New "fiscal cliff" compromise idea: Let's raise taxes on the rich without raising their tax rates

I don’t understand why either side would want to do this. Actually, wait, that’s not true: I kind of understand why Democrats would want to do it. If it happens, it’ll be a heavy bludgeon to use against Republicans in the next election cycle.

One possible change would tax the entire salary earned by those making more than a certain level — $400,000 or so — at the top rate of 35 percent rather than allowing them to pay lower rates before they reach the target, as is the standard formula. That plan would allow Republicans to say they did not back down in their opposition to raising marginal tax rates and Democrats to say they prevailed by increasing effective tax rates on the rich. At the same time, it would provide an initial effort to reduce the deficit, which the negotiators call a down payment, as Congressional tax-writing committees hash out a broad overhaul of the tax code.

That idea could be combined with the reinstatement tax code provisions that once prevented the rich from taking personal exemptions or itemizing deductions. Those rules were eliminated by the tax cut of 2001. Reinstating them would tack an additional one to two percentage points onto the effective tax rates of high-income households without raising the 35 percent rate, but which households would be affected has not been decided. In all, tax experts say, families in the top tax bracket would find their effective tax rate jump to 41 percent, even though the top statutory rate would remain 35 percent…

Under the existing tax code, the first $17,400 of adjusted gross income for a couple filing jointly is taxed at 10 percent. Above that level, up to $70,700, income is taxed at 15 percent. Income between $70,701 and $142,700 is taxed at 25 percent. Gross incomes up to $217,450 are taxed at 28 percent. The next bracket, 33 percent, ends at $388,350 for couples. The top bracket hits adjusted gross incomes only above $388,350.

In other words, instead of jacking up the top bracket from 35 percent to 39.6 percent, the way it was in the Clinton years, they’re going to essentially eliminate all of the lower brackets for taxpayers who earn beyond a certain amount (e.g., $400,000) and tax their entire earnings at 35 percent. No more marginal rates for high earners as described in the last paragraph of the excerpt. If you’re sitting on $399,999 in income and then you cross the magic threshold by earning another two bucks, boom — the marginal rates you used to calculate the taxes on your first $17,400, $70,700, $142,700, etc, instantly disappear and all the money you’ve made gets taxed at the top rate. In practice, then, this operates like a surtax of a fixed amount on top earners; if you look at the IRS’s tax tables, you can figure out the difference between $400,000 taxed entirely at 35 percent versus $400,000 taxed progressively at the current marginal rates. Unless I missed something, it’s upwards of $23,000. Whether you make $400K, $4 million, or $400 million, then, you’d be paying the same effective surtax under the “compromise” plan: An extra $23,000, on top of the 35 percent tax you’re paying as part of the top bracket.

Tom Maguire spots the problem:

Taking those tax brackets as Gospel, and relying on Excel and Keurig, I infer that if the effective average rate on income of $435,800 is 35%, the marginal rate from $388,350 to 435,600 must be 100%. Ouch. If all the phase-outs are spread out from $388,350 to $1,000,000 then the marginal rate over that bracket is 40%. In that scenario, everyone with income over $1 million will have an average rate of 35%; all income over $1 million will be taxes at a marginal rate of 35%…

And the politics of this intermediate high bracket are ludicrous for the Republicans. Obama wants to raise the top marginal rate on everyone above some threshold to 39.6% (Let’s round that to 40% for purposes of this mini-tirade). The Republican counter will be to raise the top marginal rate to 40% on incomes from $400K to $1 million and then cut the rate back to 35%? That may protect large small-business owners, but only by throwing the smaller successful ones overboard.

Paying an extra $23,000 is small potatoes if you’re making $10 million a year, but to a small business owner who’s pulling down $400,000 or a bit more, it’s a big deal. Note Maguire’s point about the 100 percent effective rate for incomes just above the magic $400K threshold. Imagine a business owner doing an earnings projection in November and determining that he’s on pace to pull down $410,000 this year. Once he’s hit with the surtax, his income will fall to $387,000. In other words, he’s … better off working less, to try to finish the year just under $400,000 in earnings so that he can keep his lower marginal rates intact. That would be less of a concern if you raised the threshold amount from $400,000 to, say, $1 million or $2 million, but I assume Democrats won’t go along with that. The amount they can raise from a $23,000 surtax aimed only at the very rich is nothing compared to the amount they could raise by restoring the top Clinton-era rate of 39.6 percent instead. (See The Monkey Cage for some back-of-the-envelope math.) To raise any real revenue this way, presumably, they’ll need to keep the threshold fairly low and target a broader taxpayer base. Right in the butter zone for small business owners.

If you don’t see already how the left will use this against the GOP in 2014 or 2016, check the title of the Monkey Cage post or read Kevin Drum. Agreeing to the compromise won’t help Republicans escape “party of the rich” demagoguery; on the contrary, the attacks will escalate on grounds that the GOP is willing to soak small business owners with a surtax in order to spare the extremely wealthy a rate hike that might really take a bite. Maybe that’s a political price worth paying for the economic benefits Republicans perceive in keeping taxes on the very rich as low as possible, but it is a price. Via Mediaite, in case you missed it yesterday, here’s Saxby Chambliss weighing his pledge not to raise taxes against the country’s need to close its deficit black hole.