Marginal Tax Rates Matter More than Average Tax Rates
Each year when I complete my federal income tax return, Turbotax tells me my average tax rate—how much tax I owe measured as a percentage of my total income. But it would be better if I learned my marginal tax rate or MTR—the percentage tax that I would pay on an additional dollar of income. That’s the rate that matters when I make various economic decisions, ranging from whether to give a lecture for an honorarium or whether to sell a stock that has risen in value to whether to give more to charity.
One problem with MTRs, however, is that you likely have more than one. Long-term capital gains and qualified dividends are taxed at lower rates than interest earned on a bank account (if any these days) or wages from a job. Earnings below the cap on payroll taxes that fund Social Security face both income and payroll taxes; above the cap you don’t pay the Social Security tax. Turbotax would have to give me lots of different values.
MTRs matter more than usual this year because of the impending fiscal cliff. If we actually topple off the cliff, MTRs will jump on January 1. The top tax rate on labor income will go from 35 percent to 39.6 percent. Resurrection of the limitation on itemized deductions (commonly known as “Pease”) would boost that by 3 percent of the basic tax rate, or an additional 1.2 percentage points. The new taxes imposed by the 2010 healthcare legislation will add 0.9 percentage points to the current 2.9 percent Medicare tax. Those increases would take the top MTR to 44.0 percent, more than 18 percent higher than the 2012 rate.*
Rates will go up even more on investment income. The top MTR on long-term capital gains will jump by two-thirds from 15 percent this year to 25 percent next year—a combination of a 20 percent basic rate, 1.2 percent from Pease, and 3.8 percent from the healthcare tax. Because dividends will be taxed as ordinary income at the 39.6 percent top income tax rate, t he top MTR on dividends (including the health care tax and Pease) will nearly triple from 15 percent to 44.6 percent.
MTRs won’t go up only for those at the top of the income scale. Expiration of the 10 percent tax bracket will raise taxes on everyone with taxable income. Households in the 15 percent tax bracket and below will see their tax on capital gains go from zero to 10 percent and their tax on dividends will rise from zero to 15 percent. Average marginal tax rates for all tax units as a group will increase by between 1.3 percentage points on wage income and 20 percentage points on dividends (see graph). TPC has estimated the average increases in MTRs on wage and salary income and on investment income for households at various income levels.
Of course, none of this may actually happen. Congress and the president could agree on a tax bill that would leave MTRs little changed. If Mitt Romney gets his way, marginal rates would fall sharply, courtesy of his proposed 20 percent across-the-board rates cut, although the rates may fall less than that depending on which deductions are removed or whether deductions are subject to new phaseouts as income rises. If President Obama gets his way, marginal tax rates may rise only for those in the highest rate brackets.
In the meantime, taxpayers have some decisions to make before the end of the year. If they think capital gains tax rates will go up in 2013, they may want to realize capital gains this year. If they expect that Congress will cut back on itemized deductions and other tax preferences, they might want to give more to charity or prepay state and local taxes. Given the very different tax proposals offered by President Obama and Governor Romney, many taxpayers may wait until after November 6 before making any decisions to move realized income or deductions forward into 2012.
* Counting both employee and employer shares of the Medicare tax requires including the employer’s share in income. That reduces the 2013 top marginal rate slightly to 44.0 percent. Similarly, the top 2012 MTR is 37.4 percent.
This post was updated at 4:00 p.m., October 10, 2012, to correct the graph.