In 1986, Congress completely overhauled our income tax system. Congress promised to lower tax rates and keep them there. Now that budget negotiations are well underway, there are some who would like to go back on that promise. They want to increase income tax rates while hiding behind what's become known as the "tax bubble."
At the heart of the 1986 tax reform is a vastly simplified tax rate structure. Our tax code has only two income tax rates now: 15 percent and 28 percent. For example, in 1990, a married couple will pay 15 percent tax on their first $32,450 of taxable income and 28 percent tax on everything more than that amount.
The tax bubble refers to a 5 percent add-on in the tax code that only applies at certain higher income levels. In 1990, a married couple with two children will pay the 5 percent add-on for income more than $78,400 but less than $208,690. Because this adds 5 percent to the 28 percent tax rate, it creates the perception of a 33 percent tax rate. Since this 33 percent perceived rate begins and ends at specified income levels, it is referred to as a 33 percent tax bubble.
The 5 percent add-on was designed in 1986 for two important purposes. First, it gradually takes away the benefit of the 15 percent tax rate. This causes upper-income individuals to pay tax at a flat 28 percent rate on all their income, rather than paying tax on some of their income at the 15 percent rate.
Second, the 5 percent add-on gradually takes away the $2,050 deduction for personal exemptions and dependents. Personal and dependency deductions reduce the taxes of families. The idea is that a family of four with $30,000 of income cannot afford to pay the same tax as a single person with $30,000 of income. However, higher-income individuals do not need this kind of a tax break, so personal and dependency deductions are taken away by the 5 percent add-on.
The bottom line is that the 5 percent add-on makes the federal income tax system more progressive because it phases out the benefit of the 15 percent rate bracket and personal and dependency deductions at upper-income levels. Once the phaseout of these benefits is accomplished, the 5 percent add-on is no longer needed, so it ends.
There is a common misconception that the 5 percent add-on is unfair because it taxes upper-middle income individuals at 33 percent and the wealthy only pay a 28 percent rate. Although the 5 percent add-on creates the perception of a 33 percent tax rate, it will never cause an individual's overall (average) tax rate to exceed 28 percent. In fact, the average tax of someone subject to the 5 percent add-on will never be as high as the average rate of wealthier individuals.
Let's look at some examples. Bill and Sally are married with taxable income of $50,000. Their federal income tax would be roughly $10,000 in 1990 -- 15 percent on the first $32,450 and 28 percent on the balance. Their average tax rate is about 20 percent ($10,000 divided by $50,000).
Another married couple, Rick and Kim, have taxable income of $100,000 and would pay roughly $25,000 of tax, including the 5 percent add-on. Their average tax rate is about 25 percent.
Last, consider Ed and Kathy, who have taxable income of $200,000, which exceeds the income levels for the bubble. In 1990, they would pay roughly $56,000 of tax, including the 5 percent add-on. Their average tax rate is about 28 percent.
During the budget negotiations, we anticipate that some Democrats will advocate "bursting the bubble." This is just a euphemism for increasing income tax rates. The proposal would add a new 33 percent rate to the tax code and eliminate the 5 percent add-on, raising more than $44 billion during five years. The revenue is raised from increasing the income tax rate, not from "fixing the bubble." It would produce a chorus of "I told you sos" from all the skeptics who said tax reform would not last. American taxpayers' worst fears would be realized -- they gave up many of their deductions with the promise of lower tax rates, but now they would be faced with higher tax rates and fewer deductions.
There has also been talk of a "compromise rate," one that adds a new 31 percent tax rate and eliminates the bubble on a revenue-neutral basis. Yet this is just another way to renege on the promise of tax reform.
Another way to approach the bubble would be to redesign the phaseout of the benefit of the 15 percent rate and personal and dependency deductions to eliminate the perception of a 33 percent rate. This is likely to add more complexity to the tax code, but certainly it is possible.
But why do anything? When you "burst the bubble" all you get is a torrent of hot air. It is premised on the misconception that the bubble imposes higher taxes on middle-income individuals. In fact, the bubble makes the tax code more progressive. In fact, upper-middle-income individuals subject to the bubble do not pay higher overall tax rates than the wealthy.
Those who want to raise revenue by increasing income tax rates should not try to hide behind the bubble. Americans need to understand that raising tax rates is not necessary to "fix" the bubble. The debate should focus on exactly what it is -- breaking the promise of tax reform and raising income tax rates.
Senate Minority Leader Dole (R-Kan.) and Sen. Packwood (R-Ore.) are former chairmen of the Senate Finance Committee. Sen. Domenici (R-N.M.) is former chairman of the Budget Committee.