Friday, August 15, 2008

Tax Plans: Some Useful Graphs

On Wednesday, I posted about an online article (which I first saw at Greg Mankiw's blog) by Alex Brill and Alan Viard in the AEI's "The American" titled The Folly of Obama's Tax Plan. I argued and still believe that the way that article is written is deeply misleading (one of the authors responded in comments, and my point-by-point response is here; but enough food-fighting -- this is a substantive post!).

My main point was that

An honest article meant to inform would show both the marginal tax rates graph and a graph of after-tax-and-transfer income against pre-tax-and-transfer income. I assure you that there is a very good reason that Brill and Viard don't include that second graph.
The original Brill and Viard piece was a vehicle to publicize a chart showing how the Obama plan would increase effective marginal tax rates for a carefully chosen type of family, at all income levels above $25k (for some reason, Brill and Viard's chart doesn't show effective marginal tax rates for those with pre-tax income below $25k). In isolation, this graph has the potential to confuse readers unfamiliar with the distinction between "taxes" and "effective marginal tax rates". As I suggested in the text I quoted just above, a fair-minded way of discussing the Obama plan's effects--even a discussion intended to raise the question of disincentive effects--would not focus only on effective marginal tax rates. Rather, such a discussion would show how Obama's plan would affect after-tax-and-transfer income for people with different levels of pre-tax income. Unless I've missed it, Brill and Viard have yet to provide such a graph or discussion.

In a happy coincidence, Obama economic advisers Jason Furman and Austan Goolsbee published an op-ed in the WSJ concerning Obama's tax plan. This op-ed led the Tax Policy Center (original source of the data used by Brill and Viard) to re-run their numbers. You can see some summary results of TPC's simulations of the Obama plan here; these results incorporate the details of the Furman-Goolsbee article. For comparison's sake, you can also see results from the same types of simulations applied to McCain's tax plan (dated July 23, 2008, and based on descriptions by McCain advisers); these results are here.

Since the TPC numbers break down the effects of each candidate's plan on various pre-tax income categories, I thought it would be helpful to provide the sorts of graphs that Brill and Viard didn't. Each graph shows the effect of Obama's plan side-by-side with the effect of McCain's plan (the analyses are relative to what is called the "tax cuts extended baseline", which I believe means that the analysis assumes extension of the Bush tax cuts; this isn't my preferred analytical baseline, but some people like it, and showing both plans relative to the same baseline removes any relative distortions).

Three notes before I get started:
  1. I haven't seen similar TPC-done effective marginal tax rate tables for the two plans (I searched the site but did not find them). If someone can point me to them, I'd be delighted to make similar graphs for effective marginal tax rates in a future post.
  2. The point of this post is to provide interested readers with information helpful to understanding what each proposal would do. Obviously I'm partial to Obama (look at the blog's title!), but I've tried to keep editorializing to a minimum in this post. Look at the facts, and make up your own mind.
  3. The TPC does its estimates under various assumptions about the plans and the tax-law/tax-policy baseline. I made these tables using the links provided by Pete Davis of the Capital Gains and Games blog, which is where I first saw that the TPC had updated its Obama-plan analysis. Analyses based on other plausible assumptions about the plans and/or future counterfactual tax rates would of course yield different charts. My guess, though, is that the basic story would be the same. I'm of course happy to be shown that I'm wrong on this guess. [Update: Turns out that the TPC analysis of the McCain plan based on McCain's stump speech is very different from the analysis I discuss here, which is based on what his economic advisers say. In short, the McCain stump-speech version would lead to considerably larger reductions in taxes paid by most groups than the version based on what his economic advisers told TPC. The overall cost of the stump-speech plan is $2.8 trillion more than the economic-advisers one. To see this, compare the next-to-bottom-row figure in the far-right column of this table (analysis of stump-speech version) to the same figure in this one (analysis of economic advisers' version). The same comparison between Obama's stump and advisers' versions involves only a $400 billion difference in his plan's total cost (the stump version is actually less expensive). I'm going to leave the rest of this post as-is, focusing on what advisers told TPC. When I have some time later, I'll try to put together a side-by-side of McCain's stump versus Obama's, as well as McCain's advisers versus McCain's speeches.]
The first pair of charts concerns the percentage change in after-tax income that would result from each plan (click on the image to see it in larger form).


As you can see, the Obama plan leads to a large percentage increase -- 8.6% -- in after-tax income for households with pre-tax income below $10k. In fact, Obama's plan increases after-tax income for those with pre-tax incomes in every category below $200k. McCain's plan would increase after-tax income for every category, though the only categories for which after-tax income would rise by more than 1% are those with pre-tax income between $500k-$1mil and $1mil+. By contrast, Obama's plan would reduce after-tax income by 1.5% for those making $200k-$500k, by 5.6% for those making $500k-$1mil, and by 11.3% for those making $1mil+.

Now let's consider actual dollars. My next charts shows the change in the net tax bill that each plan would cause for the different income categories. Note that a negative number is a tax cut, while a positive number is a tax increase. Chart A shows the change under each plan for all categories with incomes below $200k; I discuss those with higher incomes in Chart B, below.

This chart shows that both plans would reduce the net taxes paid for all groups with incomes below $200k. But Obama's plan cuts the net tax bill considerably more than does McCain's for those making below $100k. Here are the numbers by income category:
  1. Pre-tax income less than $10k: Obama tax cut is $487, McCain's is $14.
  2. Pre-tax income $10-20k: Obama tax cut is $709, McCain's is $26.
  3. Pre-tax income $20-30k: Obama tax cut is $896, McCain's is $89.
  4. Pre-tax income $30-40k: Obama tax cut is $1,039, McCain's is $178.
  5. Pre-tax income $40-50k: Obama tax cut is $1,124, McCain's is $232.
  6. Pre-tax income $50-75k: Obama tax cut is $952, McCain's is $336.
  7. Pre-tax income $75-100k: Obama tax cut is $779, McCain's is $483.
  8. Pre-tax income $100-200k: Obama tax cut is $407, McCain's is $847.
On average, McCain's plan cuts the net tax bill by $601, while Obama's increases it by $549. Thus, McCain's plan further increases federal debt over the tax cut extended baseline, while Obama's plan reduces it (note that both plans increase federal debt over current law, under which all Bush tax cuts are set to expire; McCain's increases federal debt by more than Obama's).

Chart B shows the change in net tax bills for the top three pre-tax income categories. Notice that the vertical-axis scale of this chart is very different from the scale in Chart A (that's why I broke the categories into separate charts).
Here are the numbers:
  1. Pre-tax $200-500k: Obama raises taxes $3,546, McCain cuts $1,892.
  2. Pre-tax $500-1mil: Obama raises taxes $30,499, McCain cuts $6,825.
  3. Pre-tax $1mil+: Obama raises taxes $262,371, McCain cuts $58,632.
In sum, Obama's plan involves
  • large increases in taxes paid by the highest-earning Americans, who represent a very small share of people but take in a (relatively) very large share of pre-tax income, coupled with
  • moderate-to-large reductions in the net tax bill faced by everyone else.
By contrast, McCain's plan involves
  • smaller, but still large, reductions in taxes paid by the highest-earning Americans, coupled with
  • very small reductions in the net tax bill faced by everyone else.
(I stress again that both plans add substantially to the federal debt relative to current law, which means that someone will have to pay the bill later; again, though, that bill would be smaller with Obama's plan than with McCain's.)

I now turn to the issue of average tax rates. Whereas the effective marginal tax rate answers the question, "What share of the next dollar that I earn will I have to pay in taxes?", the average tax rate answers the question, "What share of all my income do I have to pay in taxes?" Because marginal tax rates rise with pre-tax income in the U.S. tax system, and because of the way various tax credits are phased out as pre-tax income rises, effective marginal tax rates can be very different from average tax rates. The question of whether marginal tax rates or average tax rates are more important doesn't make a lot of sense, because they're both relevant to answering different questions. A person deciding whether to work one more hour should be more concerned with marginal tax rates, while a person deciding whether to work at all, or between part- and full-time work, should be more concerned with average tax rates. A person concerned with distributional fairness (whatever said person thinks that means) should probably be more concerned with average tax rates, though the disincentive effects of marginal tax rates do impact the efficiency costs of a given degree of redistribution.

With that said, my final chart shows the change in the average tax rate paid by people in each category. A negative number means that the average tax rates paid by those in the group would fall under the plan (a tax cut), while a positive number means the average tax rates would rise (a tax increase). The units of the chart are in percentage points, not percent. That is, the -8.1 figure for those in the lowest income group under Obama's plan means that instead of paying 5.3 percent of their pre-tax income in taxes, on average they would receive a 2.8 percent rebate (5.3 percent minus 2.8 percent equals 8.1 percentage points).


This chart tells a pretty simple story. McCain's plan would reduce all groups' average tax rates, though generally by very little. Except for those making more than a million dollars a year, who would see a drop in average tax rates of 1.8 points, McCain's plan would reduce the average tax rate by less than one percentage point across the board.

By contrast, Obama's plan would reduce average tax rates by a moderate to large amount (between 1.4 and 8.1 percentage points) for all groups with pre-tax income below $75k; those in the $75-100k and $100-200k groups would see average tax rates fall by 0.8 and 0.3 percent. Most notably, those in the three highest groups would see moderately small (1.2 percent for $200-500k) to large (4.1 and 8.0 percent for those making $500k-$1mil and $1mil+) increases in their average tax rates.

Update: Don Pedro has more on other aspects of the WSJ op-ed piece.

16 comments:

Gerald T. said...

Part of the problem with Obama's tax plan is that his tax cuts for those making below $100,000 essentially all come from mere redistribution (lump-sum transfers). They are mostly just tax credits which do very little for incentives. (In fact, via the income effect, it would deter work.)

Now compared to a 2011 baseline, Obama does extend the lower marginal rates, and he does (relative to 2009 baseline) lower marginal rates by patching AMT.

However, almost all of his new "tax cuts" for those in the middle-income range are merely government spending (handouts) disguised as a tax cut. That is, tax expenditures.

It's just that the IRS is the one doing the handing out instead of some other government agency.

John Rose said...

Gerald,

Do you live in some kind of parallel-universe communist United States where letting people keep more of what they earn is called a "handout"? And would McCain's plan be any less a "handout" for the super-rich than Obama's plan is for the other 95%?

Obsessing over the marginal tax rate misses the bigger point of how we are sharing the burden of running our government. Obama's plan is better for everyone who isn't super-rich and better at limiting the growth of our national debt.

Gerald T. said...

John:

You sound like those on the right who have criticized the use of the term "tax expenditures" because it somehow implies that government is entitled to all your money. It does no such thing.

My point is that there are plenty of provisions in the federal income tax that try to achieve the same goal as a government spending program, and Obama is pursuing many, many more of these types of provisions. Maybe "handout" was not the proper term...the term "transfer" is probably a better choice of words.

And equating the McCain marginal tax rate cuts to Obama's tax credits as being "handouts" proves a lack of understanding of the tax expenditure concept.

http://www.house.gov/jct/x-37-08.pdf

Jimi said...

I am definetly no expert, but the way I see it, anything that involves paying anymore in taxes anywhere along the income bracket will pay off the national debt slower, considering national spending stays the same. If you pay more in taxes you buy less, you expand your buisness less, hence other buisnesses will make less profit, and the government makes less money. Am I totally off base here?

Jimi said...

In addition, Who is it that spends all the money in this country? It is the wealthy. If we are interested in strengthening the economy and paying off national debt, then we should be encouraging the wealthy to spend thier money. They are not going to spend it if their Government is trying to take it away. The more we try to even the playing field the more we will actually hurt the lower and middle class. Who is it that provides the best opportunity to make more money to spend, the Government or the Wealthy? It looks to me both Obama and McCain are only interested in appeasing Class Envy than Economics.

Jon B. said...
This comment has been removed by the author.
Jon B. said...

Jimi said:

"If you pay more in taxes you buy less, you expand your buisness less, hence other buisnesses will make less profit, and the government makes less money. Am I totally off base here?"


Economists have generally looked at this question from a different angle. Does cutting taxes lead to increased tax revenues?

The answer, however, is no. Studies have found that revenues do not increase by enough to pay for the initial cuts.

A short explanation from FactCheck.org can be found here:

http://www.factcheck.org/askfactcheck/have_tax_cuts_always_resulted_in_higher.html

Alan Reynolds said...

The "tax cuts" in Obama's plan consist of many new "refundable tax credits." Gerald T. is correct to describe that as spending (tranfer payments) in disguise. Treasury would be sending out millions more checks on April 15 to people who pay no income tax.

The question of whether or not lower tax rates increase revenues is also a question of whether higher tax rates increase revenues.
Economists call this the elasticity of taxable income -- that means the responsiveness of reported income (or capital gain) to changes in marginal rates.

If the elasticity is one, a lower tax rate would not reduce revenues. If the elasticity is 0.5, a higher tax rate would raise revenues about half as much as would otherwise be expected. For capital gains, the elasticity averages 0.9 in a dozen top studies. For incomes above $200,000 or so, it's about 0.55-0.65 -- the latter estimate is from Emmanuel Saez at UC Berkeley.

What that means is that higher tax rates on capital gains, dividends and salaries will not produce nearly as much revenue as Obama would need to cover all his refundable tax credits (new entitlements).

What it also means is the alleged "soak the rich" aspects of higher tax rates would only work if top taxpayers were very dumb and docile (e.g., they didn't know about tax-free bonds, for example, or how to avoid the capital gains tax by not selling unless you have offsetting losses).

On this and other tax topics Factcheck.org simply cites the "bipartisan" Tax Policy Center which habitually ignores or distorts the evidence on the elasticity of taxable income. CBO is better about elasticity in general , but has always been wrong about capital gains.

kidsampson said...

FROM http://www.aei.org/about/ "AEI's 501(c)(3) tax status also forbids it from participating in any campaign for elected public office. This means that AEI may not take an institutional position for or against any political candidate and may not permit its resources, including the on-the-job time of its salaried employees, to be used in an electoral campaign. As in the case of policy advocacy, AEI's own purposes lead it to broader policies against partisanship in any of its activities. AEI research and publications, participation in its conferences, and the policy advice of its research staff and other employees, are available to government officials, legislators, political candidates, and others regardless of party affiliation. When the policy positions of AEI scholars and fellows coincide with those of a particular political party or electoral candidate, this is without any purpose of advancing the partisan interests of the party or candidate."

Isn't referring to one candidates platform as a "folly" (obvious negative connotations) without an honest analysis of his opponent's platform, seem somewhat partisan? And therefore in direct violation of AEI's policies?

jexter said...

If you really want to put more money in circulation, give it to people living paycheck to paycheck. Every extra dollar they have will go straight back into the economy. You don't have to give them any money - just let them keep more of their paycheck.

Taxing the rich is going to stifle the economy? Give me a break. Who really believes that the top one percent will stop investing if they're taxed at a slightly higher rate? Are they going to start stuffing cash in their mattresses? The big problem with using tax cuts for the rich to stimulate the economy is that it may not be our economy they stimulate. If they use their tax cuts to buy a villa in Spain, does that help Americans? If they buy a new Ferrari doesn't that help the Italian economy? A shopping trip to Paris? Vacations in Bermuda, the Bahamas?

Bill gates is a smart guy, but he hasn't written any code since the 80s. Windows XP and Vista are the product of thousands of software engineers. Because much of it is derived from the effort of thousands of others, asking him to kick back a larger percentage of his income isn't socialism - it's the decent thing to do. All of Bill's and all his engineers hard work should make them wealthy. But in this country, founded on the principle of fairness and equallity, there are millions of kids without access to decent health care. There are millions of kids without access to even average public education. And any American doing better than average should find this unacceptable. Even those completely devoid of compassion should recognize that our people are our farm team. We need to get back to basics.

Christ Almighty, how did we get to the point where America became the country of "I've got mine"?

marshall said...

I am a small business owner. What incentive is there for Bill Gates or other business entrepeneurs to start a large company and dream big if the benefit is not there. Overtaxing business owners takes away the incentive and stifles growth. Overall, I'm for Obama, but his tax plan could tax m family at close to 60% of my income. That scares the heck out or me.

Anonymous said...

I have a real question that I hope someone can answer. My biggest concern is that I could soon cross the "wealth" barrior according to Obama - and I cannot get an answer on how the removal of caps on Social Security payments will work.

Right now, we pay on all income up to approximately $103k, and then stop paying for the rest of the year. For this example, say I made $248k last year).

Let's assume my income goes up to $252k next year. Under his proposed plan - would I be taxed without limitation on every dollar of my income (as his verbage suggests)? Or only an additional tax on the income above $250k.

The difference between these is huge - as my income would be reduced (per the nex tax rule) by $100 in once scenario, but closer to $7,500 in the other. A raise would cost me money!

kidsampson said...

Anonymous - The American government has uses a marginal income tax bracket system. From http://en.wikipedia.org/wiki/Income_tax_in_the_United_States :
An individual pays tax at a given bracket only for each dollar within that bracket's range. For example, a single taxpayer who earned $10,000 in 2007 would be taxed 10% of each dollar earned from the 1st dollar to the 7,825th dollar (10% × $7,825 = $782.50), then 15% of each dollar earned from the 7,826th dollar to the 10,000th dollar (15% × $2,175 = $326.25), for a total of $1,108.75. Notice this amount ($1,108.75) is lower than if the individual had been taxed at 15% on the full $10,000 (for a tax of $1,500). This is because the individual's marginal rate (the percentage tax on the last dollar earned, here 15%) has no effect on the income taxed at a lower bracket (here the first $7,825 of income taxed at 10%). This ensures that every rise in a person's pre-tax salary results in an increase of their after-tax salary.

So, only the additional income over 250K would be taxed at the higher rate. In your case, only 2K would be taxed at this rate. And if I can assume that the numbers you are stating are GROSS income estimates, it's not likely that you would be effected by the rate increase at all since your taxable income (after deductions) would more than likely be less than 250K.

Anonymous said...

@Anonymous - If you are referring to the removal of the FICA tax cap, you are correct stating that all of your income would now be subject to teh 6.2% social security tax and not just the first $103k. Essentially this would mean an an extra $9k+ in social security tax alone. This does not account for your extra income tax due to the higher income tax rates.

Anonymous said...

@kidsampson - Your comment on the post your responded to does not answer the question. That poster was speaking of the Social Security tax not the income tax.

Currently every worker pays 6.2% on every dollar earned up to a limit of $102k. The removal of this $102k cap on this tax would mean everyone would now pay the 6.2% on every dollar. That's not a tax cut. That's an attempt to bail out the social security system by making those of us pay now for what we will likely never see when we retire.

Your analysis was focused soley on the income tax. The removal of the social security cap is a tax increase to ALL AMERICANS.

kidsampson said...

Oops! I didn't see the Social Security part of the question.

Yes, removing the cap would be an additional tax on everyone earning over $102K (2008). Not to mention the increase to the self employed who pay both the employee and employer share of SS taxes.

From Obama's online policies:
Obama does not support uncapping the full payroll tax of 12.4 percent rate. Instead, he and Joe Biden are considering plans that would ask those making over $250,000 to pay in the range of 2 to 4 percent more in total (combined employer and employee).

There's no indication where or not this would be marginal, so no real answer to your question.