Marginal Tax Rates and The AIG Tax

March 27, 2009

James Taranto at the Wall Street Journal comments on the AIG bonus tax:

So, you still work for AIG, having decided not to desert a sinking ship. For this you received a retention bonus, but the politicians have decided to make a scapegoat out of you. Last week the House passed a bill that would tax your bonus at 90%–which, since you live in high-tax New York City, means you’d end up paying more than 100% when you add up all the taxes.

He is referring to the marginal tax rate here. The marginal rate is the effective tax rate you pay on the last dollar of income, and at any given income level is calculated by dividing the change in taxes by the corresponding change in income. It seems that Taranto is simply adding the rates together to obtain a marginal rate of over 100%, but as is often the case with the tax code, the situation is not that simple.

The reason is that taxes paid to state and local governments are deductible from income if you itemize your deductions (the vast majority of high-income taxpayers itemize). The tax on bonuses passed by the House states that the total tax owed by a bonus recipient would equal the regular income tax that would be calculated on all non-bonus income plus a 90% tax on any bonus income that puts AGI over $250,000. Since the normal income tax is still calculated for income under $250,000 presumably all state and local income taxes paid, which would include taxes on the bonus, would still be deductible. Those taxes paid by a bonus recipient living in New York City, which has a 3.648% city income tax on top of the 6.85% state income tax, would be deducted from regular (that is, non-bonus) income when figuring the federal tax on that regular income.

The deduction for state and local taxes paid would have a slight effect on the marginal rate encountered by bonus recipients. If the AIG tax were to become law those subject to the tax and living in NYC would face a marginal rate, including state and local taxes and Medicare tax, of around 98.6%. Which is of course a much less onerous marginal rate than the 100%+ rate quoted by Taranto…

In his commentary Taranto quotes a piece by blogger Richard Belzer that details other interesting issues that emerge with the bonus tax, like whether bonuses returned to the employer or donated to charity would still be taxable under the regular income tax code.

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