The Obama 28% Limitation - A Study in Tax Complexity

 
 
September 20, 2011

President Obama's American Jobs Act calls for another round of government spending to stimulate the economy, but it differs from the 2009 stimulus bill in that it's paid for with a series of tax increases on the wealthy. Whether or not you support this sort of thing, I think that most people agree that, if we are going to raise taxes on the rich, we should do it in a reasonably simple and transparent way.

So I was dismayed to see the president bring back his proposal to limit the benefit of itemized deductions to 28 cents on the dollar, especially since the deficit reduction plan he released yesterday also calls for the expiration of the Bush tax cuts for wealthy taxpayers as well as what he calls the "Buffett Rule." The intent of all three of these things is to target the same group of people, and they all overlap in such a way as to create needless complexity. If the 28% limitation provision passes, the majority of jobs created by the American Jobs Act will be for tax accountants. In this post I'll look at a sample taxpayer and explain why it's so needlessly complicated.

We'll use our latest projections of tax brackets for next year (2012.) Let's first look at someone making exactly $1 million/year - to keep it simple, we'll assume (unrealistically) that this is all wage/salary income, and not capital gains. We'll also assume that she has $65,000 in itemized deductions. Under current policy, she gets a personal exemption of $3,800, plus her entire $65,000, to deduct from her income, for a final taxable income amount of $931,200. She then pays $302,681 of income tax on that amount, under 2012 rates and tax brackets. It's simple enough, though this is an unrealistically simple example.

Let's add in the various Obama tax proposals. From the expiration of the Bush tax cuts for high income taxpayers, we get the return of two provisions (PEP and Pease) that had been phased out.  PEP (the Personal Exemption Phaseout) eliminates the $3,800 personal exemption for this taxpayer.  Pease reduces the value of her itemized deductions by 3% of the amount that her income exceeds some threshold (this would be $208,250 for 2012, according to our projections.) Her income exceeds the threshold by $791,750, so her deductions are reduced by 3% of that - $23,753. She is only allowed to deduct $41,247.

In any event, her taxable income under this scenario is higher - $958,753. Using the rates and bracket structures that you'd get by letting the Bush tax cuts expire only for upper income earners, the tax on that amount is $338,481.

But wait! Even though the Pease provision has already significantly reduced the value of these deductions, we have to reduce them further because of Obama's 28% limitation. Currently, the deduction of $41,247 is worth 35% of that amount, because the taxpayer pays a 35% marginal rate on her top dollar of income. In other words, the deduction has the ultimate effect of lowering her taxes by $14,436 (35% of $41,247.) Obama's proposal caps this benefit at 28% of the deduction amount - $11,549. The original amount exceeds the cap by $2,887, so we have to add that amount back on to her tax; she ultimately ends up paying $341,368.

At least, that's how I understand it. It's unclear if the 28% limitation applies before or after the Pease limitation; if it applies before, then the cap would be 28% of the full $65,000 (or $18,200), and if that's the case, then the example taxpayer isn't affected at all, and the proposal would only affect taxpayers within a certain income range.

All of this is further complicated by the fact that the actual marginal rate on the taxpayer's top income isn't necessarily equal to the statutory 35%; it can be affected in various ways by the phase-ins and phase-outs of various other things. For example, the highest statutory marginal rate within the alternative minimum tax is 28%, so you'd think that anyone who owes AMT wouldn't be affected by this limitation at all - but you'd be wrong, because the effective marginal rates for many people in AMT are well above 28% (here's why.)

And then we have the "Buffett rule" on top of all this. Nobody is quite sure what it is or how it will work, but most indications are that it would be a bit like the alternative minimum tax used to be when it was first enacted back in 1970. The AMT's original goal was to solve the same problem that Warren Buffett now wants to solve - that high income taxpayers pay low effective rates, as a result of various deductions, preferential rates on various types of income, etc. The AMT used to be fairly simple, and was originally known only as the "Minimum Tax" - all you had to do was take your entire income (from all sources) and multiply it by a certain minimum rate; you had to pay at least that amount, regardless of any other deductions or credits or preferential rates on this or that.

Now, of course, the AMT has grown from that basic idea into an entire alternate tax system with its own set of rules, deductions, and exemptions, and many taxpayers need to calculate their tax liability using two completely different but equally complex methods and pay whichever is higher. On top of this, Obama wants to add the "Buffett rule" - essentially a third way of calculating one's tax, structured the way the AMT used to be before it morphed into the behemoth of complexity that it is today.

A better course of action would be to fix the current alternative minimum tax so that it does what it was originally intended to do. The "Buffett rule" is basically an AAMT - an alternative alternative minimum tax. Why make things so complicated? If Obama wants to raise taxes on the rich, surely there are better ways to do it than this. Rather than mucking around with phase-ins and phase-outs, limitation formulas for this and that, alternative alternative minimum taxes, etc., Obama should just raise marginal rates (or, better yet, get rid of all these deductions entirely if they're so problematic.) I'm not endorsing such a tax hike, but if you're going to raise taxes, there are good and bad ways of doing it.

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