The tax legislation unveiled last week by the House Ways and Means Committee was widely reported as retaining 39.6 percent as the highest marginal tax rate, and merely adjusting its minimum income threshold upward.
In reality, it would create a new 45.6 percent “bubble rate” for singles earning $1 million and couples earning $1.2 million.
This bubble tax is meant to cancel out the savings that upper-income families would receive from lower marginal tax rates on earlier income. Specifically, under America’s marginal tax rate system, lowering the marginal tax rate from (approximately) 15 percent to 12 percent on the first $90,000 in taxable income for married filers ($45,000 for singles) benefits not only lower- and middle-income families, but also upper-income families who pay that same rate on their first $90,000 before rising into higher tax brackets on their subsequent income. Within the GOP tax plan, the bubble tax justification is as follows (figures exclude tax credits):
· A married family with a $90,000 taxable income would pay a 12 percent income tax of $10,800.
· A married family earning $2 million would also pay $10,800 on its first $90,000 in taxable income, and then marginal rates as high as 39.6 percent on later income.
· Had the millionaire family instead been paying a 39.6 percent tax rate on the first $90,000, it would have paid $35,640.
· Thus, the 12 percent bracket saves the millionaire family $24,840 relative to being taxed at the 39.6 percent rate on the first $90,000.
The “bubble rate” is designed to take back that $24,840. Once the married couple’s taxable income reaches $1.2 million, it would pay the regular 39.6 percent marginal tax rate plus a 6 percent surtax. The surtax would continue until incomes reach $1.614 million – at which point the surtax has taken back the full $24,840 – and then the marginal tax rate would return down to 39.6 percent.
Relative to today’s tax policies, the bubble tax is an over-correction. The first $90,000 in taxable income is currently taxed at approximately 15 percent for all joint filers. Rather than merely take back the millionaire gains of dropping the rate to 12 percent, the bubble tax ensures that millionaire families pay a full 39.6 percent tax on that income.
The concept of a bubble tax is not new – the 1986 tax reforms included one. Additionally, the Personal Exemption Phaseout (PEP) and Pease limitation of itemized deductions have long served a similar purpose by taking away tax preferences – and thus raising marginal tax rates – at high incomes. This new bubble rate is estimated to raise $50 billion over the decade, which is needed to fit the House tax cuts within its $1.5 trillion cap.
Surprisingly, there has been little conservative criticism of this new 45.6 effective tax rate. After spending 24 years fighting Democratic attempts to push marginal tax brackets into the mid-40s or higher, Republicans are creating their own 45.6 percent effective tax rate without any conservative revolt. Instead, several conservative commentators have asserted that – because it is merely offsetting the savings of the 12 percent bracket – this does not count as an actual new tax bracket. That is mathematically untrue.
Within this $1.2 million to $1.6 million income range, every additional $100 in taxable income will bring $45.60 in new taxes. That is a marginal tax rate of 45.6 percent. Simple as that. It is a fixed income range with a fixed marginal tax rate for all earners, without regard to personal circumstances. The question of why this tax rate exists – such as to balance out the savings from a different marginal tax bracket – is irrelevant to the question of whether it exists.
And even if one tax rate does offset another (leaving average tax rates unchanged), marginal tax rates have an outsized influence on working, saving, investing, and economic growth. A 6-percentage point marginal tax rate increase is not insignificant. In fact, when factoring in state and Medicare taxes, some families could face a 62 percent marginal tax rate.
Fortunately, the economic pain of the 45.6 percent effective tax rate would likely be limited. Only 350,000 tax returns annually report enough income to be hit with this surtax – of which 210,000 are merely passing through this inflated bracket on their way to the next 39.6 percent tax bracket. For those families, decisions to work, save, and invest will be made according to the 39.6 percent rate rather than the higher rate.
Additionally, more than half of all income earned over the $1 million threshold reflect small business income and investment returns, most of which would not be subject to the high marginal income tax rates. And these families should, overall, come out well ahead in tax reform.
Still, the bubble rate shows a surprising level of Republican comfort with marginal tax rates in the mid-40s. Millionaires are not a sympathetic population these days, and the negative economic consequences of this policy may be minor relative to the need for $50 billion in taxes. The danger is that, over time, this policy can be easily expanded to higher rates, broader incomes, and larger populations. After all, if Republicans will not oppose a 46 percent effective tax rate, who will?
Brian Riedl is a senior fellow at the Manhattan Institute. Follow him on Twitter @Brian_Riedl.
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