By Grant M. Seiter and Alan D. Viard
Notches are provisions in the tax code that cause tax liability to jump upward by large amounts in response to one-dollar increases in taxpayers’ incomes. Although there are no notches in the income tax rate schedule, notches are more common in the tax code than one might think, and many violate principles of good tax policy. The tax provisions of the budget reconciliation bill recently assembled by the House Budget Committee add some new notches while removing others.
In a recent article, one of us (Viard) and Jason L. Saving surveyed numerous notches in the tax code and called attention to the unfairness and economic inefficiency they cause. When taxpayers do not know about the notches or cannot avoid them, the notches are unfair because nearly identical people can end up with large differences in their tax liability. When taxpayers know about the notches and can avoid them, the notches cause taxpayers to inefficiently change their behavior. Taxpayers faced with the prospect of earning incomes just above the level at which tax liability jumps upward can escape the extra tax by slightly reducing their income.
The good news is that most notches can be avoided with little change in substantive tax policy by allowing tax liability to change gradually, rather than abruptly, as income rises. Along those lines, the notches in the House budget reconciliation bill could readily be altered without changing the bill’s policy goals.
One provision of the bill (section 138111) would impose a new deduction limit on multinational corporations with annual net interest expense of more than $12 million. The limit would not affect corporations with $12,000,000 of interest expense but could deny hundreds of thousands of dollars of deductions to a corporation with $12,000,001 of interest expense. The same policy goals could have been attained without that notch by gradually phasing in the limit as interest expense rose from a value somewhat below $12 million to a value somewhat above $12 million.
Other provisions from the same bill would apply a longer holding period on carried interest (section 138149) and a less generous small business stock exclusion (section 138150) to taxpayers with incomes of $400,000 or more. The provisions would not apply to a taxpayer with an income of $399,999 but could deny thousands of dollars of tax savings to a taxpayer with an income of $400,000. Similarly, provisions imposing new contribution limits and distribution requirements on taxpayers with large individual retirement accounts (sections 138301 and 138302) would apply only if the taxpayer’s income was greater than $400,000 for singles, $425,000 for heads of household, and $450,000 for married couples. The same policy goals could have been achieved without notches by gradually phasing in the provisions as income rose around the specified levels.
While adding these new notches, the bill would remove some existing notches. One provision (section 137501) would permanently remove a notch that abruptly ended taxpayers’ eligibility for the health insurance premium credit when income exceeded 400 percent of the poverty level. (The stimulus law enacted in March temporarily removed the notch). The notch would be eliminated as part of an expansion of the credit. Even without that policy change, however, the notch could have been replaced with a gradual phase-out of the credit as income rose.
Another provision (section 131201) would reduce the impact of the notorious notches in the saver’s tax credit, which have been found to prompt tens of thousands of taxpayers to reduce their incomes. The existing notches, which can cause hundreds of dollars of tax credits to be lost when income rises by a dollar, would be replaced by a set of smaller notches. The notches would be reduced as part of a transformation of the credit into a matching grant to retirement accounts. However, the notches could have been reduced even without that policy change.
The House reconciliation bill continues the longstanding practice of adding and removing notches as unintended, perhaps even unnoticed, side effects of policy changes. A better approach would systematically avoid notches whenever they can be replaced by gradual changes in tax liability. That approach would promote tax fairness and economic efficiency.