Friday, December 28, 2012

Fiscal Cliffery: The future of tax rates

For your Friday afternoon fun, Megan McArdle has a useful note about marginal tax rates. Her point, almost always missed among the commentariat, is that small percentage increases in rates take a larger bite of one's after-tax income as marginal rates increase.

[O]ne thing that people often don't understand is that the higher the tax rate already is, the harder it is to raise it further.

This is counterintuitive because when we're talking about policy, we tend to look at tax increases as a fraction of total taxable income, or as a fraction of the current tax rate. To see what I mean, think about two cases: one where the tax rate is going from 5% to 10%, and one where it is going from 50% to 55%.

If you look at this as a percentage of total income, these two tax increases are the same.

If you look at it as a percentage of the tax rate, then the first increase is much larger: it is doubling your taxes! While the second increase is only upping them by 10%.

But in terms of behavior, the percentage increase in the rate, or the percentage decrease in total income, is much less important than a third figure: the percentage decrease in your after-tax dollar. Most people think less about their nominal annual salary than about how much they bring home in each paycheck. And if you look at it this way, the second tax increase is much, much larger than the first.

CWCID: Professor Bainbridge.

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