financial insurance justification

Source: Computations by the Tax Foundation

But the schedule for a taxpayer's effective marginal tax rate—what he pays on his last dollar of income—tells a very different story. As shown in Figure 1A for the same couple, marginal tax rates careen up and down, veering well below zero and well above the statutory rates. They can be very high for taxpayers with modest income.2

What causes marginal tax rates to deviate so sharply from statutory tax rates? The tax code is cluttered with complex deductions, exemptions and credits that affect marginal tax rates. These provisions are often "targeted" to low- or moderate-income taxpayers. In some cases, such as under the earned income tax credit (EITC), the tax benefit initially goes up as a person's earnings rise. This income range is the so-called phase-in range where the marginal tax rate is below the statutory tax rate. Conversely, may find that they earn too much to qualify for the full benefit. As they earn more they begin to lose benefit. Eventually, the benefit may be completely eliminated. This income range is called the phase-out range, where the tax benefit is "recaptured" and the marginal tax rate rises above the statutory rate.

These phase-ins and phase-outs cause marginal tax rates to deviate sharply from the statutory tax rate. As a result, charts of the marginal tax rate schedule have sometimes been likened to a major city's skyline where the skyscrapers represent the targeted tax benefits phasing in and out, causing taxpayers' marginal tax rates to fluctuate, sometimes wildly.

Some of the largest gyrations in marginal tax rates occur at the lower end of the income spectrum due to the earned income tax credit (EITC). The credit initially increases in size as a taxpayer's earnings rise. Because these very low-income taxpayers have no taxable income or other income tax, the credit takes the form of a payment from the government—a negative income tax—and their effective marginal tax rates are negative (i.e., taxpayers with incomes below about $19,200 in Figure 1A). The rate drops as low as minus 40 percent. That is, for every additional dollar earned by these very low-income taxpayers, they receive 40 cents from the federal government.

When the EITC is phased out, this phenomenon reverses. The taxpayer's liability increases as the credit is "recaptured," and the effective marginal tax rate rises above the statutory tax rate for taxpayers with incomes between roughly $19,200 and $43,000, reaching as high as 21.6 percent.

For people in the upper-income range, between roughly $100,000 and $130,000, different tax benefits are phased out-the child tax credit and the Hope and Lifetime Learning education credits-giving rise to marginal income tax rates as high as 34.5 percent.

Other provisions in current law with similar effects include the savers credit and the child and dependent care credit. Still other provisions phase out the personal exemption (the personal exemption phase-out or PEP) and itemized deductions (the so-called "Pease" provision named after Congressman Pease), which increase effective marginal tax rates for higher-income taxpayers.

How much the phase-in and phase-out of tax benefits affect a taxpayer's effective marginal tax rate depends on the generosity of the provision and the rate at which it is phased in and out. Also, some taxpayers are subject to the alternative minimum tax, which has its own tax base and tax rates of either 26 percent or 28 percent. Finally, there are also important interactions between the income and payroll tax as some income tax provisions have been designed to offset, in some manner, the payroll taxes that are paid (e.g., the earned income tax credit and aspects of the refundable portion of the child tax credit).

Source: Computations by the Tax Foundation

When designing tax provisions that are targeted by income or earnings, tax writers typically pay careful attention to the ways in which they interact with other provisions and their implications for both the income and payroll tax. Generally, there is some attempt to strike a balance between a provision's policy objective and the broader concern that marginal effective tax rates not be allowed to rise too high.

How Do the Presidential Candidates' Tax Plans Affect Marginal Tax Rates?

Both Senator Obama's and Senator McCain's tax plans affect marginal tax rates, but for different reasons. Senator Obama's tax plan includes a number of proposals for new or expanded tax benefits that are generally targeted to low- and moderate-income t