John McCain Believes Sarah Palin Could Be President Right Now

Peter Cohn
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Peter Cohn
July 17, 2014, 4:38 p.m.

Next year, a strange phe­nomen­on is set to oc­cur: Mar­ried couples earn­ing between $270,000 and $380,000 who have sev­er­al chil­dren will ef­fect­ively pay a high­er mar­gin­al tax rate than the child­less mil­lion­aire down the leafy av­en­ue.

And the more kids, the high­er the rate. Con­sider that these folks will face a stat­utory mar­gin­al tax rate of 36 per­cent. If the stars of Jon and Kate Plus Eight re­united and net­ted $370,000 in ad­jus­ted gross in­come, they would be hit with a 47.6 per­cent ef­fect­ive rate. The av­er­age couple in this in­come range with two chil­dren would pay 41.3 per­cent. Mean­while, filers earn­ing above that range would pay a top mar­gin­al rate of about 40.8 per­cent, no mat­ter how many de­pend­ents they have.

The reas­on is that next year marks the re­turn of “PEP” — the per­son­al ex­emp­tion phaseout — and “Pease,” a lim­it on item­ized de­duc­tions named after its au­thor, former Rep. Don­ald Pease, D-Ohio. The meas­ures are little-un­der­stood but sig­ni­fic­ant ele­ments of Pres­id­ent Obama’s plan to let taxes rise on the wealth­i­est 2 per­cent of Amer­ic­ans on Janu­ary 1. But even if Con­gress takes no ac­tion on Obama’s pro­pos­al and the 2001 and 2003 Bush tax cuts sun­set at the end of this year, PEP and Pease will kick in auto­mat­ic­ally.

The phaseout of the per­son­al ex­emp­tion is the pro­vi­sion that primar­ily af­fects large fam­il­ies. Tax­pay­ers can claim a de­duc­tion for each fam­ily mem­ber, shel­ter­ing a por­tion (com­puted an­nu­ally to ac­count for in­fla­tion) of their in­come. The ex­emp­tion goes down by 2 per­cent for each $2,500 in ad­jus­ted gross in­come above a cer­tain threshold. The ex­emp­tion is com­pletely neg­ated after in­come reaches $122,500 above the threshold — a fig­ure that is not in­dexed for in­fla­tion — so top earners won’t face an ex­tra bite on their last dol­lars of in­come.

It may be hard to muster sym­pathy for house­holds earn­ing nearly $400,000 a year, con­sid­er­ing that the me­di­an U.S. in­come in 2009 was about $50,000. But tax ex­perts of all stripes, even if they dif­fer on wheth­er the well-off should pay more taxes, agree that re­in­stat­ing the per­son­al ex­emp­tion phaseout and the Pease lim­it on de­duc­tions cre­ates an odd and seem­ingly un­fair scen­ario. They say that if the idea be­hind the per­son­al ex­emp­tion is to al­low par­ents with more mouths to feed to keep more of their money, it makes little sense for people who earn less money and have more chil­dren to pay a high­er tax rate than the wealth­i­est Amer­ic­ans.

“It’s bad tax policy,” said Rober­ton Wil­li­ams, a seni­or fel­low with the Tax Policy Cen­ter, run by the Urb­an In­sti­tute and Brook­ings In­sti­tu­tion. “Ideally, we’d be much bet­ter off … rais­ing the reg­u­lar tax rates. You’d get the same amount of rev­en­ue and you’d be much more ra­tion­al in terms of how you do it. That would be much more read­ily un­der­stood, and people wouldn’t be pen­al­ized de­pend­ing on wheth­er you had lots of kids or not.”

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“The num­ber of chil­dren that you have is a fact. That’s one of the things that’s so un­fair,” said Car­ol Mark­man, a cer­ti­fied pub­lic ac­count­ant and a part­ner at Feld­man, Mein­berg & Co. in Sy­os­set, N.Y. “If they want more money from this group of tax­pay­ers, then let them be hon­est about it and just raise the rate for those tax­pay­ers, rather than get it through the back door by elim­in­at­ing the de­duc­tions.”

Wil­li­ams hadn’t done the math, but he said that the stat­utory rates wouldn’t have to go as high as the ef­fect­ive rates un­der PEP and Pease would be to bring in the same amount of money. But rais­ing the stat­utory rate is a much more ob­vi­ous tax in­crease — and thus less polit­ic­ally pal­at­able.

The tax de­bate this year has fo­cused on the re­in­state­ment of the top Clin­ton-era mar­gin­al tax brack­ets — 36 per­cent and 39.6 per­cent — and high­er rates on cap­it­al gains and di­vidends. But the re­turn of the per­son­al ex­emp­tion phaseout and the Pease lim­it on item­ized de­duc­tions will raise some $204 bil­lion over a dec­ade, nearly one-third of the total tax in­crease on in­di­vidu­als earn­ing more than $200,000 and house­holds mak­ing more than $250,000. PEP and Pease af­fect more house­holds than the high­er mar­gin­al rates would be­cause they ap­ply to ad­jus­ted gross in­come, be­fore de­duc­tions and ex­emp­tions.

Ori­gin­ally en­acted as part of the 1990 budget deal between the Demo­crat­ic Con­gress and Pres­id­ent George H.W. Bush, the per­son­al ex­emp­tion phaseout and the Pease de­duc­tion lim­it were de­signed to in­crease tax rev­en­ue without in­creas­ing tax rates. Pres­id­ent George W. Bush signed the re­peals of PEP and Pease in­to law as part of his 2001 tax cut. But to mask the rev­en­ue im­pact, Re­pub­lic­ans wrote the meas­ure so that re­peal did not be­gin un­til 2006 and took full ef­fect only this year.

Con­cerns have already sur­faced about the un­even im­pact of the dis­ap­pear­ance of PEP and Pease for 2010. Ac­cord­ing to the Con­gres­sion­al Re­search Ser­vice, only 3.3 per­cent of tax­pay­ers will feel the be­ne­fits, mainly those earn­ing more than $100,000. The largest sav­ings will be en­joyed by mil­lion­aires — an av­er­age of $19,234.

The re­in­state­ment of PEP and Pease next year for up­per-in­come earners, which Obama’s plan sup­ports and which will hap­pen auto­mat­ic­ally even if Con­gress takes no ac­tion, “would re­duce the de­fi­cit, make the in­come-tax sys­tem more pro­gress­ive, and dis­trib­ute the cost of gov­ern­ment more fairly among tax­pay­ers of vari­ous in­come levels,” ac­cord­ing to a Treas­ury De­part­ment sum­mary of the ad­min­is­tra­tion’s tax pro­pos­als.

Sen­ate Fin­ance Com­mit­tee rank­ing mem­ber Charles Grass­ley, R-Iowa, a crit­ic of PEP and Pease , ar­gues that it’s re­gress­ive to tax fam­il­ies earn­ing less money at a high­er rate. “It’s one thing to ar­gue that tax­pay­ers who earn a cer­tain amount don’t de­serve cer­tain ex­emp­tions or de­duc­tions,” he said. “But it’s in­tel­lec­tu­ally dis­hon­est to down­play the ex­tent that you want to raise tax rates.”

Here’s how it works: Con­sider a couple, with two chil­dren, who earn $300,000 in ad­jus­ted gross in­come next year and have $50,000 in item­ized de­duc­tions. The Pease pro­vi­sion would give those de­duc­tions a 3 per­cent hair­cut on in­come above $254,150, so the couple’s de­duc­tions would de­crease to $48,625. Then in­stead of be­ing able to claim four full ex­emp­tions at $3,700 each, this fam­ily could claim only $2,294 per ex­emp­tion, for a total of $9,176.

Sub­tract the de­duc­tions and ex­emp­tions from the couple’s ad­jus­ted gross in­come, and they would be left with $242,200 in tax­able in­come. Un­der Obama’s plan, that fam­ily would be bumped in­to the 36-per­cent tax brack­et, which is es­tim­ated to be­gin at $237,300 in tax­able in­come, ac­cord­ing to the Joint Com­mit­tee on Tax­a­tion. The Pease pro­vi­sion would add about 1.1 per­cent to that mar­gin­al rate, and each ex­emp­tion’s loss of value from the per­son­al ex­emp­tion phaseout would add about 1.06 per­cent—for a total ef­fect­ive rate of 41.3 per­cent. Add an­oth­er de­pend­ent, and the rate jumps to 42.4 per­cent, and so on.

Now com­pare a child­less couple who earn $500,000 in ad­jus­ted gross in­come and have $90,000 in item­ized de­duc­tions. Pease rules would cut their al­low­able de­duc­tions to $82,625, but un­der the phaseout pro­vi­sions they would already have maxed out any­way. So their $417,375 in tax­able in­come would be sub­ject to the 39.6 per­cent brack­et, which is es­tim­ated to start at $382,650 next year. The Pease lim­it would add about 1.2 per­cent to that rate, for a total ef­fect­ive rate of 40.8 per­cent—which could not rise even if they had de­pend­ents.

Dur­ing his pres­id­en­tial cam­paign, Obama de­clared that his plan would re­turn tax rates to those of the Clin­ton years. However, due to in­fla­tion, Obama’s ef­fect­ive rates in some cases would be high­er than those un­der Clin­ton, be­cause the per­son­al ex­emp­tion’s value rises over time — each ex­emp­tion was worth $2,800 in 2000, for in­stance. In­fla­tion will con­tin­ue to hike the ef­fect­ive rate in later years, and that’s be­fore the 2013 tax in­creases on up­per-in­come earners kick in un­der the new health care law, Grass­ley noted.

As the de­bate con­tin­ues in Con­gress, the size of the na­tion’s debt prob­ably ne­ces­sit­ates some tax hikes, said Mark­man, who test­i­fied be­fore the Sen­ate Fin­ance Com­mit­tee in Ju­ly. “We really could not, as it turned out, af­ford the Bush tax cuts,” she said in an in­ter­view.

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