How Would President Obama’s Tax Plan Raise Tax Payments for a Couple Earning $250,000 or Less?
July 28, 2010
The Tax Foundation launched a new calculator last week that helps users see how their taxes might rise in 2011. In a FoxNews piece about it, we explained that some families making $250,000 or less could see a tax increase under Obama's budget proposal, which would be a violation of his famous campaign promise not to raise taxes on families with incomes of $250,000 or less. Here's how that would happen.
Consider a couple with two children under seventeen, with each parent making $125,000 in wages. Assume this family pays $10,000 in local income taxes, $12,500 in real estate taxes, and has a further $25,000 worth of other itemized deductions, such as charitable contributions and a mortgage interest deduction. Our calculator at www.MyTaxBurden.org shows that if all the Bush tax cuts expire, their tax burden would go up by $2,650. However, even under President Obama's tax proposals, which keep most of the Bush tax cuts in place, this family would see its income tax payment increase by $1,750. To understand why, we need to look at the specifics of the President's plan.
The most significant provisions in Obama's budget call for keeping the Bush-era tax cuts in place for all taxpayers except for those who earn enough to fall into the top two tax brackets (over $250,000 for couples). For those people, he would increase the top two rates: the current 33% rate to 36% and the current 35% rate to 39.6%. There is an assortment of other changes as well, and the relevant one for our example family is a limitation on the benefits of itemized deductions to 28 cents on the dollar, even if the taxpayer is in a higher tax bracket.
This is a fairly complex proposal. Generally, the tax benefit of an itemized deduction depends on the tax bracket one is in. For example, someone in the 36% tax bracket who makes a $10,000 charitable contribution will pay $3,600 less in taxes (36% of $10,000). Obama wants to limit the benefit of that $10,000 charitable contribution to $2,800 (28% of $10,000). In our calculator, we account for this by adding the difference (in this case, $800) back onto the regular tax after it is calculated. Because the 36% and 39.6% brackets only apply to couples making above $250,000, this provision does not affect the vast majority of taxpayers and would not appear to be a violation of Obama's campaign pledge.
But that's where the alternative minimum tax (AMT) comes in. The AMT is essentially a parallel tax system with its own tax brackets, exemptions, and definitions of taxable income. A taxpayer uses the AMT form to calculate his "tentative minimum tax," or TMT, under this alternate system. If a couple's TMT exceeds the tax owed under the regular tax system, the couple must pay in an extra amount – however much the TMT exceeds regular tax.
The AMT has a very different structure from the regular tax system. There are only two tax brackets, 26% and 28%, so at first glance, it would appear that Obama's 28% limitation on itemized deductions wouldn't apply under AMT. But nothing is ever simple when it comes to the tax code.
The AMT rules have a large exemption: $70,950 in 2009 for married filers, meaning that only income above this level is subject to the tax. A family with an income of $130,000 after deductions, under AMT rules, pays tax only on $59,050 ($130,000 – $70,950) of that income. However, this exemption, by law, decreases, or "phases-out," as income goes up. For married filers, the phase-out starts at $150,000, and the exemption decreases by 25% of income over this threshold. For a family with an income (after deductions) of $160,000, $10,000 over the phase-out threshold, their exemption is decreased by 25% of $10,000, or $2,500. It is therefore equal to $70,950 minus $2,500, or $68,450. They would pay tax on $160,000 (their income under AMT rules) minus $68,450 (their reduced exemption): $91,550.
All of this is current law. Now, let's throw Obama's 28% deductions limitation proposal back into the mix. The problem here is that if a taxpayer is subject to AMT, and is in the exemption phase-out range, the value of that itemized deduction is worth more than its value multiplied by the tax rate, as under the regular tax system. For a family in the 26% AMT bracket and the exemption phase-out range, the value of a $10,000 itemized deduction isn't simply 26% times $10,000, or $2,600. Here's why: in addition to reducing taxable income, the deduction also reverses the exemption phase-out, in this case increasing the income exemption by 25% of $10,000, or $2,500. So that $10,000 itemized deduction is really more like a $12,500 itemized deduction, because that is how much it changes the family's taxable income. The after-tax benefit of this deduction is 26% of $12,500, or $3,250: $450 more than $2,800, the amount President Obama wants to limit the benefit of the deduction to. So we need to add $450 back on to this taxpayer's tentative minimum tax if we are to account for the President's proposal.
Our calculator accounts for all this, which is why our hypothetical family described earlier sees their income tax payment rise under his proposal. This family happens to be in the range where they are subject to AMT, and they are in the exemption phase-out range, so they see a reduction in the value of their itemized deductions.
One might reasonably say at this point that the increase is relatively small and only happens under a very specific set of circumstances. This is certainly true, and Obama's proposal can plausibly be described as following the spirit, if not the letter, of the laws he promised during his campaign. Another thing to realize is that families making slightly over $250,000 will not necessarily see their taxes go up either – there are plenty of plausible scenarios where such a family sees no increase. We invite users to try many different scenarios out on our calculator at www.MyTaxBurden.org and see for themselves.
For more information on the specifics of Obama's proposal, we encourage readers to download the Joint Committee on Taxation's description of his budget. Part 1 is available here as a PDF. The portion describing the President's 28% limitation on itemized deductions is on pages 123 to 130.