President Obama’s plan to raise taxes on the nation’s highest income households may not quite mean what you think. A closer look suggests that fewer people may get whacked than either Obama or his Republican critics suggest. And for many of the victims, the club won’t be the president’s plan to raise rates to 36 percent and 39.6 percent. Those rate hikes may be getting most of the attention, but the real cudgel would be higher taxes on capital gains and dividends going to high-earners.
First, let’s look at whom Obama’s plan would hit. As most everyone knows by now, ever since his presidential campaign, Obama has promised to retain the 2001 and 2003 tax cuts for households with income below $250,000 and individuals making less than $200,000. That seems clear enough, but candidate Obama never said what he meant by “income.” His budget helps to clarify the issue by defining income very generously but parsing the policy descriptions isn’t easy.
Consider different ways the president could have defined income to determine whom he’d hit with bigger tax bills. The broadest measure—total income—counts everything you get in cash, regardless of source, including taxes your employer pays and you never see. By that measure, just over 3 percent of households have income above the president’s thresholds (see graph). The president could instead have decided to use a narrower measure, “adjusted gross income,” which excludes income not subject to federal tax such as tax-exempt bond interest and much of Social Security benefits. Just over 2 percent of tax units have AGI that tops $200,000/$250,000.
Or the president could have gone one more step and dropped exemptions and deductions from his definition of income. That’s the familiar description of taxable income (pretty much the bottom line on your 1040) and it would protect another 0.2% of households from a tax hike.
But Obama’s budget plan is even a bit more generous than that. To make sure that no one making less than $200,000 really does get hit with a tax increase, the president had to extend the 28 percent bracket to cover more income. That would cut taxes for even the richest taxpayers by a few hundred dollars and provide a small cushion against higher levies for people just over the thresholds. When all the dust settles, the Tax Policy Center figures that just 1.7 percent of households would pay higher taxes under the president’s proposal than if Congress extended all the 2001 and 2003 tax cuts.
Just as interesting is why those 2.7 million high-income taxpayers would get hit. For most of them, the answer is not the high-profile increase in the top rates. Rather, it is Obama’s proposal to hike rates on capital gains and dividends. A close look at his plan shows that fewer than three in ten affected taxpayers would be hit by the 36 percent and 39.6 percent rates on ordinary income that have drawn the loudest complaints. Another change, the limitation on itemized deductions (Pease) and the phaseout of personal exemptions (PEP) would affect less than half. But nearly 95 percent of people facing higher tax bills would pay more tax on gains and dividends. Keep in mind, btw, that while Obama would raise the top rate on capital gains from 15 percent to 20 percent, he would also tax qualified dividends at 20 percent. If the Bush-era tax cuts are allowed to expire, the top dividend rate would hit 39.6 percent.
Knowing that less than 2 percent of households would face higher taxes, mostly because of their investment income, won’t calm the debate—and by itself certainly provides no justification for backing the president’s plan—but it’s always helpful to know the facts.
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