Should New Yorkers Get a Break on Their Federal Income Taxes?

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New York

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

But people who live in areas of the country where the cost of living is unusually high complain that these proposed tax hikes unfairly target them.

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

How Our Tax System Penalizes People in High-Cost Areas

One of the key principles of the U.S. tax system is that people earning less than a certain base level of income shouldn't pay income tax. 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 on before the government starts asking them to pay taxes.

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

One study from 2009 compared Atlanta to Manhattan, and found it would take more than twice as much money -- $60,000 -- for an average household 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 income taxes even when they barely earn enough to make ends meet. Moreover, those who earn quite a bit more than subsistence wages can wind up taking a truly massive tax hit compared to 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. (His most recent offer to congressional Republicans has pushed that top figure up to $400,000 -- but the negotiations are far from over, and Democrats in the House and Senate will surely have their say, too.)

Yet many of the complaints in response from families making $250,000 or more turned out to be unintentional 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, and criticized the professor for the entitled tone of the post.

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Similar stories from Wall Street professionals after bonus cuts limited their earnings to just over the $250,000 threshold also found an unsympathetic audience among middle-class taxpayers. The woes of families who had to give up their annual ski trips to Aspen just didn't resonate with struggling households.

Nevertheless, just because those stories reflected 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 question that living in some parts of the country is more expensive than living in others. 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.

The most obvious problem with embedding cost of living adjustments into the tax rate system is that it would add another layer of complexity to an already 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 take on even greater importance.

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

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