Marginal Tax Rates and the Three-Martini Lunch. In October 2002, Senate Democrats Max Baucus (MT) and Harry Reid (NV)

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1 Marginal Tax Rates and the Three-Martini Lunch In October 2002, Senate Democrats Max Baucus (MT) and Harry Reid (NV) called for the restoration of full tax deductibility of business meals and entertainment. I guess, if ardent anticommunist Richard Nixon could embrace The People s Republic of China, two western Democrats could openly support the ultimate antithesis of liberal politics, business tax breaks. They were not totally exposed on the issue, however. Former Speaker of the House Jim Wright (D. TX) had said, If the Lord hadn't intended to have a three martini lunch, then why do you suppose He put all those olive trees in the Holy Land?" For years, the symbolic three-martini lunch has rallied the moderate American Left. President Jimmy Carter failed to eliminate the deduction, but not for lack of effort. In a populist appeal, he noted that a businessman could deduct a $50 martini lunch, but a truck driver got no tax break on his $1.50 sandwich. Perhaps opposition to a deductible three-martini lunch was good politics then. President Gerald Ford didn t win the election against Carter. In a rare foray into economic theory, President Ford had opined that the three-martin lunch was the epitome of American efficiency. Where else could you get an earful, a bellyful, and a snootful at the same time? he asked. We won t address the merits (or lack thereof) of this little bit of U.S. tax policy here. Rather, in the following we explore how tax deductions work, how they depend crucially on what economists call marginal tax rates, and how they have incentives that affect economic behavior. And when looking at behavioral effects of tax deductions and

2 marginal tax rates, we ll use a couple of examples that have a much greater impact on the economy than business meals and entertainment, work and housing decisions. Normal people sometimes think that people get things free when they have tax write-offs. In fact, the tax code doesn t provide quite that good a deal, but it does provide a deal, and the amount of the deal depends on the marginal tax rate. As always, when you see or hear the word marginal associated with anything economic you know that something important is happening. And happening is the operative word here. The word marginal or the phrase at the margin means that we are talking about a change, an action. When we have action, we have choice, and choice changes well-being. Economics is about maximizing well-being. A marginal tax rate is simply the change in the tax you pay as a percent of the change in the tax base the rate applies to. Any tax payment, from your point of view, or tax revenue from the government s viewpoint, is the product of a tax rate times a tax base. In Idaho we have a 5% sales tax. Here, the tax base is the value of taxable purchases, like food, beer, automobiles, and nights in a hotel. The marginal rate in this case is 5%. If you spend an additional $100 at the grocery store in Idaho, your sales tax paid goes up by $5. The change in the tax base is $100; the change is the tax paid is $5. The marginal tax rate is $5/$100, which, when converted to a percentage, is 5%. Other tax payments involve tax rates multiplied by tax bases, as well. The base of the property tax is the assessed value of the property. The marginal property tax rate is the sum of rates applied by all the separate taxing districts and authorities, the county, the school district, the library, the fire district, and the cemetery district. For example, where we live, the marginal tax rate for the Moscow Cemetery District is My wife and

3 I pay 18 cents cemetery tax for every one thousand dollars in the value of our property. If our property rises in value $1,000, we pay 18 cents more. If the value of our property goes down $1,000, we pay 18 cents less. For people with low or moderate income, the most important marginal tax rate is the payroll tax, which is mainly to fund social security payments and health benefits for the U.S. elderly. Employees face a marginal tax rate of 7.65 % for the payroll tax. Employers pay the same amount for their employees (although economists suggest that workers really pay the employer portion as well, in the form of lower wages). If you get a raise of $100 a week, Grandma takes 7.65% off the top. The most important marginal tax rate for middle and upper income people is their federal income tax rate. Unlike sales taxes, property taxes, and payroll taxes, federal marginal income tax rates differ for different levels of the tax base, taxable income in this case. In general, the higher your taxable income, the higher your marginal tax rate. For the 2004 U.S. tax year, we had six different federal marginal income tax rates, 10%, 15%, 25%, 28%, 33% and 35%. The range of taxable incomes to which each tax rate applies is called a tax bracket. The Miller family was in the 25% in 2004, along with other tax paying American couples with taxable incomes between $58,100 and 117,250. Often marginal tax rates are at the heart of political and economic discussions of tax policy. Cuts in marginal tax rates in the 1920s, 1960s, and 1980s, were in part responsible for extended periods of economic growth in those decades. In 2002 and 2003, President Bush and other proponents of cutting marginal tax rates made growth arguments as well.

4 Economists are fascinated by marginal tax rates because they provide incentives, and incentives affect behavior. Moscow, Idaho, is eight miles from Pullman, Washington. Washington doesn t have a sales tax on food. This might give some an incentive to buy groceries across the border. Payroll taxes affect the net after-tax income from working, and are a consideration in the choice of whether to work for pay or not. Property tax rates might have incentives with respect to property maintenance or improvement, or whether to get a building permit for a property improvement and alert the county assessor to an increase in the value of your property. By far, the largest tax-induced effect on behavior comes from federal and state marginal income tax rates. Let s first look at the decision to work. Nonmarket activities such as leisure or non-market (unpaid) work are not taxed. Time allocated to market (paid) activity is taxed, and the proper measure of the tax disincentive is the marginal tax rate. Imagine an upper middle income married couple with two young children. Suppose Dad works outside the home and Mom works in nonmarket home production, taking care of the kids, shopping, cooking, cleaning, and gardening. You might find one of these families on a cable channel somewhere, i.e., Ward and June Cleaver. Feel free to substitute Murphy Brown married to Mr. Mom if you like, or any other TV couples. Let s imagine that the 2004 Cleavers are having a family meeting and the main topic of conversation is whether Mom should get a job, perhaps to generate some savings for the boys college education. Suppose Ward and June are in the 25% federal income tax bracket. Let s also assume they live in a state that has an 8% marginal state income tax rate. June would also have to pay payroll tax of 7.65%. This combined marginal tax rate is about 41%, which means that June would be working for 59 cents on the dollar.

5 Maybe the job is worth it. Maybe not. But economists would certainly recognize that marginal tax rates are an important consideration, in any case. If Ward and June were in a higher tax bracket, the tax bite out of additional family income would be larger. When economists consider tax policy, they always suggest consideration of the incentive effects of marginal tax rates, and recognize that changing the rate can have an effect on the base, as well. Another important incentive effect of marginal tax rates is the pursuit of tax deductions, i.e., arranging spending to avail oneself of economic advantages through tax deductions. A tax deduction is an amount the government allows you to subtract from your gross income to arrive at your taxable income. Most U.S. taxpayers take what is called the standard deduction, $9,700 in 2004 for a couple filing jointly, but for many it pays to itemize deductions. The largest itemized deduction in the U.S. tax code is that for interest payments on home mortgages (loans). We may for cultural reasons want a nice house with a white picket fence, but economists focus more on the tax advantages of borrowing to buy a home. If a family is in a 33.3% marginal tax bracket (federal and state combined), Uncle Sam or Uncle Governor pays about one-third of its housing costs. A numerical example really helps here. As is the economist s convention, let s make a few assumptions. First, let s assume that 100% of a house payment is either interest on a home mortgage or property taxes (also deductible). In the early years of a 30-year mortgage, this is not far from the actual truth. And for the purposes of illustration here, let s ignore other housing expenses such as insurance and maintenance. Suppose house payments are $1,000 a month. $12,000 a year. Does the family actually pay $12,000 a year for housing? Not at

6 all! When filing their federal and state tax returns at the end of the year, this family will be able to deduct $12,000 from their taxable income. The amount they save in taxes depends on their marginal tax rate. If it s 33.3%, their taxes are $4,000 lower (33.3% times $12,000). So after taxes their housing cost is not $12,000, but $8,000. If their marginal tax rate is higher, the home ownership incentive is even greater. Not many rich people rent houses. Understanding marginal income tax rates is crucial to the rent-or-buy housing decision. Three very different decisions, whether to have a three-martini lunch, to work for pay, or to rent or buy a home are all very much related. And it s not that if you have the former, you are in no position to do either of the latter. Each decision is affected by federal and state tax policy, and a key ingredient in each decision is one s marginal tax rate. Again, in the beginning was the word, and the word was marginal.