The Independent View: Tax Reform Must Do Away with Stealth Rate Hikes

Although the Tax Reform effort began with the Goal of Reducing Marginal Tax Rates, the House and Senate Tax Bills stray from that objective in one key area, both Bills maintain many of the Current Tax Code’s INCOME-BASED PHASEOUTS (IBP) and even introduce a few New Phaseouts. These IBP violate Basic Principles of Tax Transparency by triggering Hidden Increases in Taxpayers’ Marginal Tax Rates.

One IBP in the Senate Bill has gained notoriety because it could actually push a few Taxpayers’ Marginal Tax Rates above 100%. The Conferees will undoubtedly fix that Egregious Provision, but they shouldn’t stop there. Instead, they should aggressively Remove IBP throughout the Tax Code.

Here’s how IBP works: When a Taxpayer earns Extra Income, they pay Extra Tax based on their Tax Bracket. For example, a Taxpayer in the 28% Bracket pays $28 additional tax if they earn an additional $100. But the Taxpayer may also be hit with further Tax Payments due to numerous IBP that Reduce Specific Credits and Deductions as Income Rises. These Stealth Provisions increase the Taxpayer’s true Marginal Tax Rate, the Fraction of their Extra Income that goes to the Government.

For example, a Phaseout Provision may Reduce one of the Taxpayer’s Tax Credits by $5 when their Income goes up by $100. Then, Earning an Extra $100 causes their Taxes to go up by $33, $28 from the Official Tax Bracket and $5 from the Lost Credit. Some taxpayers may be subject to Multiple Phaseouts at the same time, compounding the disincentive Effects.

IBP are usually Bad Tax Policy. If a particular activity meets the high standards required to merit a Tax Break, the Break should generally be available to anyone who engages in that Activity, regardless of their Income. If Congress wants to impose Additional Taxes on High-Income Taxpayers, it should raise their Tax Brackets rather than fencing them out of Specific Tax Breaks. Sweeping away most IBP should have been an important part of the Tax Reform effort. Unfortunately, the House and Senate Bills do not take that path.

To be fair, the Bills would Eliminate some IBP, often by scrapping the Tax Breaks that featured the Phaseouts. Under the original House Bill, for example, the Student Loan Interest Deduction would no longer be Phased Out as the Taxpayer’s Income Rose, because there would no longer be any such Deduction. Nevertheless, the Bills would retain the Majority of the Tax Code’s Phaseouts. So if it is returned, does the IBP get removed.

The Bills would even introduce a few New IBP. For example, the House Bill would apply a New Phaseout to the Tax Break for Homeowners who sell their Homes at a Profit. The Senate Bill’s New Tax Break allowing Business Owners to Exempt Part of their Profits from Tax would be accompanied by an IBP. Although the Exemption would Apply at All Income levels for many Businesses, the Exemption for Owners of some Service Businesses would start to Phase Out as the Owner’s Income rose above $500,000, Disappearing when her Income reached $600,000.

The Urban-Brookings Tax Policy Center’s Joseph Rosenberg recently explained that a Business Owner who earned an extra $100 within that Income Range could face almost $50 of additional Tax from the IBP. The Combination of the Phaseout and the 35% Tax Bracket would result in the Owner Paying more than $80 Tax.

Analysts at the Tax Foundation pointed out to the Wall Street Journal that, after Self-Employment Taxes and State Income Taxes were added in, the Owner could Pay more than $100 Tax on the extra $100 Income. In other words, they could end up with Less Money than if they had never Earned the Income. We hope the Conferees will Modify the Provision to Avert that Extreme outcome, perhaps by Phasing out the Tax Break more slowly over a longer Income Range. But that type of tweak would Fall Short of what’s needed. Instead, the Conferees should Eliminate the Phaseout altogether, either by scraping the New Tax Break or by providing it to Business Owners at all Income Levels. Then, they should go after other IBP. The Conferees should Seize this Historic opportunity to Remove Stealth Rate Hikes from the Tax Code.