neutral, a tax cut for one group means a tax hike for another. One significant problem with statements like these is that politicians never define “rich” or “fair share.”
A longstanding tenet of good tax policy is the concept of vertical equity, which states that taxpayers who do not have the same income should not pay the same tax. If taxpayer A makes twice as much as taxpayer B, then taxpayer A should pay more tax. The question is, “How much more?” Twice as much (a proportional or flat rate)? Three times as much (a progressive rate)? Less than twice (a regressive rate)? The Internal Revenue Code (IRC) embraces the concept of vertical equity through a progressive tax system; the tax rate rises as income rises. Some of the progressivity is plainly visible in the IRC section 1 rates, where the marginal tax rate rises from 10% to 39.6%. That, however, is where the clarity ends.
Beyond section 1, the IRC contains numerous deductions, credits, and other rules tied to income level. These provisions represent a “backdoor” rate increase that has exploded in recent years and creates great difficulty in calculating a taxpayer’s marginal tax rate. For example, taxpayers who anticipate a $10,000 increase in income cannot simply multiply $10,000 by their marginal tax rate to determine how much tax they will pay on that $10,000. Instead, they must also calculate how much their deductions, credits, and other adjustments will decrease because of the $10,000 increase in income. These rules and their unnecessary complexity would be bad enough if the income level at which they apply were all the same; however, the income levels vary significantly among the provisions and further compound the complexity and lack of transparency in determining one’s marginal tax rate. Further contributions to inequity include the fact that some, but not all, of these provisions are adjusted for inflation, and many exhibit marital bias.
The policy argument supporting phaseouts is to increase progressivity, which is a measure of equity. Assuming progressivity is a desirable goal, are phaseouts the best way to increase progressivity? Would it be easier, more equitable, and more transparent to simply change the tax rate schedule? Tax progressivity means that the tax rate increases as income increases and that wealthier taxpayers should pay more, proportionally, than poorer taxpayers. The current tax rate schedule is progressive, with rates rising from 10% to 39.6%; however, the numerous different phaseouts add greatly to tax complexity. This extra complexity is regressive, because the wealthy can more easily afford tax advisors to help them avoid these tax rate increases.
The seemingly arbitrary definition of “rich” implied in these phaseouts is not the result of top-down deliberate tax policy. Rather, it has grown organically over time due to political pressures when tax changes were made. Often, tax legislation must be revenue neutral, and an easy way to accomplish this is to include phaseouts of various deductions and credits at whatever income level is necessary to offset tax cuts in other areas. The phaseout levels send a message, deliberate or not, about who the government thinks is rich, and this definition is not uniform. This sends a very confusing, inequitable, and unnecessary message to taxpayers.
This article identifies areas in the IRC where the rules change based on income levels. It assumes that Congress does want to ensure that the rich pay their fair share, without addressing the question of what that fair share might be. The online version of this article will include a comprehensive list of the myriad deductions, credits, and other provisions that are based on varying income levels in the IRC (http://www.cpaj.com).
Phaseouts
Child Tax Credit.
The Child Tax Credit (CTC) is a $1,000 credit for each qualifying child. The credit is reduced, however, $50 for every $1,000 or portion of $1,000 of the taxpayer’s modified adjusted gross income (MAGI) over the threshold limit [$75,000 for single or head of household (S/HOH); $110,000 for married filing jointly (MFJ); and $55,000 for married filing singly (MFS)]. For example, a taxpayer with two qualifying children filing as a head of household with a MAGI of $81,050 could claim only a $1,650 CTC. Why does the phaseout for the CTC for married taxpayers start at $110,000 instead of $150,000 (twice the single threshold)? And why have the CTC phaseout thresholds never been indexed for inflation since 1997?
Education benefits.
Congress has provided several education benefits in the IRC, each subject to unique rules and phase-outs. Taxpayers can choose from the American Opportunity Tax Credit (AOTC), the Lifetime Learning Credit (LTLC), or the Tuition and Fees Deduction. All of them have phaseouts beginning and ending at different amounts, and there are rules to prevent taxpayers from benefitting from more than one provision for the same expenses. This creates incredible complexity for taxpayers trying to decide which provision will best benefit them. Coordination of the phaseout amounts, if phase-outs are necessary, would be a good first step toward simplifying this area.
Assuming progressivity is a desirable goal, are phaseouts the best way to increase progressivity?
Personal exemptions and itemized deductions.
The phase-outs for personal exemptions and itemized deductions begin at the same MAGI dollar amounts, but the calculation for each is different. The phaseout of the personal exemption is 2% for each $2,500 or portion of $2,500 ($1,250 MFS) of MAGI over the threshold (single, $261,500; HOH, 287,650; MFJ, $313,800; MFS, $156,900), reaching full phaseout at $122,500 above the threshold ($61,250 MFS). The phaseout for itemized deductions is the lesser of 1) 3% of MAGI over the threshold or 2) 80% of the total itemized deductions subject to the limitation. Itemized deductions not subject to the limitation are investment interest, casualty or theft losses, gambling losses, and medical expenses.
For 2017, both the exemption and itemized deduction phase-outs begin at $261,500 for single taxpayers, but only $313,800 for married filing jointly (adjusted annually for inflation). Why is there such a huge marital bias in the phaseout? Two single taxpayers who decide not to marry could shelter $523,000 from these phaseouts, or $209,200 more than a married couple. What justification is there to consider a married couple making over $313,800 to be rich, but an unmarried couple making under $523,000 not rich?
Higher Taxes Based on Income
There are several other areas where taxpayers meeting the government’s definition of rich pay a higher tax rate or are subject to additional taxes. The income levels where the differential treatment occurs vary significantly.
Social Security benefits.
The taxation of Social Security benefits has one of the lowest thresholds for differential treatment. A single taxpayer with MAGI over $25,000 ($32,000 if filing a joint return) must pay tax on up to 50% of Social Security income, and on up to 85% if MAGI is greater than $34,000 ($44,000 if filing a joint return). Social Security income is considered ordinary income, so taxpayers pay the marginal tax rate on the amount subject to tax. Apparently, Congress believes that a retired person making as little as $34,000 is rich and should include 85% of their Social Security benefits in taxable income. How is the single retired person making $34,000 considered wealthy while the single person making less than $261,500 (i.e., the phaseout of itemized deductions and exemptions) is not?
In recent years, Congress has been reluctant to raise overall tax rates; instead, it has chosen to implement backdoor taxes at varying income levels, causing disparate treatment of taxpayers.
Additional Medicare tax on earned income.
Taxpayers who earn wages or self-employment income above the threshold amounts (S/HOH, $200,000; MFJ, $250,000; MFS, $125,000) are subject to an additional Medicare tax equal to 0.9% of income above the threshold. For example, a single taxpayer receiving wages of $250,000 will pay $450 in additional Medicare tax.
Net investment income tax.
Taxpayers who receive investment income and have MAGI above the threshold amounts (S/HOH, $200,000; MFJ, $250,000; MFS, $125,000) are subject to the net investment income tax (NIIT). This 3.8% tax is imposed on the lesser of net investment income or the amount that MAGI exceeds the threshold. For example, a taxpayer filing a joint return with $275,000 MAGI and $30,000 of net investment income is subject to NIIT of $950. It is important to remember that MAGI is not calculated the same way for different provisions in the IRC.
Alternative minimum tax.
The alternative minimum tax (AMT) is probably the most well-known and oldest special tax on high income taxpayers. The income thresholds for alternative minimum taxable income (AMTI) and the AMT exemption phase out over a range (S/HOH, $120,700–$337,900; MFJ, $160,900–$498,900; MFS, $80,450–$249,450). The rules for determining AMT are much different than the regular tax code, and a discussion of the specific provisions is beyond the scope of this article. It is worth stating, however, that AMT is calculated by subtracting regular income tax liability from tentative minimum tax; thus, if a taxpayer is subject to AMT, the phase-outs to reduce regular tax benefits (causing an increase in taxable income) do not actually increase the taxpayer’s overall tax liability. On the other hand, the additional taxes discussed above are in addition to the regular tax liability, so a taxpayer subject to AMT could also have to pay the additional Medicare tax and NIIT. Once again, this creates increased complexity; the equity provisions within the IRC compete with each other. As a result, the AMT sends a complex and confusing message about who Congress thinks is rich.
Recommendations
As demonstrated above, the IRC does not apply rules uniformly for all taxpayers, so it is important for taxpayers to know the potential changes that can occur to their tax liability as they approach income levels where the provisions change. Calculating the potential effect of these changes is made significantly more complex, however, by the myriad definitions of rich. In recent years, Congress has been reluctant to raise the overall tax rates; instead, it has chosen to implement more backdoor taxes at varying income levels, causing disparate treatment of taxpayers. There is every reason to expect this trend to continue.
Since the IRC applies to taxpayers nationwide, it is particularly important for taxpayers in high cost-of-living areas to be aware of provisions based on income levels. Vertical equity demands a clear, transparent, and uniform definition of rich, which the current hodgepodge of wealth adjustments to tax rates does not achieve. One way to simplify matters would be to eliminate phaseouts and other complex treatment of income, deductions, and credits. If that is not feasible, then at least adopting a uniform set of thresholds—a quantitative definition of rich—would reduce complexity and increase equity and transparency.
