Ever seen a square bubble?
A scientist might call such a thing impossible, but since the laws of taxes do not conform to the laws of nature, you need look no farther than the tax code to find one.
For most Americans -- married couples who make less than $78,000 a year -- the bubble is largely a curiosity. But now that President Bush's lips have emitted the T-word, the bubble is moving back to center stage, as tax experts and interest groups argue over its shape, its size and what, if any, significance it has.
What is really at issue is whether to raise taxes on upper-income people. In many cases, the cries of "fair" or "unfair" are nothing more than justifications for the crier's position on that issue. But since these discussions are likely to get a lot of attention in the coming months, it is worth understanding what the combatants are talking about.
The bubble in question becomes visible if you draw a picture of current federal income tax rates, which were established by the 1986 Tax Reform Act. (As you can see from the accompanying diagram, this is the square -- rectangular, actually -- bubble.) Although there are nominally only two tax brackets, 15 percent and 28 percent, people with incomes beyond certain thresholds ($78,400 for a married couple filing jointly) are subject to what works out to a 33 percent marginal rate.
This higher marginal rate stems from the fact that higher-income taxpayers lose the benefit of the 15 percent bracket and of the personal exemptions they have taken. When a couple's income climbs above $78,400, some of their income, on which they had already paid tax at the rate of 15 percent, now is no longer taxed at that lower rate but is suddenly also taxed at 28 percent.
The result is that they loses not 28 cents but 33 cents in taxes when they earn that 78,401th dollar. This effect continues until all the money originally taxed at 15 percent has also been taxed at 28 percent. And it continues until all of the benefit from taking personal exemptions has been exhausted.
At that point, all subsequent income is taxed at 28 percent.
A heated debate has been raging for more than a year over this 33 percent rate -- the bubble. It boiled to the top during the debate over Bush's plan to cut the tax rate on capital gains -- profits from the sale of assets -- and then faded from view when Congress blocked the cut.
The debate did not subside, however. It continued in tax and academic journals, and now that a tax increase is officially on the table, proponents and opponents of the current structure are back on the talk shows and op-ed pages with their arguments well-honed.
There are two central questions to the debate: Is the bubble unfair? And if it is, could Congress kill two birds with one stone by simply subjecting all income above a certain level to a 33 percent rate?
To understand the fairness issue, it is first necessary to understand the difference between marginal tax rates and effective tax rates. The marginal tax rate is the amount of tax levied on the next dollar you earn. In a progressive system, as income increases, so does tax, so that the last dollars you earn -- those "at the margin" of your income -- are generally subject to more tax than the first dollars you earn.
The effective tax rate is the total tax you pay on your income. If you earn $100 and pay $10 in taxes, the effective tax rate is 10 percent, regardless of how the brackets are structured.
Because of the bubble, some taxpayers in the present system pay higher marginal rates than others whose incomes are higher. The diagram shows where the bubble falls for married couples with no children. In this case, a couple with an income of $90,000 a year would be in a higher marginal bracket than a couple earning $200,000. When the $90,000-a-year couple earn another dollar they pay 33 cents, whereas when the $200,000-a-year couple earn another dollar, they pay 28 cents.
To a lot of people, that seems unfair. Some of these, particularly Democrats in Congress, a logical cure would be to extend the bubble so that all higher incomes are covered.
Defenders of the current rate structure argue that in reality effective rates rise steadily with income to a 28 percent ceiling and level off. Thus, while many upper-income people pay the same tax rate, no one pays a higher effective rate than someone whose income is greater.
According to this view, the bubble in fact helps make rates more progressive by depriving upper-income people of the benefits of the lower brackets. The resulting effective rates, since they rise steadily with income up to the 28 percent ceiling, are fair.
"Simply put ... people do not pay marginal tax rates; rather, they pay taxes in cold hard cash," Byrle M. Abbin of Arthur Andersen & Co. wrote last year in the journal Tax Notes.
Abbin's conclusion has been challenged by Steve Charnovitz of the House Democratic Steering and Policy Committee, who argues that there is a bubble in effective rates as well. The difference arises from the figure used as income. Abbin takes one line on the Form 1040 (adjusted gross income minus deductions, line 35), while Charnovitz uses another (taxable income, line 37).
Abbin characterizes himself as a member of "an ever-expanding Verity Squad ... whose aim is to tell the truth about the bubble." All he asks, he said, is that people in Congress "not hide behind the populist slogan -- 'the bubble is unfair' -- if their real agenda is simply to raise taxes."
Charnovitz, also writing in Tax Notes, replied that "the popular case against the bubble remains perfectly valid. The bubble is real. It causes a serious inequity which cannot be solved by definitional gymnastics."
Donald L. Korb, a former Internal Revenue Service official now practicing law in Cleveland, has a classic Washington solution: Simply move the bubble over, and the fairness issue goes away. Under his plan, taxable income would be calculated first, then the length of the bubble to which the taxpayer is subjected, then the 33 percent bubble rate is applied to the uppermost portion of the taxpayer's income. Thus, instead of a bubble, the 33 percent becomes a third bracket applied to the uppermost fraction of a taxpayer's income, no matter how high.
That way, no one could ever say that someone with a higher income was in a lower marginal rate.
"Why not just move the bubble so it coincides with the last dollar of your income?" Korb asked. "We're not changing anything" regarding the amount of taxes actually paid, he said. "The Democrats are trying to extend the bubble," using the fairness question as a lever, Korb said. "We are just trying to give the Republicans something to answer that with."