New York Times: When $250,000 Isn't Actually $250,000

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(Original Post)

December 7, 2012, 3:00 pm


Binyamin Appelbaum and I have an article in Friday’s paper about President Obama’s proposal to raise marginal income tax rates for married couples earning “more than $250,000.”

As we note, there are lot of couples earning more than $250,000 whose tax liability would not be affected.

There are two main reasons: inflation, and the very narrow way income is defined in this proposal.

First, the thresholds that Mr. Obama originally staked out – $250,000 for married couples filing jointly and $200,000 for single taxpayers – referred to policies he wanted to take effect in 2009, and he has been indexing most of them to inflation so that they’re higher today. The adjusted thresholds for 2013 are $266,100 and $212,850, according to the independent Tax Policy Center. Mr. Obama uses $250,000 as shorthand for the higher-income taxpayers the increases are aimed at — perhaps for consistency’s sake, and perhaps because $250,000 is a nice round number. (The White House declined to comment on why the president still uses the $250,000 number.)

Second, the thresholds refer to a specific accounting term called adjusted gross income, or A.G.I., that excludes a lot of categories of income.

Now, if you ask people how much they make, they probably don’t respond with their exact A.G.I. Instead they probably think about their salary, wages, pension income, and maybe a bonus and investment income if those categories brought in substantial money.

That rough mental accounting for how much you make would include some money not counted in A.G.I. (and exclude some money that is part of A.G.I.). In other words, a lot of people might have more than $266,100 flowing into their bank accounts during the year but still have an A.G.I. below $266,100.

A.G.I. includes wages, salaries, investment income and bonuses – the categories mentioned earlier that might be part of a quick mental accounting of how much you make. But it can also be reduced by subtracting items like certain business expenses; health savings account deductions; some moving expenses; contributions to some retirement accounts like an I.R.A.; alimony paid; most Social Security benefits; some income earned overseas; tax-exempt interest on municipal bonds; and college tuition, fees and student loan interest, subject to limits.

On the other hand, there are some categories in your A.G.I. that you might not think to include if someone asks how much you make. These include rents; royalties; income from operating a business; alimony received; share of income from partnerships and S-corporations; income tax refunds; and the ever-popular gambling winnings.

For example, a married couple might make $300,000 annually in salaries and investment income, but after subtracting health savings account deductions, alimony paid and I.R.A. contributions, they might have an adjusted gross income of about $270,000. That means they would probably not be affected by the tax increases aimed at “high income” people even though they are indeed near the top of the income distribution.

To make things even more confusing, note that some of the tax increases intended for “high income” people (using Mr. Obama’s stated $250,000 and $200,000 thresholds from 2009) will actually apply to even fewer people than this analysis so far suggests.

Those whose income exceeds those thresholds would be affected by new taxes created by the Affordable Care Act, including additional taxes on both their earned income and their investment income. (And here the thresholds are actually $250,000 and $200,000, with no indexing. All the other taxes aimed at “high income” individuals are indexed; for some reason the Affordable Care Act taxes were not.)

But many at those income levels will not be affected by the expiration of the Bush marginal income tax cuts for upper-income people. That’s because the Bush tax cuts refer to an even narrower measure of income called taxable income, which is basically a subset of adjusted gross income that many high earners can reduce substantially with the help of a skillful accountant.

Taxable income is calculated by subtracting personal exemptions and deductions (either itemized or standard) from adjusted gross income. Itemized deductions include things like home-mortgage interest payments, health expenses, state and local taxes, and charitable contributions. While subject to limits, those deductions can bey large. Generally the reason to go through the hassle of itemizing deductions, after all, is to reduce your taxable income by much more than the standard deduction would.

Mr. Obama has defined all the thresholds for whose taxes he wants to raise in terms of A.G.I. But again, tax rates are based on taxable income. Mr. Obama’s method of translating his A.G.I. cutoffs into taxable income cutoffs is to take the A.G.I. threshold and subtract the minimum amount a family is entitled to exclude: one standard deduction and two personal exemptions for married couples, totalling about $20,000.

So when Mr. Obama promises he won’t raise tax rates for married couples with a 2013 A.G.I. of $266,100, the policy translates to taxable income thresholds of about $246,000.

Those are conservative calculations for how much taxable income people with these levels of A.G.I. will report. Usually people at those A.G.I. levels choose to itemize their deductions, which reduces their taxable income.

If you have a lot of deductions and personal exemptions, you might end up reducing your taxable income by so much that you no longer fall into a tax bracket whose marginal tax rate Mr. Obama proposes to raise. (You might still be subject to the alternative minimum tax – a parallel tax system that basically says you have to pay at least a given share of your income, regardless of how many deductions you take – but you will not be hit by the higher marginal tax rates on earned income that Mr. Obama is proposing.)

For example, a married couple earning $300,000 in A.G.I. might have itemized deductions of about $50,000 and a child, which means three personal exemptions. This comes to a total of more than $60,000 in deductions and exemptions, meaning this couple would have taxable income below the president’s threshold for higher tax rates. In fact, about 70 percent of all couples in the $250,000 to $300,000 A.G.I. range in 2013 would be unaffected by Mr. Obama’s proposal to raise taxes on those earning over $250,000, according to Citizens for Tax Justice, a liberal advocacy group.

Remember that all these higher tax rates refer to marginal rates – the escalating rates on each successive tier of income – not average rates.

That means that even if you do earn enough in taxable income to be affected by the higher tax rates, not all of your income would be taxed at higher rates. Only the income above the thresholds would be subject to a higher tax rate under Mr. Obama’s plan. The first couple of hundred thousand dollars would be taxed at the same rates that now apply.