“Notches” in the Marginal Tax Code

Tax (Photo credit: 401K)

One of my favorite blogs, Econlog, has a great point of clarification of marginal tax rates that I’d like to emphasize. In today’s article by David Henderson, he links his own previous post. He explains one unique problem with “progressive” tax rates that another author suggests.

Here’s what Megan McArdle advocated today:

eliminate the tax-deductibiity of health insurance benefits for people making more than $150K a year in household income, $100K for singles.

So now imagine that you’re a married person with a family and you’re making exactly $150K a year. Your employer pays $10K toward your health insurance. Of course, it’s not subject to federal income tax, state income tax, or Social Security or HI tax. You and your spouse make a total of $150K, split roughly evenly, so both of you pay the marginal payroll tax rate of 7.65%. You also pay a marginal income tax rate of 25% and a state income tax rate of 5%. So your total marginal tax rate is 25 + 5 + 7.65 = 37.65%.

Now you earn one more dollar. What happens? That whole $10K employer contribution becomes taxable and so you pay tax on it at 37.65% or $3,765. You made an extra buck and you paid $3,765 extra in taxes. Oh, yes, plus $0.3765. So you paid $3,765.3765 in taxes. Your marginal tax rate on that dollar: 376,537.65%

Henderson explains why this is a notch:

Imagine drawing the Marginal Tax Rate on the vertical axis against income on the horizontal. If there is no phaseout, you get a big jump at the $150,001 point and then a big drop at the $150,002 point. If there is a phaseout over some income range, you get the MTR line kinking and becoming steeper at the $150,001 point.

In what sense is a marginal rate of $376,537.65 a good idea? Is it fair? Is it efficient? Is it just? I’d love to hear the answer.

The reason I post this is to show how sketchy some aspects of progressive taxation can be. People need to be carefully in advocating for tax-hikes and understand what they are really saying.