The Hidden Costs of Cliff Effects in the Internal Revenue Code

Cliff effects in the Internal Revenue Code trigger a sudden increase of federal tax liability when some attribute of a taxpayer — most commonly income — exceeds a particular threshold value. As a result, two taxpayers in nearly identical economic situations can face considerably different tax liabilities depending on which side of the triggering criterion they fall. The magnitude of the equity and efficiency costs associated with cliff effects is significant: cliff effects are attached to tax provisions amounting to hundreds of billions of dollars, the majority of which are targeted at low- and moderate-income taxpayers. Cliff effects have received little attention in legal academia. Prior scholarship has primarily discussed the relevant tax provisions in isolation, focusing on financial consequences on a single taxpayer or limiting analysis to taxpayers in one geographic area. This Article addresses the void in legal scholarship by first recognizing potential rationales for cliff effects and identifying situations where their definitional clarity might compensate for any equity and efficiency losses. Next, the individual and aggregate costs of cliff effects are quantified and plausible statutory alternatives are identified.This Article argues that a cliff effect based on income is necessarily problematic on both equity and efficiency grounds because it improperly penalizes taxpayers and disincentivizes the economic empowerment the associated tax provision is intended to promote. A methodology is then provided by which these costs can be compared to the potential savings provided by the bright-line rule of the cliff effect. This empirical analysis is performed on the two cliff effects of the health premium subsidy of the Affordable Care Act and finds that the cliff effects will, if unchecked, represent a misallocation of over $8.5 billion by 2025. This Article presents several options for replacing problematic cliff effects, including those in the health care subsidy. The most novel of these strategies awards a credit based on the severity of the cliff effect and ensures that no taxpayer is made worse off post-tax by virtue of earning more pre-tax income. The Article concludes by extending the analysis to cliff effects associated with state and local tax regimes and direct transfer programs