Tax Reform At The Bottom Of The Cliff

Stan Collender

Whatever Congress and the White House do in the next couple of weeks will reinforce the case for tax reform.  The seeming sanctification of low tax rates that occurred with the Tax Reform Act of 1986 has not meant keeping top tax rates low; it has meant only the death of honesty in talking about rates.  The result is a patch work of hidden rates and additional wage taxes that is likely to continue.

Following the 1986 Act, the advertised top marginal tax rate increased from 28 percent to 31 percent in 1990 and to 39.6 percent in 1993 and then decreased to 35 percent in 2001.  But, Congress also added a number of hidden rate increases.  In 1990, it added the phase out of personal exemptions and a haircut on itemized deductions (These were gradually eliminated under the 2001 Act).   In 1993, it removed the cap on wages subject to the Hospital Insurance (HI) Tax and, in 2010, it added an additional HI tax on high-income individuals.
If either the Country goes over the Fiscal Cliff or the President prevails in restoring pre-2001 law for top income taxpayers, then a self-employed high-income taxpayer who earns an extra $1,000 will find $440 of it going to Washington instead of the $396 that the top tax rate discussion might suggest to an ordinary person.  Here’s the math (rounded):
Advertised top tax rate
39.60%
Effect of 3% haircut on deductions
1.19%
“Employee” HI Tax
1.45%
“Employer” HI Tax
1.45%
Deduction for Employer HI Tax
-0.57%
ACA additional HI Tax
0.90%
Real marginal rate
44.0%
 Of course, their spouse’s wages from employment would be taxed effectively at 43.1 percent, their dividends at 44.6 percent and their capital gains at 24.4 percent.
This system fails some of the fundamental tenants of sound tax policy.   It is not transparent, neutral or simple.  It begs for reform.  I would bet that most high-income individual, confronted with this array of rules and policy fixed at this level of taxation, would prefer a single simple top tax rate on ordinary income of 44 percent and a straight-forward, single capital gains rate or exclusion.
Unfortunately, I also would bet that, if and when we get to a larger tax reform, politicians will prefer gimmicks that allow them to advertise a lower post-reform tax rate.
Originally published at Capital Gains and Games.

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