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September 7, 2011

USA Today mistake: There is no tax bracket cliff

USA Today writes a "Math Tips For the Rest of Us" squib and in turn has to get some math tips from Dean Baker and Alex Tabarrok.

In USA Today's original item, one tip said: “That raise actually might not be as good as it looks. The extra money is nice, but it could very well bump you into the next tax bracket, possibly leaving you with less money than you had before the raise.”

Alex and Dean correctly go bonkers. Tax brackets are marginal. If the rate under $50,000 is 10 percent and the rate over $50,000 is 40 percent, it doesn't mean you pay tax of $20,400 if you earn $51,000 -- or 40 percent on all your income. You pay 40 percent only on the amount that's more than $50,000 -- in this case, $1,000. A "cliff" is what fiscal pros call situations in which an extxra bit of income or assets subjects the entire amount to a new rate. Tax cliffs are pretty rare in this country.

Now USA Today has corrected the item, which now says:

A hefty raise might not be as big as it looks. Extra money could bump you into the next tax bracket, which means you’ll pay a higher tax rate on earnings above a certain threshold. Relax: Your earnings below that threshold are still taxed at the previous, lower tax rate.
Posted by Jay Hancock at 11:51 AM | | Comments (5)
Categories: Taxes



The Maryland tax code has a real tax cliff that results from the child tax credit being abruptly eliminated at an AGI of $150K (the federal code phases it out). As a consequence it is possible for extra income of only a few dollars to results in a tax increase of several hundred dollars.

Back in the '70s when there was high inflation and a plethora of tax brackets it frequently was the case that a person could get a 10% raise but have the extra income taxed at a higher rate all the while the cost of living increased 10%. In this case one was left with less rather than more. I believe it is this memory that causes people to blindly assume the same can happen today.

With all due respect, most reporters fail to make this essential point when discussing tax policy and proposed changes to marginal rates. Thus, people who read about a proposal to increase rates for those with an adjusted gross income over $250K, often erroneously believe that there will be a dramatic impact on prosperous, but still small, businesses. That is simply not the case.

I think that every time there is a proposal to increase marginal rates, reporters have an obligation to emphasize that the increase is only on the marginal income above a certain level and, generally, is only a modest rise for the vast majority of, not just all taxpayers, but taxpayers in the upper 10%. In fact, an additional marginal tax on households making $250K (with the additional tax beginning at $250K) will affect only some, but not all, of those in the top 5%. (Based on 2007 figures, the top five percent begins at $197,000, so many, if not most, of those in that category will not be affected at all.) See the chart at the bottom of the page here, sourced to IRS statistics.

In response to Stuart, I wonder if he appreciates how powerfully high marginal tax rates impair economic growth. Consider, for example, the successful shop owner who is earning $250K. This shop owner is considering expanding her enterprise but realizes that as a consequence of Obama's tax on millionaires (which interestingly includes a majority of taxpayers who are not millionaires) her marginal tax rate, or in other words the tax on any new profits she makes, will consume 50% of her income. This intelligent shop owner decides expansion is simply not worth it and thus, the new jobs that would go to store clerks and managers don't get created.

Economics is all about the margins which is why the issue of marginal tax rates matter as much as they do.

Of course I think about the effect of raising marginal rates. However, the size of marginal rate increases that are currently suggested are fairly small and will not negatively affect economic growth. See here:

Dan's comments clearly set up a fairly ridiculous choice. The issue is not whether the hypothetical store owner will invest in her store. The issue is whether she will (i) invest (whether in her store or in some other "store"), (ii) stuff money that she would otherwise invest into a mattress, or (iii) spend that money on personal consumption.

We know that periods of relatively high marginal rates and high degrees of tax progressivity are positively correlated with increases in GDP and that, conversely, tax cuts tend to reduce economic growth. Stated simply, the theory you posit is contra to our actual experience going back to the '30's. Mike Kimmel at the Angry Bear blog has produced a great deal of research on this issue. His most recent posting can be found here:

Concurring with Stuart here.

Average US GDP growth was over a full percentage point higher from 1947-1981 when the top marginal rate ranged from 70-94%, versus the period from 1982-2011 when the top rate ranged from 28-50%

Regression analysis shows a small (depending on the study, it's around .05-.1) positive correlation between the top marginal rate and GDP growth. In laymen's terms, statistical historical analysis since 1930 shows that if anything, higher top tax rates are slightly correlated with higher economic growth.

An article I wrote goes into a little more detail on the subject

As counter-intuitive as it sounds, when you consider some of the things the uber-rich spend their money on, as well as the tendency for extreme concentrated wealth to shift markets away from perfect competition, and towards monopolistic competition, it makes sense. Monopolistic competition reduces total wealth as well as concentrates what is left relative to perfect competition.

Also note, the top marginal rate's impact on GDP should not be conflated with the total tax burden as a % of GDP's impact on GDP. That has shown to be negatively correlated.

Bottom line: truly pro-growth tax policy would have total taxes that are much lighter, but structured much more progressively than ours are.

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About Jay Hancock
Jay Hancock has been a financial columnist for The Baltimore Sun since 2001. He has also been The Baltimore Sun's diplomatic correspondent in Washington and its chief economics writer. Before moving to Baltimore in 1994 he worked for The Virginian-Pilot of Norfolk and The Daily Press of Newport News.

His columns appear Tuesdays and Sundays.

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