Now, time for a rant.
I rarely ever delve into the murky, stinky waters of politics here, and really, I’m not going to start now. If you’ve listened to the news, you probably know about the good and bad of the $800 billion (and growing) stimulus package that will soon be taken up in the Senate. I’m actually optimistic that the Senate–the chamber where swiftly passed bills in the House come under closer scrutiny–will be able to pass a workable, bi-partisan bill. Let’s keep our fingers crossed.
However, my rant today is based on policies that have been adopted by Democrats, Republicans and Independents alike. I’m talking about the various tax credits currently in the tax code, and the income thresholds that apply to them. Some aspects of the current stimulus bill include these thresholds.
For instance, if you have one child, you can chop your Federal tax bill by a whopping $1,000 per year. I certainly don’t have a problem with that! What I do take issue with is that the credit phases out if your adjusted gross income (think income, less 401(k) or health care deductions, plus capital gains) tops $110,000 for a couple or $75,000 for a single parent.
Then we have President Obama’s “Making Work Pay” tax credit, which is part of this stimulus bill. If you have a job and you’re married, you and your spouse will get $1,000 back on your taxes … assuming your income is under $150,000. Anything above that, and it begins to phase out.
There’s also a home buying tax credit being bandied about to help boost housing demand. Basically, if you’re buying a primary residence before July 1 and haven’t bought a house in a few years, you might be able to get a $7,500 credit on your taxes … if your income (for married couples) is below $150,000.
There are other examples, but you get the hint. All of the credits sound great. But the income limitations are creating some bad incentives.
So what’s wrong with these income thresholds, you ask? Why should a couple making $300,000 or $500,000 or $1,000,000 a year get to claim a child tax credit, or get a bunch of money if they buy a new home? It’s a good question, which I hope to explain here.
Socially, I agree that “the rich” don’t need most of these tax breaks. The last thing I want to see is some scumbucket (I love that term–it is one of my Dad’s favorites) officer from Merrill Lynch or Citigroup get an extra few thousand bucks after paying themselves a few million in bonuses … after their company went up in flames. Despicable.
But economically, these income thresholds create more than a few problems. First, as my beautiful wife repeatedly points out, income levels vary widely by region. If you make $200,000 in, say, North Carolina, it’s different than if you make $200,000 in New York City. (My wife works in the employee relations side of the HR field.) Yes, I realize you get paid more in New York City, but the cost of living–from food to transportation to parking and housing–is a different ballgame totally. So the income limitations are pretty arbitrary.
Another problem is the incentive effect. I’m no tax accountant (thank heavens!), but let’s examine a hypothetical couple living the white-picket-fence style of the American dream–married, good job, two kids, living in suburbia around Boston … you get the picture. Let’s say the couple is cranking out a solid $100,000 per year.
However, now let’s say an opportunity arises for the couple to take a chance, and move to a different, riskier company (or start-up their own operation) that could pay them, say, $175,000. That’s a pretty good bump! But how much of that increase would they actually keep?
Right off the bat, you know that 25% to 28% of any extra earnings goes to the Feds. Probably another 5% or so is going to state taxes. And some of that income bump will likely get paid into FICA (Social Security and Medicare). So right then and there, you’re probably talking about a 35% marginal tax rate–for every extra dollar earned, the couple is only keeping 65 cents.
Then you have to throw in the various tax credits. For instance, with two kids, this couple was keeping $2,000 a year that it would normally pay in taxes. If they take the new job and earn more money, that credit would likely disappear entirely. (Again, I’m not a tax expert, and I don’t know all the exact phase out schedules–but I think that’s right.) And remember, that’s $2,000 out of this couple’s pocket … probably the equivalent to $3,000 or more of pre-tax income.
The couple also wouldn’t get the $1,000 (or the full $1,000) from the “Making Work Pay” rebate (again, that’s out of pocket), and if they were planning on buying a new house, you can forget about the potential $7,500 tax credit for that.
That doesn’t even get into potential income thresholds for capital gains and dividends, which may be raised in a couple of years for those above a certain income limit. (The rate could go back to 20% or more, compared to 15% today.) And let’s not forget about certain education-related tax credits for the kids, which again, could phase out above a certain income level.
All told, of the extra $75,000 the couple will get paid, they might only keep half that or less. That’s a huge “wedge” between risk-taking and reward. (By risk taking, I’m not talking about crazy hedge funds leveraging themselves 100-to-1; I’m talking about an entrepreneur starting a new company with a new product.) And the bigger that wedge, the less risk-taking the economy will have, and the less growth we will have.
Incidentally, that is why capital gains and dividend tax rates are probably the most important for economic growth–both are direct taxes on innovation and risk taking, so when they’re hiked, you get less funding from venture capital firms and wealthy individuals for new, exciting enterprises … which means a smaller chance of launching the next Google or First Solar or Amazon.com or whatever.
But back to my larger point, the U.S. tax system is basically creating an incentive to earn up to $100,000 to $150,000 per year … but then the wedge appears in force. Above those levels, and it pays much less (read: the effective marginal tax rate is onerous) to work harder and take chances. I find it admirable that many less fortunate workers are able to get some tax breaks, but it would be far better to get rid of these credits and just lower the income tax rates directly for those folks.
Again, I’m not saying that $150,000 is pocket change, or that we should be handing out checks to the wealthiest Americans. My point is that this big wedge is hurting the economy by discouraging risk-taking by those who actually have the capital (extra money) to take the chances. There are better ways to help those in need, while keeping rewards in place for people to take chances.
What do you think about the tax credit situation? Tell us here.
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13 responses so far ↓
1 Tony // Feb 2, 2009 at 6:06 pm
The reason behind keeping tax credits in the code, as well as much of the other confusing mess of rules and grey areas, is simple; most people don’t apply for them. Credits are like rebates in that you have to do something to get that money back. Credits allow the government to get the revenue first and they hope you don’t ask for it back.
2 Ed // Feb 2, 2009 at 6:13 pm
My wife and I are retired. No child at home. Already own a home. So, we do not get any tax credit?!
But, we are hurting also, with retirement income, other than SocSec down 35%, and re-setting at that lower figure for a full year.
We would gladly spend any stimulus coming to us!
3 June Eastman // Feb 2, 2009 at 6:19 pm
The tax disincentive is even worse for single heads of household, I’m a single (widowed) mother and moved from a wage job where I was barely making it into a entrepreneur situation.
I have greatly improved my income, but lost tax credit after tax credit.
I’m buying a home this year, and at a mere 75K, I begin to lose the 7500 tax credit, despite still having a family to raise and support, while childless married couples qualify for a much larger income threshold.
4 Malcolm // Feb 2, 2009 at 6:50 pm
Couldn’t agree with you more. Did you ever sit down and figure out what your true marginal tax rate is when you include. Federal income tax; State tax; credit phaseouts; social security and medicare taxes; sales taxes plus the cornucopia of miscellaneous user fees that hit you frlm every direction. When you add up ALL the money you pay to various Gov’t entitities it is north of 50% of your income. So, effectively I work for the Government for more than 6 months of the year. If that is not socialism I don’t know what is. This by the way is before the increased taxes we are all going to have to pay because of the massive underfunding of Social Security and Medicare amounting to trillions of dollars. Think also of the massive amounts currently being borrowed by the Govt in the name of “stimulus”. The Fed is printing money on a monstrous scale . Ihave travelled all over the world on business and lived overseas also in countries with hyper inflation {Brasil and Argentina. People think it cannot happen here but it can and will if the Govt continues on this path.
5 penny // Feb 2, 2009 at 7:22 pm
I totally agree with your rant. In addition to the geographical cost of living disparities in people earning >$150,000, there are also family size disparities. e.g. Couple with one child vs couple with more than 2 children going to college, etc. Or couples helping out their elderly parents as well. In addition, what this economy needs most is for people to spend. The people with a little more disposable income are the ones most likely to be able to help spend us our way out of this deflationary spiral. SO lets not tax away any disposable income they might generate. From the get-go I felt that Obama’s tax policies are designed to punish a productive element of society.
6 David // Feb 2, 2009 at 8:34 pm
A congressman from out area(the midwest) favors a national sales tax that would replace the current income tax system. We already have the sales tax system setup because most states use a sales tax and a federal tax system would be an extension of that system. The problem would be the switch from one system to the other and what items would be subject to the tax and who would be liable to pay the tax(would corporations pay the tax and on what items). The problem with the current code is it is so complex and it treats different types of asset sales in many different ways(the difference in the type of assets to my way of thinking is not explained very well-thick as mud-and I wonder how many “tax preparers” really understand. I just got my brokerage 1099 and I have different kinds of interest and different kinds of dividends and yet when it comes down to it there is probably not that much difference in how they are treated for tax purposes. In the situation we are in the sales tax receipts would be way down;however with the layoffs and the companies all suffering losses the tax receipts are going to drastically fall with the current code. We just need something more simple.
7 Robert Sides // Feb 2, 2009 at 9:05 pm
Great point in your blog today. As a person who lives in an extremely high cost of living area, where $2000/mo might rent you a one bedroom condo, I daresay that “one size fits all” seems unfair in these income limits.
Then again, my lower middle class parents always made just a few bucks more than income limits for financial aid when I went to college (and not enough to give me a dime), so why am I even surprised that now I get a shaft on the other end.
Since I’m a reasonably intelligent individual and Washington DC is full of idiots, I declare, Taxation without Representation!
8 Bill Risso // Feb 2, 2009 at 10:35 pm
Many thanks for the plain talk demonstrating that not everyone in the US has lost reality! You’ve hit the center of the target. Or, maybe, you’re standing on the center of the target? Thanks, Mike!
9 Sally G // Feb 3, 2009 at 5:04 am
I’m on the fence about this. I realize that income levels are arbitrary, and will hurt those on the borderlines more than others. However, I don’t think tax consequences should be the main determinant for lifestyle decisions, such as buying a new house. Owning rather than renting is a huge difference in everyday life, from doing repairs or paying for them, to doing landscaping or paying for it, to freedom to relocate or being tied to the property you own, etc.
Even Warren Buffett acknowledges that when taking payroll taxes into account, his assistant pays a greater rate than he does, and that that situation is not right—especially when you realize that a single dollar makes up a greater proportion of a smaller income than of a larger one. (E.g., if “basic living expenses”—food, shelter, clothing—average (put any number here, say $30,000), someone making $100,000 has $70,000 in discretionary inocme, whereas someone making $50,000 has only $20,000.) Therefore, the $1,000 credit is worth more to someone making a lower wage.
Capital gains and dividend taxes? Again, I’m not sure. Things are just so complicated, what with depreciation, carryover losses, etc., that it seems hard to determine the “real” tax rate anyone pays. Besides, whether you do physical labor for your income (which takes its toll on your body), have a desk job (which can be very stressful, but which has a less-intense impact on physical health and stamina), or make most of your money from investments (i.e., capital gains and dividends), all dollars spend the same.
So no conclusions, except that FICA and unemployment insurance shouldn’t have a top cutoff regardless of salary: those with the largest salaries can certainly afford to pay it, and those programs meed the cash. Social Security was put in when life expectancies were much lower than they are now; nobody expected to draw SS payments for 20 to 25 years, nor was the system designed for that.
10 Holly // Feb 3, 2009 at 12:56 pm
It’s like my daddy always said: “If you give the people a reward for not succeeding, that’s exactly what they will do!”
11 Cindi Showalter // Feb 3, 2009 at 1:11 pm
As far as tax credits go, there really is no reason to phase them out at all. Let’s assume they apply equally to all taxpayers. The $1000 tax credit for someone paying $2000 in taxes is a whopping 50% reduction in their total tax bill. For someone paying $50,000 in taxes, it amounts to a reduction of 2% of their liability. Basic math takes care of fairness issues.
The real issue is complexity and phase-outs just add to the problem. If our tax code is so complex that our current Secretary of the Treasury (who is also head of the IRS) and several of our Congressmen can’t seem to fill out their own tax returns correctly, then what are the rest of us poor folks to do?
I would suggest repealing the whole darn thing and lock them (our Congressmen) in a room until they re-write the entire code in 5000 words or less.
The first income tax return was one page long and that included the instructions. I bet even our Congressmen could figure out to fill that one out.
12 Donal // Feb 3, 2009 at 4:05 pm
Let’s pass the incentive package NOW and fine tune it later.
13 Kevin Beck // Feb 6, 2009 at 12:57 am
I would cast my vote for the Fair Tax. This would eliminate all taxes related to income, and instead would have two components:
1: A flat consumption tax built into the price of all goods and services sold;
2: A rebate based upon family size in the amount of the tax that would be paid by a household at the poverty level.
This would make all investments with tax-free dollars; it would eliminate all tax deductions; it would eliminate having to keep records available to the Feds regarding your entire financial life; it would repatriate trillios of dollars into the United States economy; and best of all, it would end the political power that comes from being able to set all these thresholds and barriers to the individuals who are achievers in our economy.
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