Three points about taxes

So it seems that the Obama administration is not planning on pushing for an extension of the Bush tax cuts when they expire at the end of this year… at least, not for those in the top 2% income bracket. As there is certain to be much attention paid to this topic in the coming weeks and months, I thought I would offer three important points.

First, be aware that this is being framed by competing politicians in different ways. Those who would like to extend the tax cuts will frame the failure to do so as a “tax increase” because the rates will rise. Those who would not like to extend the tax cuts will frame it as “letting the tax cuts expire”. Who is right? From an objective standpoint, both are accurate, depending on what you are taking as your baseline. Do you consider the rates of the Bush era to be the baseline or those of the Clinton era?

This brings us to our second point. In determining baselines, it would be helpful to see what the tax rates have historically been for the last few decades:

If the Bush tax cuts are allowed to expire, the rates for the top 1% of income earners will rise from 35% to 39.6%, approximately 5%. Depending on your perspective, this could be a lot or a little. Compare, though, these rates to those of the 1960s and 1970s (see chart above). Top tax rates then were around 45%. If you go even further back (see chart here), it may be surprising to find that the tax rates for the top 1-2% was around 80% in the 1940s, 90% in the 1950s, and 70% in the 1970s. So if you take the first 70 years of this last decade as your “baseline”, the top 2% still has it pretty good (comparatively speaking) at 40% if the Bush tax cuts are allowed to expire.

Finally, just to clarify how the tax brackets work. There is a misperception that those in the top tax bracket are taxed on all of their income at that higher rate. In actuality, only the income they make within that bracket is taxed at that rate. The income they earn in the lower brackets is taxed at the lower rates, same as everyone else in those brackets. (See here and here.)

For example, pretend that all income below $300K is taxed at 10% and all income above $300K is taxed at 25%. A person earning $305K (in the higher tax bracket) will not be taxed 25% on all $305K of their income. They will be taxed 10% on $300K of their income and 25% on the remaining $5K of their income.

This is important to keep in mind when judging whether or not the tax code incentivizes someone to earn less income to avoid greater taxation. It’s been argued that some who are only slightly over the tax bracket line may try to keep their income below the cut-off mark so that they’re not subject to the higher taxation rate. In such cases, it would be helpful to understand that only the income they earn over that cut-off line will be taxed at the higher rate. Everything else under the cut-off line will be taxed at the same rate as everyone else in the lower tax bracket.

An excellent chart with complete information about historical tax rates from 1913-2010 can be found here:

http://www.taxfoundation.org/publications/show/151.html#fed_individual_rate_history-june2010

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