Adam N. Michel
Recent Democratic proposals to expand the amount of income exempt from the income tax highlight an existing feature of the US tax system: depending on your circumstances, large amounts of income are already shielded from taxation. Under current law, some families benefit from well over $100,000 in tax-free income, but not everyone is so lucky.
Both parties are increasingly competing to exempt larger amounts of income from federal taxation. Sen. Chris Van Hollen recently proposed an alternative maximum tax that would include larger income tax exemptions of $46,000 for singles and $92,000 for married couples. Sen. Cory Booker’s plan would more than double the standard deduction (currently $16,100 for single taxpayers and $32,200 for married) while also expanding the child tax credit and the earned income tax credit. Each would pay for the tax cuts by raising taxes on higher-income earners. And it’s not just Democrats; last year, advisers to Donald Trump floated the idea of eliminating income taxes for households earning under $150,000.
Recent policy changes have already moved in this direction. The “no tax on tips” and “no tax on overtime” provisions enacted last year allow some workers to exclude tens-of-thousands of dollars in earnings from income tax. When combined with the standard deduction and an expanding collection of targeted credits, the threshold at which many households begin paying federal income tax can be surprisingly high.
However, those thresholds vary widely depending on how income is earned and which preferences a household qualifies for. Two taxpayers with the same total earnings can face very different tax liabilities simply because one receives overtime pay or has multiple children in daycare.
Figure 1 illustrates how the amount of income shielded from federal income tax varies widely depending on household circumstances and income sources.
A married couple without children begins paying federal income tax on regular income above $32,200, while a single person in a similar situation begins paying at a little more than half that, after accounting for the standard deduction and the earned income tax credit. The figure shows that using a subset of available credits and deductions, households with access to additional tax preferences can shield as much as $158,800 in income from tax. The maximum situation may not be common, but it is instructive to understand how tax benefits stack for well-situated taxpayers.
Consider a two-earner family with two children earning $100,000 of household income. After the standard deduction, that family would owe $7,640 in federal income tax before credits. Two child tax credits reduce that liability to $3,240. If both children are under 13 and in childcare, additional credits can cut taxes to as little as $1,140. That’s an average effective tax rate of 1.1 percent. If one or both parents earn enough income from tips or overtime, the family could pay no federal income tax.
As in the case above, 96 percent of households pay far less in total federal taxes as a share of their income than the 23 percent share of national income the federal government spends. This gap exists because a significant portion of federal spending is financed through persistent deficit spending, while the income tax itself is highly concentrated on higher earners who pay tax rates above 23 percent. Before the most recent reforms, the Treasury estimated that the top 10 percent of households paid nearly 80 percent of all federal income taxes. That’s an unusually narrow tax base, leaving federal revenues exposed to swings in capital gains and business income.
Simply layering new exemptions and alternative tax regimes on top of the existing patchwork risks deepening complexity, increasing revenue volatility, and expanding inequities instead of true reform. If the substantial revenue reductions from large new income exemptions are paired not with spending cuts but with new tax increases on higher-income taxpayers and businesses, it would entail high negative economic costs.
A better reform would simplify the system by consolidating existing deductions and credits into a new, larger, uniform deduction that treats similar taxpayers more consistently. This is the approach taken in the Cato Tax Plan and should be a model for future reforms.