NCPA - National Center for Policy Analysis

How Phase-Outs Boost Marginal Tax Rates

March 12, 2001

The marginal tax rate is the rate a person must pay on an additional dollar of income -- which affects taxpayers' decisions on whether to work, save or invest. Added income is normally taxed at the statutory tax rate; but it can push a taxpayer into a higher tax rate because various tax deductions, exemptions and credits phase out as taxpayers' incomes rise. These phase-outs increase marginal tax rates.

Some examples are: deductible individual retirement accounts, Roth IRAs, the earned income tax credit (EITC), the exclusion of Social Security benefits from taxable income, the child credit, education credits and deductions, a portion of itemized deductions, even the personal exemption.

Here is how this might affect some married couples filing jointly in 2001 (see figure):

  • Parents with two or more children lose 21.06 cents of the EITC for every additional dollar of income between $13,090 and $32,120 -- creating a marginal tax rate spike of 21.06 percentage points.
  • If the parents are in the 15 percent rate bracket, the EITC phase-out boosts their effective marginal federal income tax rate to 36.06 percent.
  • Their overall effective marginal tax rate can approach 50 percent with the inclusion of payroll taxes and state and local income taxes.

Adding yet more complexity, phase-out ranges are usually specified in terms of "modified" adjusted gross income, and the modifications differ across phase-outs.

Two of the fastest-growing phase-outs are the limitation on total itemized deductions, which snared 9.5 percent more taxpayers in 1998 than in the prior year, and the disallowance of personal exemptions.

Because of phase-outs, a couple with four dependent children will probably find that the itemized deduction limitation and the phase-out of personal exemptions bump them into a bizarre succession of elevated brackets: 31.93 percent, 36.25 percent, 42.09 percent, 37.08 percent and finally 40.79 percent.

Source: Michael Schuyler (Institute for Research on the Economics of Taxation), "If You Like Complicated Hidden Taxes, You'll Love Phase-outs," Brief Analysis No. 350, March 12, 2001, National Center for Policy Analysis.

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