Notches in the Tax Code

Why you shouldn’t earn that extra $ if your adjusted gross income is $218,000.

Note to Subscribers of I Blog to Differ

I’m in Phoenix most of this week to record some lectures on free-market economics for the Peterson Academy. It’s going well. My energy is in that, which means I probably won’t post here on Tuesday or Wednesday.

But I wrote this one last weekend.

Introduction

One of the parts of the job I liked most when was at the Council of Economic Advisers was perusing the Weekly Reader. This was a compilation of the memos of the CEA economists from the previous week. All the memos written by Junior Economists (who included John Cochrane and Tom Gilligan), the Staff Economists (who included Lawrence B. Lindsey and Greg Mankiw), the Senior Staff Economists (who included Ben Zycher, Evan Kwerel, Thomas McCaleb, and me), the Domestic Policy Economist (Larry Summers), and the International Policy Economist (Paul Krugman) were included. Sometimes the memos of the members, Bill Niskanen and Bill Poole, and the chairman, Marty Feldstein were published, if these three consented to have their memos in the reader.

I would read through the whole thing and, in about an hour every week, learned a ton.

One memo I remember vividly was written, I think, by Thomas McCaleb, who covered taxation and public finance. It laid out the distinction between kinks and notches.

Let’s say, as often happens, that Congress wants to give a special tax deduction but wants to remove it for people above a certain income. There are two ways to do so.

The Kink

The first is to phase it out over some income range. So let’s say it’s a $1,000 tax credit and people filing jointly with income up to $100,000 qualify. But Congress wants to take it away for incomes above $100,000. Then it can reduce the amount of the credit by, say $1 for every $10 of AGI above $100,000. People with income between $100,000 and $110,000 will get some tax credit. People with an AGI of $110,000 or more get a zero credit.

Notice one important implication for marginal tax rates. For people with AGIs between $100,000 and $110,000, there is an addition of an implicit ten percentage points to people’s marginal tax rates. That can have substantial incentive effects.

This phaseout leads to the term “kink.” If you were graphing net of tax income on the vertical axis against income on the horizontal axis, the line would kink and become closer to horizontal at $100,000 in income.

The Dreaded Notch

But let’s say Congress doesn’t want anyone with income above $100,000 to get the $1,000 tax credit. Then someone who has an AGI of $100,000 will lose the usual tax on income plus $1,000 when he gets that first dollar of income after $100,000. So let’s say his normal tax rate, including the state income tax rate and payroll taxes, is 35%. When he makes that next dollar, he loses 35 cents plus $1,000, for a total loss of $1,000.35. His implicit marginal tax rate is 100,035 percent on that dollar.

Why is it called a notch? Now graph after-tax income on the vertical axis and income on the horizontal axis. When income reaches $100,001, after-tax income falls like a rock. Thus the word “notch.”

I learned all this from Tom McCaleb’s memo.

Now to Today

Congress, or, at least, the Congressional staffers who understand taxes, usually try to avoid notches and settle for kinks.

But not always.

A recent news item in the Wall Street Journal titled “The Medicare Charge That’s Taking a Bigger Bite Out of Social Security Checks,” WSJ, January 23, 2026, gives an instance.

The issue is not taxes but Medicare premiums that are “income-related monthly adjustment amounts,” or Irmaa.

But the principal is the same. The news item’s author, Laura Sanders, gives a table that show the extra monthly Medicare premium you’ll pay when your income reaches a certain level.

So, for example, joint filers with an income of $218,000 will pay an Irmaa of 0. But, if the couple makes one additional dollar, their Irmaa rises to $81.20 per month, which is $974.40 per year. Their implicit marginal tax rate due to Irmaa alone, therefore, is 97,440 percent. (Their actual explicit tax rate for that dollar is rounding error.)

Notches.

By the way, here’s an example of an economically literate and generally very careful economic journalist making the case for a huge notch: “McArdle Advocates 376,537.65% Marginal Tax Rate,” EconLog, January 20, 2010.