Obama tax plan: Who gets hit - and why

WASHINGTON (CNNMoney) -- Roberton Williams is a senior fellow at the Urban Institute and contributor to TaxVox, the blog of the nonpartisan research organization Tax Policy Center. He was at the Congressional Budget Office from 1984 through 2006. The opinions expressed in this commentary are solely those of the writer.

President Obama's plan to raise taxes on the nation's highest income households may not quite mean what you think.

A closer look suggests that fewer people may get whacked than either Obama or his Republican critics suggest.

And for many of the victims, the club won't be the president's plan to raise rates to 36% and 39.6%. Those rate hikes are getting most of the attention, but the real cudgel would be higher taxes on capital gains and dividends going to high-earners.

First, let's look at whom Obama's plan would hit.

As most everyone knows by now, ever since his presidential campaign, Obama has promised to retain the 2001 and 2003 tax cuts for households with income below $250,000 and individuals making less than $200,000.

That seems clear enough, but candidate Obama never said what he meant by "income," although his budget helps to clarify the issue by defining income very generously.

Defining "income": First, let's define our terms.

The broadest way to measure income -- total income -- counts everything you get in cash, regardless of source, including taxes your employer pays and you never see. By that measure, just over 3% of households have income above the president's thresholds.

Or the president could have decided to use a narrower measure, "adjusted gross income," which excludes income not subject to federal tax such as tax-exempt bond interest and much of Social Security benefits. Just over 2% of tax units have AGI that tops the $200,000 and $250,000 thresholds.

Finally, the president could have gone one more step and dropped exemptions and deductions from his definition of income. That's the familiar description of taxable income -- and pretty much the bottom line on your 1040 -- and it would protect another 0.2% of households from a tax hike.

How Obama does it: Instead, Obama -- in his budget -- uses a definition that is even a bit more generous than any of those.

To make sure that no one making less than $200,000 really does get hit with a tax increase, the president had to extend the 28% bracket to cover more income. That would cut taxes for even the richest taxpayers by a few hundred dollars and provide a small cushion against higher levies for people just over the thresholds.

Who would pay and why: When all the dust settles, the Tax Policy Center figures that just 1.7% of households would pay higher taxes under the president's proposal than if Congress extended all the 2001 and 2003 tax cuts.

Just as interesting is why those 2.7 million high-income taxpayers would get hit. For most of them, the answer is not the high-profile increase in the top rates. Rather, it is Obama's proposal to hike rates on capital gains and dividends.

A close look at his plan shows that fewer than three in ten affected taxpayers would be hit by the 36% and 39.6% rates on ordinary income that have drawn the loudest complaints.

Another change, the limitation on itemized deductions and the phaseout of personal exemptions would affect less than half.

But nearly 95% of people facing higher tax bills would pay more tax on gains and dividends. Keep in mind, by the way, that while Obama would raise the top rate on capital gains from 15% to 20%, he would also tax qualified dividends at 20%. If the Bush-era tax cuts are allowed to expire, the top dividend rate would hit 39.6%.

Knowing that less than 2% of households would face higher taxes, mostly because of their investment income, won't calm the debate -- and by itself certainly provides no justification for backing the president's plan -- but it's always helpful to know the facts.