Monday, September 10, 2012

How not to blow it with phase-outs

Today's Wall Street Journal article, How Not to Blow It With Financial Aid, appparently about financing college education, has important lessons for the ongoing grand fiscal debate.

The article is about college financial aid, especially federally funded, and unwittingly exposes the atrocious incentives of the system.
"Every $10,000 reduction in income is going to improve your aid eligibility by [about] $3,000" if you have one child in college..

Every dollar a child has in assets—that includes bank accounts or trust funds—cuts their possible award by 20 cents. Every dollar a child makes in income above $6,130 (the limit for 2013-14 aid) cuts their possible award by 50 cents...

Every dollar a student gets from a 529 plan owned by other relatives is considered income to the student and reduces potential financial aid by 50 cents if the student is above the income threshold
So, we're looking at 30, 20, and 50 percent additional marginal tax rates on income or savings -- how much you lose if you make or save an extra dollar. The journal is full of useful tips to game the system.

Now, to the larger question. What matters for economics is the total, marginal tax rate. If you earn one extra dollar, and then spend it, how much stuff or services do you actually get -- after all taxes are included, including payroll, federal income, estate, excise, state income and excise, local, sales or property (if a good) or a second round of income and social insurance taxes (if a service). Ideally, we'd add in the burden of taxation incorporated in product prices too -- if the government taxes a business and that raises the price of what you pay, that's just like taxing you for buying the good.

And phaseouts. Phaseouts of deductions and eligibility for benefits count the same as taxes. If earning an extra dollar lowers your eligibility for college financial aid by 30 cents, that that is exactly the same thing as a 30 cent additional marginal tax rate.

In our grand national discussion about taxes, I seldom see any attempt to add this up -- to addess the total marginal rate, including all sources of taxation and deduction and benefit phaseouts. (And all questions of margins and distributions should include benefits in the same breath with taxes. If the tax system were flat and the government writes checks to people with lower income, that's the same progressivity as if the tax system were progressive and spending were not.) The debate over Federal taxes focuses on the headline federal income tax rate, 35 vs. 39%. But that is basically meaningless. The extra 30% marginal rate for people sending kids to college has not been mentioned once. Or the effects on the economy if people follow the Journal's advice to intentional impoverishment.

I wish I got to ask a question at the Presidential debate, of both candidates: Sir, what do you believe is the highest total marginal tax rate any American should pay, including all sources, phaseouts, and means-tested benefits? What do you think that rate is now? What steps will you take to ensure that no American pays a  higher rate?  Just asking the first question should send the fact-checkers on a field day and we'd start talking about how high marginal tax rates are now.

Even the Journal gets this wrong on occasion. Here's a graphic, from today's Hollande-Arnault story

No, dear Journal, this is not even close to the "top marginal rate." To start with, the US has state and local taxes, which Europe does not. And Europe has fewer phaseouts.

And now the conundrum of tax policy: As you can imagine, I'm a big fan of lowering rates and paying for it by eliminating deductions and tax expenditures. If I were in charge, the mortgage-interest and charitable contribution deductions would be gone, as would the deductibility of employer-provided group health plans. Now you know why I'm not in charge.

In this weekend's Meet The Press interview, Gov. Romney said he wanted to "limit deductions and exemptions for people at the high end" only.   Well, phasing out deductions is the same as a marginal tax rate.  If earning an extra dollar lowers, say, the deductions you can take on your existing income by 50 cents, that counts as a 50% marginal tax rate every bit as much as  if we just take the money.

I haven't done the numbers, but that's going to make it  harder to lower the economically meaningful marginal rates. It would seem far better to give the lower-rate-and-no-deductions offer to everyone.

The extraordinary complexity of the tax system is also curious. Perhaps the hope is that, since no economist seems to be able to calculate the true marginal rate, and people seem not to talk about it much, that nobody notices and so ignore the disincentives. Alas, there is an army of tax lawyers who are very good at this sort of thing, and even Wall Street Journal articles can advise that the year before your kid goes to college might be a good one to take that round the world tour rather than make any money.


Casey Mulligan wrote to let me know his upcoming book "The redistribution recession (cover at left, link to Amazon) undertakes a lot of marginal tax rate calculations, finding a maximum over 400 percent,  "over a pretty wide range of income, although applicable to a small percentage of the population." It will be on top of my stack as soon as it comes out.

A physician wrote with a comment, on my statement that economists don't calculate total marginal rates often enough:

..I certainly did. As a solo general surgeon in private practice, in 2004, with a gross business income before taxes of roughly $500K, I figured that the 39.6% Federal + 9.98% state top income tax rates + 6% [state] sales + Medicare which no longer peaked out, + property taxes, medical license fees, malpractice fees which were already at $100K for me and headed higher, and no scholarship help for the 4 out of 10 kids in college at the time, my marginal rate was somewhere north of 70%. Once I 'retired' from surgery and became a biology professor, making around $50K, my gross income was one tenth as much, but now one of my kids got a full-ride scholarship at [University], another got a half-ride scholarship, and another got a couple thousand that would not have been given under my earlier circumstances. By my 'going Galt', I figure that the .gov took at least a $200K hit (I remember previously paying $161K in fed. income taxes alone), whereas my disposable income was only about half of what it had been before. So you can bet that we non-economists, with all the individually detailed information at our disposal do indeed make these kinds of calculations, even if they're tough for economists to do in aggregate. At least for me, the argument that a simple 36% federal income tax is below the Laffer curve hump is lame, given other factors