Thanks, Obama: Highest Earners’ Tax Rates Rose Sharply in 2013

Data released by the I.R.S. on Wednesday shows that tax rates on the income of America's 400 wealthiest taxpayers rose sharply to 22.9 percent in 2013, erasing a majority of the last two decades' decline in their effective tax rate.

As described in an article in The New York Times on Wednesday, tax rates on America's 400 wealthiest taxpayers fell sharply from the late 1990s through 2012, when their average effective income tax rate fell to 16.7 percent from 26.4 percent.

The reason behind the reversal is instructive. Broadly, if tax shelters are a problem, there are two ways to fix it. One is to outlaw them. The other way is to change the tax rate rules, so money inside the shelter is not treated so differently from money outside the shelter.

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The spike in the wealthiest people's tax rates was mostly achieved the second way, and mostly through initiatives of President Obama. Two laws that he championed became effective in 2013, raising tax rates on high earners and limiting the value of tax deductions they are entitled to take.

Taxes
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One was the American Taxpayer Relief Act of 2012, which extended the so-called Bush tax cuts for most taxpayers, but allowed certain breaks for people making over $500,000 to expire. The other was the Affordable Care Act, which imposed new taxes on high earners, applying to both regular income and income from capital gains, like the profit from appreciated stock.

Put together, these two laws raised the maximum tax rate on regular income by more than five points, and on capital income (like capital gains and dividends) by almost nine points. The Relief Act also led to the restoration of rules, repealed under President George W. Bush, that limit the value of tax deductions (like those for mortgage interest and state income taxes paid) for people with high incomes.

The nature of this approach is important. When lawmakers seek to disallow specific kinds of tax shelters, they must chase the lawyers and accountants who are creatively thinking up new ones. The 2013 approach simply raised the effective tax rate on income inside many shelters, without anyone needing to argue about their validity.

For example, even if a taxpayer used a strategy to turn ordinary income into capital income, such as the Bermuda insurance approaches discussed in Wednesday's article, the 2013 changes raised the tax rate on such income to 23.8 percent, from 15 percent. So it's no surprise the tax bills of the top 400 taxpayers rose so much.

There was also a one-time issue that suppressed top earners' tax rates in 2012. Recognizing that higher tax rates would arrive in 2013, many wealthy people sold stock or other assets to take any accrued capital gains in 2012. That meant top earners' income in 2012 was more weighed toward tax-preferred gains than usual. This suppression in 2012 was a partial contributor to the pop in 2013, though the 2013 rate was also much higher than in the several years preceding 2012.

It's likely that high earners will seek new ways to avoid their newly higher tax rates. But not all of those strategies are created equal, from a public policy perspective.

For example, as other tax shelters become less effective, wealthy people may respond by giving more income away to charity. The resulting decline in tax revenue may not be desired, but as tax shelters go, charitable giving is more likely to align with the public interest than other options.