Marginal vs. Average Obama

Alex Brill and Alan Viard of the (right-wing) American Enterprise Institute argue that "Senator Obama's proposed 'tax cuts for the middle class' are actually marginal rate hikes in disguise." Note the word marginal - that is, the share of an additional dollar of income that is paid in taxes. The basic point of their analysis is that when you have tax deductions and credits that are targeted at lower- and middle-income households and therefore "phase out" over different ranges of income, the marginal rates can be high because people are losing some of their deductions and credits as their income rises, on top of the regular tax rate.

Brill and Viard analyze a specific example (carefully chosen, one suspects):

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.

What accounts for the higher rates? First, Obama expands the maximum child and dependent care credit for families with one young child from $1,050 to $1,500 and phases down the credit over a longer income range, from $30,000 to $58,000. Throughout this income range, the credit is phasing out at a rate of $30 per $1,000 of income, thus raising the effective tax rate by 3 percentage points. Obama also makes certain credits refundable, which introduces a tax penalty of 10 percent or 15 percent, depending on the income bracket

While Obama has publicly embraced a tax rate of 40 percent for couples earning over $350,000, his tax policies would result in a staggering 45 percent effective marginal rate in the $110,000 to $120,000 income range for this family. That is 11 percentage points higher than under current law.

The culprit in this case is Obama’s proposed reform of the Hope Scholarship Tax Credit for college tuition, which he would rename the “American Opportunity Tax Credit.” He would increase the credit’s maximum value from $1,800 to $4,000 while still phasing out the credit over the same income range, $100,000 to $120,000. The larger phase-out would boost the penalty on work from 9 percentage points to 20 percentage points.

It is important not to lose sight of the fact that, overall, average tax rates - i.e., the share of income paid in taxes - for households in the lower 80% of the income distribution are lower under Obama's proposals than under (i) McCain's proposals, (ii) a scenario where the Bush tax cuts and patch of the alternative minimum tax are extended and (iii) current law, which includes the scheduled expiry of the 2001 and 03 tax cuts in 2010. This chart is based on the Tax Policy Center's analysis: (Specifically, Tables T08-190, T08-201 and T08-0207; for Obama this does not include the possible modification of the cap on social security payroll taxes, which could further increase rates at the top).

So, for the vast majority, the tax burden will be lower under Obama's proposal. However, the structure of the plans means that marginal tax rates could be high for some "middle class" households. Is that a problem? Sort of, maybe. It is the marginal tax rate that affects incentives - e.g., the benefit of working overtime or taking a second job would depend how much of the additional income you actually take home. Higher marginal tax rates would be expected to distort people's decisions more. So, if this actually causes people to change their behavior significantly, it is problematic. Most economists would agree on that, in principle, but the magnitudes matter, and much of "conservative" thinking on taxes seems to rely on an exaggerated view of the size of the effect.

Matthew Yglesias notes that real problem with Obama's tax proposals may be that they won't bring in enough revenue to meet public needs.

Via Economist's view, Brill and Viard's analysis taken apart.

Obama economic advisors Furman and Goolsbee explain his plan in a WSJ op-ed.

Update (8/17): Via Mankiw, more explanation from Viard.

Update #2 (8/17): EconomistMom says: "Alex and Alan are trying to make a big deal out of a small point, and a small point that has hardly any policy relevance." And she has evidence.