It’s hard to avoid the politicians ranting either for or against the extension of the Bush tax cuts. Like many issues in life, for every complex problem there is a simple solution that is absolutely wrong.
Those opposed to the extension often try to separate the issue of “who” gets the extension. The theory is the high income earners should not get the extension and therefore pay more in taxes because they can afford it.
Those in favor of extensions for everyone say if the extension of the cuts isn’t done it will cost jobs and be a drag on the economy.
In this case the unfortunate truth is they may both be right. So if they are both right how do we decide which policy is best.
Let’s take the case of Mary who owns a pest control business. Like many small business owners her income can vary wildly from year-to-year. For the sake of this discussion let’s say that she and her husband, who also works in the business, make $300,000 combined. Since many politicians have said that the tax cuts should not be extended for those who make over $250,000 let’s use that as income above which the Bush tax cuts expire.
So let’s go with that, Mary and Bob currently make $300,000 per year and, if the Bush tax cuts are eliminated, they are going to get a 10% tax increase on income over $250,000. I’ll use round numbers again..their new tax rate goes to 40% from today’s current 36%.
Now Mary and Bob have a good idea. They think they can grow their business next year and increase their income by $50,000 to $350,000 but they will need to hire someone for $32,000 a year to do the job. Seems like a good idea right? Spend $32,000 and make an extra $50,000..easy decision. Well, maybe not. Here’s the math if the Bush tax cuts expire for her:
- Mary pays an employee $32,000.
- Mary makes additional $50,000 before tax and $30,000 after taxes (40% tax rate)
- Mary pays additional tax of 3.6% (difference between old rate and new) on the $50,000 she already makes above the $250,000 tax increase line. That’s another $1,800 in taxes
So what happened here? Mary made $50,000 more and has $3,600 less in cold hard cash. (The math is $50,000 – $32,000- $20,000 – $1,600 = -$3,600)
What would you do? Take the risk of hiring someone for $32,000 so you can lose $3,600?
The same situation if the tax rate for Mary is extended:
- Mary hires and pays an employee $32,000
- Mary makes additional $50,000 before tax and $32,000 after taxes (36% current tax rate)