When Your Taxes Go Up

With it looking increasingly likely that we will "go over the fiscal cliff" at least temporarily (once everyone's tax rates have already gone up, a whole different set of factors may come into play and make Congress want to reduce some people's taxes back down again) it's not a bad time to think about what effect we feel when our taxes go up. The obvious answer is "pain". As Megan McArdle points out, the best way to quantify this is not how much your taxes go up, but rather how much your take home income goes down:

[W]hen we're talking about policy, we tend to look at tax increases as a fraction of total taxable income, or as a fraction of the current tax rate. To see what I mean, think about two cases: one where the tax rate is going from 5% to 10%, and one where it is going from 50% to 55%.

If you look at this as a percentage of total income, these two tax increases are the same.

If you look at it as a percentage of the tax rate, then the first increase is much larger: it is doubling your taxes! While the second increase is only upping them by 10%.

But in terms of behavior, the percentage increase in the rate, or the percentage decrease in total income, is much less important than a third figure: the percentage decrease in your after-tax dollar. Most people think less about their nominal annual salary than about how much they bring home in each paycheck. And if you look at it this way, the second tax increase is much, much larger than the first.

Taking your tax rate from 5% to 10% decreases your after tax income by 5.26%. But by the time your tax rate is 50%, you're only keeping half of your income. So increasing the tax rate by 5% decreases your after-tax income by 10%: you used to take home 50 cents out of every dollar, but now you only take home 45 cents.

If you were surprised that Gerard Depardieu decided to leave France rather than pay the new 70% top rate, think of it this way: the rate increase was only 30%, but it was going to cut his income in half. Yes, that would still leave him with more money than you and I live on. But people don't think this way: if the government came and took half your after-tax income away, that would still leave you with more money than a middle-class family in Bangalore lives on, and you would still be hopping mad, not to mention panicking about how the mortgage was going to get paid.