Obama, Reagan, and Marginal Taxes

When he was interviewed by Bill O'Reilly, Ed Meese explained why Ronald Reagan had such a strong low tax philosophy. Meese explained that when Reagan was still an actor, his friends in the business told him to only make two movies yearly. That's because once he made a third movie, he wound up in a much higher tax bracked and as a result wound up taking home much less. Reagan couldn't believe anyone would be encouraged not to work and became a fervent pro tax cut advocate as a result. By cutting taxes, Reagan hoped to encourage people to work, and the economic revolution that was created under his administration proved him right.



In the book, The Working Poor, David Shipler examines a similar phenomenon to what Reagan witnessed as an actor only from the perspective of the very poor. Because there are so many giveaways at the very bottom like food stamps, Medicaid, and the earned income tax credit folks that start to work their way out of poverty wages often wind up taking less home. That's because as their income rises, many of these benefits go away. As such, while their pre tax income maybe higher, after they stop qualifying for all of these giveaways, their post tax income is lower.



This brings me to this article by the Wall Street Journal examining Obama's tax proposals. The key to the piece is this graph.

Here is how Wikipedia explains the marginal tax rate.

A marginal tax rate is the tax rate that applies tothe last dollar of the tax base (taxable income or spending),[1] and often applied to the change in one's tax obligation as income rises:

Think of marginal taxe rates, as they apply to income taxes, as the punishment for making more. Under the current tax plan, there is little or no more punishment for making more until an individual starts making six figures. Then, their taxes begin to shoot up progressively.

Under Obama's tax plan, there is significant punishment for extra income at only $25,000. In other words, the few thousand that someone makes more than $25,000 will be taxed significantly. As such, someone that is used to keeping most of their paycheck will see the extra income taxed very heavily. Of course, this punishment doesn't include all of the government giveaways that Mr. Kipler described in his book. What Obama's tax plan will do is literally punish those that see their income rise from $25,000 to say $27,000. Because many of the giveaways begin to get phased out as income goes up, many folks will actually see their after tax income actually go down as their income goes up.

Here is how the Journal describes this phenomenon.

There's another catch: Because Mr. Obama's tax credits are phased out as incomes rise, they impose a huge "marginal" tax rate increase on low-income workers. The marginal tax rate refers to the rate on the next dollar of income earned. As the nearby chart illustrates, the marginal rate for millions of low- and middle-income workers would spike as they earn more income.

Some families with an income of $40,000 could lose up to 40 cents in vanishing credits for every additional dollar earned from working overtime or taking a new job. As public policy, this is contradictory. The tax credits are sold in the name of "making work pay," but in practice they can be a disincentive to working harder, especially if you're a lower-income couple getting raises of $1,000 or $2,000 a year. One mystery -- among many -- of the McCain campaign is why it has allowed Mr. Obama's 95% illusion to go unanswered.

In other words, because Obama has so many tax giveaways to those at the bottom, and many of those giveaways go away as you earn more, the marginal tax begins to go up dramatically at just $25,000 per year. So, when Barack Obama says that 95% of the people will get a tax cut, what he doesn't say is all those people that will get a tax increase as their own pre tax income rises. It's one of the many flaws of offering tax cuts to those that pay no taxes.