The Tax Cut You May Have to Send Back

34% Effective Rates Are No Longer Just for the Rich

Barack Obama has promised a "tax cut" for everyone, except for the 5% of taxpayers who have large incomes and are supposed to pay more. The tax cuts are refundable, meaning that people can apply for a check up to $500 per taxpayer (or $1000 per family) if the "cut" is greater than the taxes paid. Even if no tax was originally paid. Additional refunds are promised for expenses such as college tuition.

This is not a tax cut in the usual sense. People with more income will pay people with less income, and will pay for most of government in addition. Payments from the rich to the poor are usually called "welfare".

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I said "people can apply for", because the taxpayer (or non-taxpayer) does not get the money automatically. He needs to document the expenses that are favored for a tax rebate, and file a more complicated tax return.

This is like the $20 off coupons that retailers hand out. Just collect all the paperwork, clip the coupons, do the math, send it in, and get the refund. Your tax preparer will charge a bit more for the service, or you can study the tax booklets yourself.

Some people will lie about eligibility, just as they currently lie about extra dependents to get current tax deductions. The temptation to lie is greater, because they can walk away with a check, not just a reduction in the tax owed. The government will spend even more money trying to catch them, or checking up on you. There is an incentive to file under a false social security number, get the check, and disappear.

Taxes will be made more horribly complicated. Obama proposes phase-outs and rate changes along with the cuts. The cut you get this year may be reclaimed reduced in following years by inflation and any increasing family income.

The chart below is from American.com: The Folly of Obama’s Tax Plan. It shows the Marginal Tax Rate for our current tax law and under Obama's plan. Marginal Rate means how much income the government takes out the next $1000 for each income level.

Obama says he will give you $1000 plus other amounts. The downside is that these benefits "phase out" (reduce gradually) as income increases. So, either you don't get the full benefit at your income, or the benefit disappears if you earn more in the next year. If you lose $500 in benefit, it feels the same as paying $500 more in tax.

From the graphic, say you get a raise from $30,000 to $35,000. Current law takes $1000 of that $5000, a marginal tax rate of 20%. Obama's proposal takes $1700. You give back an extra $700 of whatever benefit was originally granted to you, because something is being "phased out", for a marginal tax rate of 34%.

The very high marginal rate shown in the graphic (the red line and pink area) drops back steeply at $45,000. This means that most of the tax "cuts" have been reclaimed at that income. Much of the rest disappear at an income of about $83,000. This is for a family with two children (see the original article).

The original tax gift feels great. The phase out is a gotcha. Just when you are happy to make more money, you will find out that you owe much more tax. Just hope you didn't spend it already. I'm not happy with Obama's plan or with the current tax law. We should have simpler, understandable tax laws, not a grab-bag that hides who is paying what.

Obama has put forward a complex proposal. He talks about tax "cuts", but they are really gifts that are reduced according to income. He gives no public idea of the social evaluations that he is using to decide how these benefits phase out. It seems detailed and arbitrary. There is no general philosophy to refer to if he is elected and wants to change things around.

Everyone should pay less tax and know what they will keep if they work hard and earn more. You should not need a tax accountant for a $35,000 income. On the plus side (smile) you may have a chance to feel like that rich person, who pays 34% ($340) out of each additional $1000 he earns.