As this year’s legislative session winds down, a new tax cut proposal is on the agenda of the state legislature this week. The proposal would reduce the top marginal tax rate from 4.9% to 4.7%. This essay considers some of the features of the proposal.
Arkansas has a unique multi-tier system of tax tables, first established in the context of tax cuts in 2015. Accordingly, the newly proposed legislation, Senate Bill 549, adjusts two tax tables separately. The Low Income tax tables are adjusted as shown in Table 1:
Tax cuts for income-earners in this range are affected primarily by adjusting the tax brackets; for example, by increasing the threshold for zero taxes from $5,000 to $5,100. Toward the upper end of the scale, threshold incomes are increased and the top marginal tax rate is reduced from 4.9% to 4.7%.
The effects of these changes on average and marginal tax rates for incomes up to $84,500 are shown in Figure 1:
The changes in tax-bracket thresholds results in lower taxes for all earners within the income range considered. The tax savings are fairly small: for example, for a taxable income of $32,000, the tax burden is lowered by $32.50—a reduction of 0.10%. At the higher end of the scale, a taxpayer with an income of $84,500 would receive a tax cut of $137.50 (about 0.16%).
The high-income tax tables are adjusted as shown in Table 2. As in Table 1, the thresholds for the tax brackets are revised, along with a reduction in the top marginal tax rate from 4.9% to 4.7%. The breakdown of statutory marginal tax rates into income brackets in this case is completely fictional. The tax obligations in Table 2 could be equivalently stated as “$250 plus 4.9% of all income over $8,500” under existing law, or in the case of the proposed changes, “$260 plus 4.7% of all income over $8,800.”
But here’s where it gets complicated: Under either tax regime, existing or proposed, the two tax scheduled don’t align. Consider the proposed bill: for an income of $87,000 the tax burden from Table 1 is $3,509. If we turn to Table 2 to calculate the tax obligation for an individual with an income of $87,001, it turns out to be $3,939, a tax increase of $430 for an income increase of $1. That’s an enormous effective marginal tax rate! This is an example of what is known as a “tax cliff.”
The legislative “fix” to this problem has been to append an adjustment ladder. In the proposed legislation, for example, an adjustment table reduces the tax burden for individuals with incomes in the range of $87,001 through $87,100 by $460. This assures a smoother transition at the $87,000 income threshold. The adjustment amount is reduced by $10 for every $100 until it reaches zero at an income level of $91,300. In effect, this turns one enormous tax cliff into 46 mini tax cliffs as shown in Figure 2, expressed in terms of average tax rates.
At each one of these mini-cliffs, the marginal tax rate spikes: a $1 increase in income increases an individual’s tax burden by $10.047 (one dollar for the ladder-adjustment plus 4.7% for the one-dollar increment).
The standardized tax tables are set up in increments of $100, so if we use that as our basic unit, a $100 increase in income results in a $10 increase due to the ladder-adjustment plus $4.70 due to the marginal tax rate–a total marginal tax increase of 14.7%. Figure 3 illustrates how this feature results in an effective marginal tax rate of 14.7% over the adjustment range, along with how the proposed 2023 tax cut affects marginal tax rates.
*Marginal Tax Rate calculated in $100 increments.
So, although the proposed tax cut plan does reduce the maximum statutory marginal tax rate from 4.9% to 4.7%, the maximum effective marginal tax rate is 14.7% (down from 14.9%) through the adjustment-ladder income range (which itself is shifted by the proposal).
Economic theory and evidence tells us that the effective marginal tax rate is the relevant measure to consider when it comes to to evaluating economic incentives. The tax system introduces economic inefficiencies by discouraging the incentive to seek a higher income when marginal tax rates are high. By this measure, the 14.7% marginal tax rate over the income range of $87,000 to $92,000 is a clear disincentive.
The stated intent of income tax cuts is generally two-fold, to reduce the economic inefficiencies induced by taxation and to reduce the burden on individuals and households. The proposed tax-cut legislation leaves in place the oddity of a very high marginal tax rate over a specific income range, but how much does it satisfy the second objective: lowering taxpayers’ burden?
Figure 4 shows the tax savings under the proposed changes. For a net taxable income of $20,000, the tax cut would yield tax savings of $6.60. The savings jumps to $17.70 for an income level of $23,600 and rises to $128.50 for incomes of approximately $80,000.
For a range of incomes from $84,500 to $91,900 the tax cut represents more substantial savings, peaking at $385 for incomes just over $85,100. The magnitude of the tax cut drops to $170 at an income level of just over $91,450.
In dollar-value, the value of the tax cuts cannot be dismissed, but in terms of percent-of-income they are relatively small. Figure 5 converts the tax-cut savings into changes in average tax rates. For incomes below $24,000 the tax cuts amount to about 0.05% of taxable income. The percentage rises to 0.16% for incomes above 80,000. At higher incomes (above $92,000), the percentage tax savings converge toward the 0.2% change in the statutory maximum marginal tax rate.
Taxpayers with incomes in the range of $84,500 to $91,900 receive the largest tax reductions, both in absolute dollar terms and as a percent of income. For this segment of taxpayers, the incentive effects of tax cuts are most likely to have an impact. Those who face the highest marginal tax rates are those who benefit the most from tax-rate reductions.
The ongoing presence of an effective marginal tax rate of nearly 15% over a range of incomes is a significant potential source of economic distortions. Arkansas is the only state in the U.S. with this kind of two-tiered tax table—a remnant of past political compromise that has become a fixture of our tax system. Tax reform to increase the efficiency of our tax system should address this built-in artifact of our tax code as much as it addresses the issue of lowering the statutory marginal tax rate.