Back in Action

For readers that paid attention to this blog in the second half of 2011, I apologize. I intended to take a one-month hiatus in December. The one-month hiatus turned into two months and then three months.

Meanwhile, there has been no shortage of "tax news." Most of it is politically motivated rubbish. Team Obama continues to hype its class warfare fantasy that increased taxes on the "rich" will solve virtually every social, economic and environmental problem that has surfaced in the past decade. The political right has countered with its own policy lies and distortions. It's going to be a long year for us political independents.

I can't possibly "catch up" on the barrage of tax news clippings over the past 10 or 11 weeks. So I'll jump back into the fray as developments catch my eye.

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As I've previously observed, Team Obama is completely incoherent when it comes to tax policy. Sometimes, Obama talks the talk of common sense tax reform. Mostly, Obama walks the walk of a populist Robin Hood. Sure, he wants tax simplification ... but he also wants to expand tax incentives for "favored" industries and activities. Sure, he wants to improve the competitiveness of U.S. businesses ... so long as the government can use tax policy to shape the winners and losers in the domestic business landscape.

The President's fiscal 2013 budget proposal reflects his irreconcilable tax priorities: simplification; competitiveness; corporate welfare; income redistribution. The former two goals would be good for all of us. The latter two goals are good for politicians seeking annuities -- in the form of political donations -- from corporate lobbyists, unions, and other special interest groups. Martin Sullivan puts it this way:

As it is trying to promote tax reform [in its fiscal 2013 budget proposal], the Obama administration is defying the logic of real tax reform -- the economic logic that tax neutrality is best for growth and job creation except in extraordinary circumstances.

What administration incentives hinder true tax reform efforts? A conversion of the already complicated section 199 manufacturing deduction into a two-tiered incentive. A temporary incremental wage credit for small business. A tax credit for investment in communities that have experienced a job loss event. A tax credit for moving expenses when companies move jobs to the United States. New tax credits for alternative energy to replace the existing ineffective and outdated ones.

This is big government through tax policy. The complexity of these new tax breaks is extraordinary even by the standards of our tax code... And as for the coming corporate tax reform, there is no more place for them there than there is for a fox in the henhouse. (134 Tax Notes 922 (Feb. 20, 2012))

In his 2008 election campaign, President Obama vowed that he would renounce "politics as usual." That empty promise, like so many others, was simply "politics as usual." No surprise that, come 2012, we're getting more "politics as usual."

Team Obama is not interested in, nor committed to, fundamental tax reform. The existing system creates winners and losers, and the Obama administration believes that the government exists to create winners and losers. Team Obama is very comfortable with the status quo, so long as it can influence the choice of winners and losers.

The media and the blogosphere will spill much ink on the topic of "fundamental tax reform" this year. The Obama administration will give a wink to simplification and a nod to increased competitiveness. But it's all about distraction in 2012. Any debate about "tax reform" takes some of the focus off trillion dollar budget deficits as far as the eye can see. It's savvy "politics as usual" from a master of smoke and mirrors.

Hypocrisy and McMansions

Happy Thanksgiving Weekend!

With the national economy sputtering and unemployment around 9%, many Americans will need to tighten their belts this holiday season. Meanwhile, Democrats and Republicans in Washington teamed up to serve up a big order of Hypocrisy on a silver platter.

On November 18, President Obama signed into law a bill that reinstates higher conforming loan limits for the Federal Housing Administration through 2013.

In plain English, home purchasers can now receive cheaper financing on home loans up to $729,750. The financing is "cheaper" because it's effectively guaranteed by the federal government (i.e., taxpayers). The interest rate on non-conforming jumbo loans is roughly 0.75% higher that the interest rate on conforming loans.

Hypocrisy...

Gee, isn't this a sign of progress? Team Obama was finally able to hammer out a bipartisan consensus with Republicans. The House passed the bill with a healthy 298-121 majority. Of the dissenters, 101 were Republicans and 20 were Democrats.

The main progress here was the blatant display of hypocrisy. Politicians didn't hold their noses against the stench and enact this bill in the dead of night. They transparently abandoned their "core principles" in broad daylight.

Let's start with the Democrats. The Obama administration and Congressional Democrats have relentlessly spun the following narrative:

The Great Recession was brutally difficult for lower- and middle-income Americans. But upper-income Americans emerged largely unscathed. And many of them actually profited from the economic downturn. The top 1-2% have "unclean hands" because they have not suffered the harshest effects of the economic downturn. And it is time to "spread around" some of their wealth by creating or expanding government programs funded by increased taxes on the top 1-2%.

Rhetoric aside, these tireless advocates for the middle class understand where their bread is buttered. The most expensive real estate in the United States is concentrated in Democratic strongholds on the East and West Coasts. Wealthy liberal enclaves provide enormous financial support to Democratic politicians. Note that House Democrats overwhelmingly supported the legislation.

A middle-class American cannot afford a million-dollar McMansion. She does not need a $700,000 jumbo loan, conforming or non-conforming. This legislation was nominally intended to keep an ailing real estate market on life support. But the main people hurt by a softer real estate market are the affluent real estate brokers and financial institutions that service upscale local markets. To quote tax blogger James Maule, "boo hoo" for affluent real estate brokers. Democrats howl about cuts to services for the "most vulnerable" Americans. Yet when push comes to shove, they prioritize subsidies to affluent real estate brokers by propping up home values in the wealthiest communities.

How about the Republicans? Most Republicans argue that free markets work, and that government intervention tends to cause more problems than it solves. Many Republicans have criticized government policy for exacerbating the housing bubble that burst in 2007 with such a devastating effect.

But Democrats do not have a monopoly on wealthy political donors in expensive homes. The "crony capitalism" that riled up the Occupy Wall Street crowd has deep roots on both sides of the political aisle. The main Republican advocate of the bill was John Campbell (R-Calif), whose constituents in Orange County have taken large haircuts on million-dollar homes. Republicans lose all credibility when they argue that certain sectors of the economy should remain on taxpayer-funded life support.

Republican also like to play the "certainty" card. They frequently argue that the economy is sputtering because individuals and businesses are uncertain about the future of government policy. But in this case, Republicans reversed course on a prior aspiration to scale back the federal government's role in residential housing finance. The acting director of the Federal Housing Authority bluntly criticized the legislation as "sending the wrong signal."

...and McMansions

The federal government (i.e., you and me as taxpayers) provide two main subsidies to the residential housing market. The first involves federal loan guarantees, which shift risk from private lenders to the government and, ultimately, taxpayers. Federal loan guarantees make it cheaper for homeowner to borrow money, which means that they can bid more for homes.

The second involves the deduction for home mortgage interest. Effectively, the mortgage interest deduction is a tax subsidy for home owners. Although the mortgage interest deduction is capped, it has the same overall effect as the federal loan guarantees. By reducing tax liabilities, the mortgage interest deduction frees up cash to service home mortgage principal and interest payments.

Here's the funny thing about the federal subsidies. They are nominally intended to make home ownership more accessible. But they don't make housing more affordable. On the contrary, the subsidies make housing less affordable, because they permit home buyers to qualify for bigger mortgages and pay for more expensive homes than would be possible without the subsidies.

Okay, if homes aren't more affordable, then who benefits from the subsidies? In other words, who benefits from government policies that increase the cost of housing above market rates?

Primarily the housing lobby, comprised of home builders and real estate agents. The former group (home builders) employs large numbers of union and other blue-collar workers in the construction industry. No surprise that Congress might want to direct economic subsidies to this group. In addition, local governments benefit from higher real estate prices, which translates into higher property tax revenues. Many local governments jumped on the bandwagon during the bubble years, assuming that real estate prices and property taxes would increase in perpetuity. They developed long-term budgets and entered into contractual obligations with service providers (teachers, police officers, bureaucrats) that have become unsustainable after the bubble popped.

The deduction for mortgage interest is second largest tax expenditure (estimated to cost $99 billion in 2012). Eliminating it would tend to make housing more affordable over time (by reducing the inflation-adjusted value of residential real estate). That's a bad result for many existing homeowners, but a good result for new homeowners. If political actions mirrored rhetoric, we would expect that Democrats and Republicans could agree on a plan to phase out the deduction over time. Home prices would become more affordable for the 99%. And individuals would re-allocate capital away from (subsidized) housing into more productive activities.

But political hypocrisy is just as certain as death and taxes.

Subsidizing Millionaires

On Tuesday, Paul Caron and Peter Pappas linked to a report by Senator Tom Coburn (R-Okla). The report is entitled "Subsidies of the Rich and Famous: Federal Programs and Tax Breaks That Help Millionaires." The full report is 37 pages. It focuses on tax programs that benefit millionaires, and also spending programs that benefit millionaires.

Teslas and Golf Carts

Pappas is mildly critical of the report. The report lists several tax expenditures and summarizes the share of each tax expenditure captured by millionaires. I agree with Pappas that eligible millionaires are not doing anything "unfair." Congress enacts tax expenditures because it wants to influence economic behavior.

Take the electric vehicle credit. The Coburn report indicates that $12.5 million in electric vehicle credits were claimed by millionaires in 2009. To my knowledge, a $7,500 credit was available for the purchase of electric vehicles during the calendar year (Section 30D). The primary vehicle available for on-road transportation in 2009 was the Tesla Roadster. The base price for the Roadster is $108,000. Middle-class taxpayers were not rushing out and purchasing these vehicles. (As Paul Caron document in 2009, some upper- and middle-income taxpayers apparently claimed the credit to defray the purchase of golf carts.)

Remember, Democrats controlled Congress and the White House in 2009. They had the power to amend the Code and prevent millionaires from claiming the credit against purchases of Teslas (and golf carts). But they want to encourage an overall shift to "green" energy. The tax credits for electric vehicles are consistent with that larger policy commitment. Electric vehicles are expensive. Congress knew or should have known that millionaires would take advantage of the credits, because very few non-millionaires can drop $100,000 on an electric vehicle.

The fact that Congress designs stupid tax policy (like electric vehicle credits for millionaires) to support other policy objectives (like a transition to "green" energy) demonstrates that Congress can be stupid. This is not some kind of "loophole" for the wealthy. Congress opened a door to encourage upper-income taxpayers to purchase electric vehicles. Some upper-income taxpayers decided to walk through the open door. We don't know how many, if any, were encouraged by the credit. Tax incentives that don't change economic behavior are dollars down the drain.

On balance, the Coburn report highlights a number of these intersections between economic/social policy and tax/fiscal policy. The report demonstrates the law of unintended consequences. It doesn't make much sense to give tax credits to millionaires who purchase electric vehicles (but it's a consequence of supporting "green" energy manufacturers). It doesn't make much sense to pay unemployment or Medicare or Social Security benefits to millionaires (but it's a consequence of a political aversion to means testing for entitlements). We should be revisiting and reshaping these policies over time.

Closer Look at the Numbers

The Coburn report parrots a widely-reported data point: that 1,500 millionaires paid no income tax during 2009. To be more precise, 1,470 individual taxpayers reported AGI in excess of $1 million, but paid zero income tax.

I've seen this data point before, and it piqued my curiosity. How are these upper-income taxpayers zeroing out their federal income tax liability?

It seems likely that most of these taxpayers are making large charitable contributions. A wealthy individual may have resources to make a large cash or in-kind donation to charity and claim the amount as a miscellaneous itemized deduction (Line 40 of Form 1040).

In this respect, the Coburn report is misleading. This table in the Coburn report lists a number of "tax breaks" claimed by millionaires. The two biggest "tax breaks" are the deduction for mortgage interest ($27.7 billion from 2006-2009), and the deduction for rental expenses ($64.3 billion from 2006-2009). The report omits to mention the total charitable deductions by millionaires during the same period. I suspect that Coburn's staff included "bad tax breaks" (like mortgage interest expense) while excluding "good tax breaks" (like charitable deductions). This type of cherry-picking tends to muddy the waters -- all tax expenditures should be on the table when we start talking fundamental tax reform.

One thing is clear -- the list of "tax breaks" enumerated in the table would not zero out a millionaire's taxable income during a given year.

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Interested readers can locate the 1,470 individual taxpayers on page 40 of this report.

Here's the breakdown among the different income groups:

	Returns		Paid Tax		No Tax
$1.0 under $1.5	8,274		8,211		63
$1.5 under $2.0	14,322		14,236		86
$2.0 under $5.0	61,918		61,535		383
$5.0 under $10.0	44,273		44,015		258
$10.0 or more	108,096		107,416		680
Total	236,883		235,413		1,470

Free Lunch Politics

I've been critical of the tax and economic policies advocated by Team Obama and its cheerleaders on the political left. However, for the last 30 years, Republicans in Congress have been complicit in the debt-fueled expansion of the federal budget.

Despite their public animosity, Democrats and Republicans have each promoted a "free lunch" philosophy to the voting public. Of course, their marketing of the "free lunch" philosophy is slightly different.

Democrats target their message to middle- and lower-income taxpayers. They argue that increased taxes on "millionaires and billionaires" can finance larger entitlements and higher discretionary spending. The middle-class can enjoy a "free lunch" courtesy of income redistribution. The harsh reality -- which most Democrats won't acknowledge publicly -- is that we cannot plug the long-term budget gap through increased taxes on "millionaires and billionaires." To fund Democratic spending initiatives, we'll need higher taxes across the board. Today, the political left defines the "wealthy" as working professional families with $250,000 in taxable income. How low will they go to finance tomorrow's spending initiatives?

Republicans target their message to middle- and higher-income taxpayers. Under Team Bush, they cut taxes while increasing entitlement spending for seniors. Lower taxes, higher spending? Sounds like a "free lunch" to me. Except for that little problem with deficit financing. Today's deficit spending will increase future interest expense and impose higher tax burdens on future generations of taxpayers. I'm not suggesting that all deficit spending is problematic. But Republicans have been disingenuous by attempting to kick the can permanently down the road.

Today, Republicans oppose "tax increases" as a mechanism to reduce the federal budget deficit. Like obsequious courtesans in the House of Norquist, they conflate elimination of tax expenditures with marginal tax rate increases. But tax expenditures have the same impact on federal deficits as on-budget cash outlays. Lowering tax expenditures will increase taxes for some taxpayers, but may permit broader tax relief for all taxpayers. As Congress grapples to slow the accumulation of federal debt, Republicans should be aiming to reduce federal spending and tax expenditures.

The other problem with tax expenditures is the fact that they distort economic behavior. Tax expenditures provide government subsidies for activities that Congress wishes to encourage. Given his defense of tax expenditures, Grover Norquist must believe that members of the Ways and Means Committee are better capital allocators than the free market.

By distorting economic behavior, tax subsidies can lead to over-consumption of goods and services. For example, the exclusion from taxable income for employer-sponsored health insurance is a major contributor to the runaway inflation of health care costs. Employees with generous health care packages have no incentive to control costs. Absent a price transmission mechanism, they consume more and higher-cost health care services. The excessive demand outstrips supply for medical products and services. The supply-demand imbalance translates into higher insurance premiums for individuals and businesses.

Tax expenditures can also lead to the mis-allocation of capital. For example, the mortgage interest deduction encourages taxpayers to "stretch" and purchase a little more home than they can otherwise afford. The behavior wasn't a problem during the real estate bubble. However, it had devastating consequences on thousands -- if not millions -- of homeowners during a period of high unemployment and real estate deflation.

Finally, tax expenditures can result in tax "windfalls" for high-income taxpayers that don't need the underlying tax subsidy. Take the home mortgage interest deduction. The home mortgage interest deduction has a higher value to a high-income taxpayer that pays a top marginal rate of 35% than a lower-income taxpayer that pays a top marginal rate of 25%. The lower-income taxpayer saves $250 in tax on $1,000 in mortgage interest expense. The higher-income taxpayer saves $350 in tax on $1,000 in mortgage interest expense. But capping the benefit of the mortgage interest deduction is no solution. If a taxpayer can afford a half million dollar home -- or a million dollar home -- why are we providing a tax subsidy at all?

I'm not the first to highlight the problems with tax expenditures, and I won't be the last. We desperately need fundamental tax reform, which I define as base broadening combined with marginal tax rate reductions. The first step towards any such tax reform must include an acknowledgement by Free Lunch Republicans and Free Lunch Democrats that tax expenditures are on the chopping block.

Government Spending: 2x Inflation

On Friday, I discussed Steve Shay's recent insights on fundamental tax reform. Today, I want to circle back to some interesting numbers in Shay's article.

Shay notes that federal on-budget expenditures have grown from $807 billion (18.3 percent of GDP) in 1986 to $2.9 trillion (20 percent of GDP) in 2010. Tax expenditures were approximately $1 trillion in 2010. Thus, the sum of on-budget and "off-budget" spending in 2010 was approximately $3.9 trillion.

According to a report by the Tax Policy Center, tax expenditures were approximately $362 billion in 1985. (I can't quickly locate the numbers from 1986, which were excluded from the Tax Policy Center report.) The sum of on-budget and "off-budget" spending in 1985/1986 was approximately $1.2 trillion.

Adjusting for inflation, $1.2 trillion in 1986 dollars is $2.4 trillion in 2010 dollars. Had federal spending kept pace with inflation, the federal budget would have grown by approximately 100% between 1986 and 2010. Instead, the federal budget grew by more than 200%.

I don't have time to poke around the state data, but I'd be surprised if state expenditures grew materially slow than federal expenditures between 1986 and 2010.

Here is the question for the advocates of big government. During the past 25 years, federal spending has outpaced inflation by more than a 2 to 1 ratio. Are we all better off today as a result? Are the "most vulnerable" Americans and the middle class doing better today than their counterparts in 1986? Has the binge of federal spending increased the quality of life of the vast majority of Americans? Has the growth of federal spending increased standards of living commensurate with the resources tapped to fuel the spending?

If the answer is "yes," then how do you explain 9% unemployment? How do you explain the tea party movement and and nationwide Occupy Wall Street protests? How do you explain the frustration over the inter-generational burden that debt-fueled government spending will place on our children and grandchildren (and their children and grandchildren)? How do you explain the general public dissatisfaction with our political and business leaders?

If the answer is "no," then how do you justify demands for increased government spending? Can government spend more money to "cure" problems that are correlated with increased government spending? Government spending has increased at a 2 to 1 ratio compared to inflation over the past 25 years. Would we all be better off had spending increased at a 3 to 1 ratio? A 5 to 1 ratio? How much faster does government have to grow before before it becomes obvious to everyone that government expansion blunts the vibrancy of the private sector?

Ironically, the expansion of government spending has tracked the rising inequality of income and wealth distribution that so agitates the political left. The left does not seem to realize that bigger government creates more opportunity for business and individuals to capture economic premiums by exploiting the "regulatory state." How does a regulatory or tax attorney justify an hourly billing rate of $1,500 ($3 million/year at 2,000 hours/year)? Because he or she helps businesses and individuals navigate the regulatory state. How does a CEO justify compensation of $5 million or $10 million per year? Because he or she pays the regulatory and tax attorneys $3 million per year simply to navigate the regulatory state!

Steve Shay on Tax Reform

Earlier this week, Steve Shay published an article in Tax Notes with his observations on fundamental tax reform. See "Jobs, Deficit Reduction, Revenues, and Fundamental Tax Reform," 133 Tax Notes 213 (Oct. 10, 2011).

I always pay attention to articles written by Shay and Edward Kleinbard. Both are seasoned tax professionals with experience in private practice, government and academia. Shay practiced with Ropes & Gray for 20 years before jumping to Treasury in 2009. He served for two years as Deputy Assistant Secretary for International Tax Affairs. Kleinbard practiced at Cleary Gottlieb for 30 years before serving as Chief of Staff of the Joint Committee from 2007-2009. After grinding away as tax attorneys for decades, and then bashing their heads against DC gridlock for a couple years, Shay and Kleinbard both sought refuge in the ivory tower. Shay teaches and writes from Harvard Law School; Kleinbard from the USC Law School.

As tax attorneys who represented a wide range of domestic and multinational businesses in private practice, Shay and Kleinbard bring thoughtful voices to the dialogue over U.S. tax reform. Politics aside, we need more contributions to the tax policy debate from experienced practitioners who have a more balanced view of the relationship between the private and public sectors. We get way too much loaded rhetoric from business lobbyists and "career academics" on the political left.

A few highlights from Shay's article:

[1] Shay urges policymakers (presumably aiming towards the political right) not to take revenue increases off the table while considering tax reform options. Shay does not advocate "millionaire surcharges" or the "Buffett Rule," whatever his personal view on those proposals. Shay primarily focuses on tax expenditures, and the opportunity to increase revenues "by eliminating tax expenditures and rationalizing the income tax base, as part of an overall plan to restore a sustainable fiscal policy." He's basically following along a trail blazed by Kleinbard, among others.

[2] In Shay's view, fundamental tax reform "should make the income tax code a fairer and more efficient instrument suitable for the economy of today and the future."

The objective of fundamental tax reform should be a more comprehensive income tax base that is simpler and fairer and does not make losers of domestic manufacturers and winners of video game companies with offshore intangibles.

Funny how that theme keeps surfacing in discussions of fundamental tax reform. I outline the problem of "multinational princes" and "domestic paupers" in this post (discussing a tax reform proposal by Bill Parks).

[3] Shay gently scolds President Obama for his class warfare rhetoric:

[The President] has acknowledged a need for new revenues, but limiting shared sacrifice to those with incomes of $250,000 and above is inconsistent with rationalizing many wasteful tax expenditures that benefit middle-income earners as well as the very wealthy. In exchange for job-creating stimulus, Democrats should be open to sharing sacrifice more broadly, but without sacrificing a fair distribution of overall tax burden.

Shay doesn't define a "fair distribution of the overall tax burden," but he implies that "shared sacrifice" should include tax increases on all Americans. The top 1% of taxpayers currently shoulder 37% of the total income tax burden. If deemed "fair," policymakers could aim to keep that number constant, while increasing overall revenues from the tax system. By definition, such an effort would require an increased "contribution" by the bottom 99% of taxpayers.

[4] Shay bluntly scolds Team Obama for its lack of leadership on tax reform. But let's face it, this administration has other priorities. President Obama focused on socializing health insurance during the worst economic crisis since the Great Depression. Now he's focused on his 2012 re-election despite a widespread economic malaise and 9% unemployment rate. I'd wager my $100 that Team Obama will not lead us to the Promised Land of Fundamental Tax Reform.