Should New Yorkers Pay Less Income Tax?

Some believe cost of living should play a role in tax rates.

By Dan Caplinger

The looming fiscal cliff has drawn a lot of attention to the tax rates that taxpayers across the country pay. Proposals to raise tax rates on the highest-income taxpayers have gotten praise from middle-class Americans hit hardest by the recession.

But those who live in areas of the country where costs of living are extremely high complain that tax hikes unfairly target them.

For New Yorkers and other expensive-city dwellers, six-figure salaries may be far more common than in the rest of the country. Yet workers who earn those salaries have to pay a lot more in expenses -- and they're far less likely to call themselves "rich" than the Middle America residents who look only at their inflated gross income.

How Taxes Hurt People with High Costs of Living

One of the foundations of the U.S. income tax system is that for those earning below a certain base level of income, paying taxes shouldn't be necessary. Tax breaks like the standard deduction, personal exemptions, the Earned Income Tax Credit, and extremely low marginal rates for low wage-earners are all designed to allow income earners to make enough money to live at a subsistence level without having to pay tax. 

One major problem with those provisions, though, is that they largely ignore costs of living in calculating tax liability. No matter where you live or what your actual costs of living are, the figures for those deductions, credits, and tax brackets are the same across the nation. Yet when it comes to maintaining a certain standard of living, costs vary greatly.

One study from 2009 found that in comparing Atlanta to Manhattan, it would take more than twice as much -- $60,000 -- to maintain a standard of living just above the federal poverty line than it would take in Atlanta, where $26,000 would get you by.

As a result, those who live in expensive areas such as New York City can end up having to pay tax even when they barely earn enough to make ends meet in those areas. Moreover, those who earn quite a bit more than subsistence wages can get a truly massive tax hit over those in cheaper locales.

When Looking Rich Isn't Being Rich

One focus of President Obama's tax plan is to characterize singles making more than $200,000 and couples making more than $250,000 as targets for higher tax rates. Opponents of tax increases have pointed to costs of living as one reason to set those thresholds at even higher levels.

Yet many complaints from those making $250,000 or more turned out to be caricatures of the expectations of high-income individuals.

Back in 2010, when tax rate increases were first proposed, University of Chicago Law School professor Todd Henderson drew plenty of criticism when he made a blog post arguing that after he took care of essential expenses like paying a house cleaner and lawn-mowing service, as well as covering private school for his three children, his greater-than-$250,000 income is barely enough to scrape by. Ordinary Americans weren't persuaded, instead criticizing the professor for the entitled tone of the post.

 Similar stories from Wall Street professionals after bonus cuts limited their earnings to just over the $250,000 threshold also drew a lack of sympathy from middle-class taxpayers. Having to give up on annual ski trips to posh areas like Aspen just didn't resonate with struggling households.

Nevertheless, just because those stories posed unrealistic expectations of what a reasonable standard of living should include doesn't mean that tax rates fairly consider relative costs of ordinary living expenses.

There's no debate that living in some parts of the country is more expensive than living in other parts. Yet with the exception of a few deductions that are larger in pricier parts of the country where deductible expenses are more costly, taxpayers don't get any recognition of that fact.

A Catch-22

Of course, the main problem with cost of living adjustments to tax rates is that it would add yet another layer of complexity on top of what's already a massively burdensome set of tax laws. Having to account for geography would lead to all sorts of opportunities for abuse, as where you maintained your tax home would have even greater importance than it does now.

One thing is certain, though. As long as tax hike proposals focus on certain income limits, expect those who earn near those limits to argue why they should be different.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger.