California Governor Jerry Brown is dealing with a "taxing" headache these days. Within the last week, Brown has taken a jarring one-two punch.
[1] The state is projected to run budget deficits for years to come. Despite rosy economic assumptions, Brown's 2012-13 budget was expected to result in a $9.2 billion deficit. A report issued today by the nonpartisan Legislative Analyst's Office concludes that Brown's forecast is overstated by approximately $6.5 billion.
Brown was looking at roughly a $9 billion budget gap. Now he's looking at $15 billion. To quote another governor wunderkind: "Oops"!
Silicon Valley is experiencing a "mini-bubble," and Facebook's pending IPO is expected to create hundreds of new millionaires. Brown's revenue estimate assumes that "social networking" entrepreneurs and investors will pay billions in state taxes on capital gain income. The LAO report emphasizes that capital gain income is highly variable and notoriously difficult to project. California has been down this road before. Those who cannot remember the past are doomed to repeat it.
California is lurching down a path towards Greek-style insolvency. Here's the basic formula. Politicians create an expansive state bureaucracy. The state employees organize into dues-paying members of public employee unions. The unions funnel dues into political elections to support candidates who promise to keep the gravy train running. The politicians become pawns of union bosses. They borrow money to cover budget deficits as state employees become increasingly detached from the public sector.
In the long run, the cycle is unsustainable and doomed to implode. California cannot afford to pay its recurring bills and satisfy its health and pension commitments to retired state employees. However, that's a problem for the next generation. Brown is a political careerist, and he has no interest in disrupting the cozy relationship between Democratic politicians and public employee unions in California.
[2] Brown wants to solve the $9.2 billion budget gap with a two-pronged tax increase. He wants state voters to approve an initiative to raise tax revenue. The "Brown Tax Initiative" would raise the sales tax by half a cent and raise tax rates on families who earn more than $250,000. In a savvy -- but disgusting -- political move, Brown would link a failure of his initiative to automatic cuts in the K-12 education budget.
Does the income threshold sound familiar? Yes, another Democratic politician defines a working family with $250,000 in income as nouveau riche. To give Brown some credit, his initiative would at least "spread the pain around." Everybody pays sales taxes; a vote to increase the sales tax is a vote to tax me and the "man behind the tree." I'm more disgusted by Brown's decision to hold K-12 teachers and students ransom for his tax increase proposal. (Full disclosure: my wife is an elementary-school teacher.)
The LAO report complicates Brown's overall strategy. The Brown Tax Initiative will not cover the LAO's projected revenue shortfall. Brown will have to go back to the drawing board. Or play games with the numbers, which is usually the "solution" to problems in Sacramento.
[3] Meanwhile, recent poll data suggests that the Brown Tax Initiative may be caught in the crossfire among competing initiatives. Someone pass the Tylenol!
Brown is not the only advocate for higher taxes on the "wealthy." Public employee unions are pushing a "Millionaire Tax Initiative." They want to increase tax rates by 3% for incomes over $1 million, and by 5% for incomes over $2 million.
A wealthy lawyer (Molly Munger) and the state PTA is pushing the "Munger Tax Initiative." The Munger Tax Initiative would progressively raise taxes on all taxpayers, and would funnel the revenue into education.
According to the recent poll, likely voters express support for the Millionaire Tax Initiative (63%) and the Brown Tax Initiative (58%). More likely voters oppose (48%) than support (45%) the Munger Tax Initiative. No big surprise. The first initiative provides a "free lunch" courtesy of the highest-income taxpayers. The second initiative echoes Team Obama's drumbeat to raise taxes on the top 3%. The third initiative would require increased taxes for everybody, which triggers some soul-searching among voters.
If you need to guard the entrance to Hades, I'd recommend a three-headed monster named Cerberus. However, a three-headed tax initiative may confuse and fatigue California voters. Team Brown conducted an unofficial poll suggesting that voters will play "knock out" and select one plan while rejecting the others. If so, voters may fragment their support for the initiatives and tank the entire process. (Team Munger disputes Brown's logic.)
A final remark on the California initiative process. Why exactly do we elect state politicians, when they put any tough decision on the ballot?
Showing posts with label tax policy. Show all posts
Showing posts with label tax policy. Show all posts
Monday, February 27, 2012
Wednesday, February 22, 2012
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.
* * * * *
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:
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.
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.
* * * * *
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.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."
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))
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.
Monday, November 28, 2011
Sheppard on Earnings Stripping
Our favorite tax fashionista, Lee Sheppard, has an interesting article out today. See "News Analysis: The Fashion in Interest Deduction Restrictions," Tax Notes, Nov. 28, 2011, p. 1061.
Earnings Stripping
What is earnings stripping? First, some background. Many jurisdictions, including the United States, permit taxpayers to deduct interest expense in computing net taxable income. Deductible interest reduces pre-tax income and taxes owed to the revenue authority. The deductibility of interest expense creates a difficult challenge for policy makers. The issue will be lurking below the surface as Congress begins wading into the waters of tax reform.
Deductible interest creates a "bias" for debt-heavy capital structures ("overleverage"). The deduction for interest expense artificially decreases the "real" cost of debt relative to the "real" cost of equity. Overleveraged capital structures are more likely to capsize during the "trough" of business cycles, creating turmoil and trauma for stakeholders of the overleveraged business (employees, customers, local communities, etc.).
Deductible interest also permits business owners to "strip" taxable income out of the the tax base. This "earnings stripping" or "base erosion" involves variations on a theme. Sheppard's article focuses on cross-border earnings stripping.
A corporate parent with a foreign subsidiary may be able to fund the subsidiary with "shareholder loan" capital that pays interest. With proper treaty planning, (i) the shareholder loan pays interest, (ii) the interest expense is deductible, reducing taxable income and tax liabilities in the subsidiary's jurisdiction, and (iii) low or no withholding taxes apply to the interest payment. This type of structure permits the parent to "strip" earnings out of a higher-tax jurisdiction into a lower-tax jurisdiction.
Designing an "interest strip" is not rocket science. Tax advisors can use the basic structure in domestic transactions. Assume a group of pension funds pools capital and purchases a U.S. business organized as a corporation. The pension funds capitalize an acquisition vehicle with a mix of equity capital and "shareholder loan" capital. The decision to capitalize with equity and debt is effectively "deemed" to have economic substance. The target business generates taxable income after the acquisition. But the acquisition vehicle pays deductible interest expense on its shareholder loans. The pension funds are tax-exempt entities, so pay no tax when they accrue or receive interest. Voila, an "interest strip" -- shifting tax revenue from the U.S. Treasury to the pension funds.
(In the long run, query whether foreign and domestic pension funds will be able to use their tax-advantaged status to purchase every commercial enterprise on Earth. Marx would be vindicated. The working class -- through pension funds and their investment managers -- would control the means of production.)
U.S. Rules
Congress understands that earnings stripping can be a big problem. It enacted Code section 163(j) to address the issue. Sheppard snorts at the U.S. rules: "[I]t remains ridiculously easy to strip [income out of the United States] using interest deductions, despite a statute squarely aimed at foreign-parented groups."
I won't go into section 163(j) in detail. It limits a corporation's related-party interest deductions if the corporation has too much leverage and too much interest expense. It works in some cases, but has a couple obvious shortcomings. First, it doesn't apply to my domestic example above (where a group of pension funds acquire a U.S. business and use shareholder loans to interest strip). The statute only bites if the shareholder loan capital is provided by a "related" person.
Second, the U.S. limitation does not expressly contain any transfer pricing limitation. Take a technology business. Many technology businesses are capitalized with low ratios of third-party debt to equity ("leverage ratios"). But let's assume that a foreign parent corporation purchases a U.S. target corporation and injects leverage (a shareholder loan) into the target's capital structure. Assume that external leverage ratios in the industry are very low (10% or lower). But the foreign parent capitalizes its new subsidiary with $20x of equity capital and $80x of shareholder loan capital (an 80% leverage ratio).
The U.S. earnings stripping rules do not prohibit the legal structure. And while the U.S. transfer pricing rules impose "arm's length" pricing requirements on intercompany transactions, IRS agents do no commonly focus on shareholder loans (in my experience). Unlike Sheppard, I don't fault section 163(j), so much as lax or unsophisticated U.S. tax administration.
German Rules (and Copyists)
Historically, the U.S. has exported principles of tax law and administration. But the rest of the world has caught up. Sheppard summarizes discussion at a recent International Bar Association annual meeting in Dubai. Tax professionals explored various European earnings stripping limitations. At some point, U.S. policymakers will start paying attention.
According to Sheppard, Germany was the first country to revise its earnings stripping rules. The German rules have serious teeth. The rules apply to all debt of a German affiliated group (an organschaft). The deduction for net interest expense is limited to 30 percent of EBITDA, regardless of whether the payer is related to the lender. EBITDA for this purpose is capped by the group's taxable income. (This effectively limits the benefit of timing or temporary differences to an organschaft with external or internal leverage.)
Practitioners apparently regard the limitation as "stingy." In my view, this is another example of German sensibility and efficiency. The rule is simple to describe and understand. It keys off EBITDA of a business; the financial metric that lenders and equity investors care about when financing an enterprise. The limitation may get low marks on "elegance," but it gets high marks from an administrative perspective. From a tax compliance perspective, policymakers should balance ease of administration against "technical perfection."
Italy has adopted a close variation of the German rule. The French legislature is considering a similar regime to address perceived abuse of French thin cap rules. The Dutch, Irish and Swedish are openly struggling with excessive leverage in domestic capital structures due to cross-border private equity transactions.
If you work in the international tax space or the domestic M&A space, Sheppard's article is definitely worth a quick read.
Earnings Stripping
What is earnings stripping? First, some background. Many jurisdictions, including the United States, permit taxpayers to deduct interest expense in computing net taxable income. Deductible interest reduces pre-tax income and taxes owed to the revenue authority. The deductibility of interest expense creates a difficult challenge for policy makers. The issue will be lurking below the surface as Congress begins wading into the waters of tax reform.
Deductible interest creates a "bias" for debt-heavy capital structures ("overleverage"). The deduction for interest expense artificially decreases the "real" cost of debt relative to the "real" cost of equity. Overleveraged capital structures are more likely to capsize during the "trough" of business cycles, creating turmoil and trauma for stakeholders of the overleveraged business (employees, customers, local communities, etc.).
Deductible interest also permits business owners to "strip" taxable income out of the the tax base. This "earnings stripping" or "base erosion" involves variations on a theme. Sheppard's article focuses on cross-border earnings stripping.
A corporate parent with a foreign subsidiary may be able to fund the subsidiary with "shareholder loan" capital that pays interest. With proper treaty planning, (i) the shareholder loan pays interest, (ii) the interest expense is deductible, reducing taxable income and tax liabilities in the subsidiary's jurisdiction, and (iii) low or no withholding taxes apply to the interest payment. This type of structure permits the parent to "strip" earnings out of a higher-tax jurisdiction into a lower-tax jurisdiction.
Designing an "interest strip" is not rocket science. Tax advisors can use the basic structure in domestic transactions. Assume a group of pension funds pools capital and purchases a U.S. business organized as a corporation. The pension funds capitalize an acquisition vehicle with a mix of equity capital and "shareholder loan" capital. The decision to capitalize with equity and debt is effectively "deemed" to have economic substance. The target business generates taxable income after the acquisition. But the acquisition vehicle pays deductible interest expense on its shareholder loans. The pension funds are tax-exempt entities, so pay no tax when they accrue or receive interest. Voila, an "interest strip" -- shifting tax revenue from the U.S. Treasury to the pension funds.
(In the long run, query whether foreign and domestic pension funds will be able to use their tax-advantaged status to purchase every commercial enterprise on Earth. Marx would be vindicated. The working class -- through pension funds and their investment managers -- would control the means of production.)
U.S. Rules
Congress understands that earnings stripping can be a big problem. It enacted Code section 163(j) to address the issue. Sheppard snorts at the U.S. rules: "[I]t remains ridiculously easy to strip [income out of the United States] using interest deductions, despite a statute squarely aimed at foreign-parented groups."
I won't go into section 163(j) in detail. It limits a corporation's related-party interest deductions if the corporation has too much leverage and too much interest expense. It works in some cases, but has a couple obvious shortcomings. First, it doesn't apply to my domestic example above (where a group of pension funds acquire a U.S. business and use shareholder loans to interest strip). The statute only bites if the shareholder loan capital is provided by a "related" person.
Second, the U.S. limitation does not expressly contain any transfer pricing limitation. Take a technology business. Many technology businesses are capitalized with low ratios of third-party debt to equity ("leverage ratios"). But let's assume that a foreign parent corporation purchases a U.S. target corporation and injects leverage (a shareholder loan) into the target's capital structure. Assume that external leverage ratios in the industry are very low (10% or lower). But the foreign parent capitalizes its new subsidiary with $20x of equity capital and $80x of shareholder loan capital (an 80% leverage ratio).
The U.S. earnings stripping rules do not prohibit the legal structure. And while the U.S. transfer pricing rules impose "arm's length" pricing requirements on intercompany transactions, IRS agents do no commonly focus on shareholder loans (in my experience). Unlike Sheppard, I don't fault section 163(j), so much as lax or unsophisticated U.S. tax administration.
German Rules (and Copyists)
Historically, the U.S. has exported principles of tax law and administration. But the rest of the world has caught up. Sheppard summarizes discussion at a recent International Bar Association annual meeting in Dubai. Tax professionals explored various European earnings stripping limitations. At some point, U.S. policymakers will start paying attention.
According to Sheppard, Germany was the first country to revise its earnings stripping rules. The German rules have serious teeth. The rules apply to all debt of a German affiliated group (an organschaft). The deduction for net interest expense is limited to 30 percent of EBITDA, regardless of whether the payer is related to the lender. EBITDA for this purpose is capped by the group's taxable income. (This effectively limits the benefit of timing or temporary differences to an organschaft with external or internal leverage.)
Practitioners apparently regard the limitation as "stingy." In my view, this is another example of German sensibility and efficiency. The rule is simple to describe and understand. It keys off EBITDA of a business; the financial metric that lenders and equity investors care about when financing an enterprise. The limitation may get low marks on "elegance," but it gets high marks from an administrative perspective. From a tax compliance perspective, policymakers should balance ease of administration against "technical perfection."
Italy has adopted a close variation of the German rule. The French legislature is considering a similar regime to address perceived abuse of French thin cap rules. The Dutch, Irish and Swedish are openly struggling with excessive leverage in domestic capital structures due to cross-border private equity transactions.
If you work in the international tax space or the domestic M&A space, Sheppard's article is definitely worth a quick read.
Friday, November 25, 2011
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:
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.
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.
Wednesday, November 23, 2011
Reilly and Solomon on 28% Cap
I want to highlight a terrific article published by Mary Anne Reilly and Martin B. Solomon in yesterday's Tax Notes. See "Sophistry Supporting Complexity: The 28 Percent Deduction Limit," Tax Notes, Nov. 21, 2011, p. 1019.
I'm a big fan of examples in tax articles and reports. Reilly and Solomon provide good examples that illustrate something I've been saying for months. Team Obama is unable or unwilling to articulate a coherent tax policy agenda. The Obama administration sometimes articulates principles that resonate with the political left and the political right. But the principles always degrade into populist mish-mash when translated into specific legislative proposals.
Background
In September, President Obama launched his 2012 re-election campaign by proposing a $447 billion new stimulus measure (ahem, "jobs plan"). With a 9% national unemployment rate, Obama will be facing headwinds in the next election. He decided that he might be able to save one job (his own) by deflecting criticism to "obstructionist" Republicans.
We are running deficits as far as the eye can see. As partial funding for the new stimulus measure, the Obama administration proposed a 28% cap on certain deductions and exclusions. The specific proposal begins on page 137 of this PDF (page 134 of the report). The new cap is projected to raise approximately $400 billion. It's unclear how the new cap would apply if the 2001-2003 temporary individual tax discounts (the "Bush tax cuts") expire in 2012.
Howard Gleckman at Tax Vox reacted to the proposed cap as follows:
Reilly and Solomon criticize the 28% Cap Proposal on three grounds.
First, they argue that it represents politically-motivated sleight of hand. I'm not going to dwell on this argument. I believe that we should eliminate tax expenditures directly, not limit tax expenditures through complicated and unfair caps and floors. All variations of the 28% cap represent political expedience, not good tax policy.
Second, they argue that the "complexity created by separating the tax cost of income from the tax benefit of deductions is quite significant." Ironically, the "principles for tax reform" outlined by Obama in his recent message to Congress include "a call for simplification." The 28% Cap Proposal goes in the opposite direction. Do we want simplification? Or do we want to induce migraine headaches for tax preparers? You decide. The 28% Cap Proposal would require:
Reilly and Solomon provide an example of a family (the Cliff Family) with two parents and two children. The example compares the tax liabilities of the Cliff Family assuming AGI of $250,000 and $250,001, respectively. The authors hold other numbers constant to demonstrate the impact of the 28% Cap Proposal. Based on "middle of the fairway" assumptions, the authors demonstrate that $1 in additional salary income to the Cliff Family would trigger a $5,708 incremental tax liability.
The political left has vehemently argued that the "wealthiest" taxpayers are not paying their "fair share." The Obama administration has consistently defined "wealthy" taxpayers to include a family with $250,001 of taxable income. Does a $5,700 tax liability on $1 of incremental income satisfy the administration's definition of "fairness"? Is there someone on the political left creative enough to defend the "fairness" of the cliff effect? I'll stay tuned for that development.
I'm a big fan of examples in tax articles and reports. Reilly and Solomon provide good examples that illustrate something I've been saying for months. Team Obama is unable or unwilling to articulate a coherent tax policy agenda. The Obama administration sometimes articulates principles that resonate with the political left and the political right. But the principles always degrade into populist mish-mash when translated into specific legislative proposals.
Background
In September, President Obama launched his 2012 re-election campaign by proposing a $447 billion new stimulus measure (ahem, "jobs plan"). With a 9% national unemployment rate, Obama will be facing headwinds in the next election. He decided that he might be able to save one job (his own) by deflecting criticism to "obstructionist" Republicans.
We are running deficits as far as the eye can see. As partial funding for the new stimulus measure, the Obama administration proposed a 28% cap on certain deductions and exclusions. The specific proposal begins on page 137 of this PDF (page 134 of the report). The new cap is projected to raise approximately $400 billion. It's unclear how the new cap would apply if the 2001-2003 temporary individual tax discounts (the "Bush tax cuts") expire in 2012.
Howard Gleckman at Tax Vox reacted to the proposed cap as follows:
Sophistry, Complexity and InequityAn across-the-board cap on the benefit of deductions and the like is often seen as rough justice — a way to tackle the Revenue Code’s trillion dollars in tax expenditures without fighting over each one. The theory: It is an easier political lift to curb such popular breaks as the mortgage interest deduction through a broad reduction of all subsidies than to fight the powerful housing industry head-on.
But Obama does pick and choose the preferences he wants to target. He nails all itemized deductions, all right, but he also goes after some – but not all – above the line deductions. Of the roughly two dozen write-offs available to those who take the standard deduction, Obama targets just eight, including health insurance for the self-employed, medical savings accounts, health savings accounts, and some higher education expenses.
He also reduces the benefit of two other hot-button breaks — the tax exclusions for municipal bond interest and the value of employer-sponsored health insurance. In other words, for those making more than $200,000, some muni bond interest and some of the value of their medical coverage would be taxed.
However, Obama would protect other exclusions, including those for retirement savings. Picking winners and losers this way is likely to defeat any claims of rough justice and make passing the plan that much tougher.
Reilly and Solomon criticize the 28% Cap Proposal on three grounds.
First, they argue that it represents politically-motivated sleight of hand. I'm not going to dwell on this argument. I believe that we should eliminate tax expenditures directly, not limit tax expenditures through complicated and unfair caps and floors. All variations of the 28% cap represent political expedience, not good tax policy.
Second, they argue that the "complexity created by separating the tax cost of income from the tax benefit of deductions is quite significant." Ironically, the "principles for tax reform" outlined by Obama in his recent message to Congress include "a call for simplification." The 28% Cap Proposal goes in the opposite direction. Do we want simplification? Or do we want to induce migraine headaches for tax preparers? You decide. The 28% Cap Proposal would require:
[A] computation of the tax on a new item called adjusted taxable income (ATI); a determination of another new item, the minimum marginal rate amount (MMRA); computation of tax on the greater of taxable income or the MMRA; and a computation of the "additional amount," which is the excess of the tax on ATI over the greater of the tax on taxable income or the MMRA, plus 28 percent of the excess of ATI over the greater of taxable income or the MMRA. This last number represents the additional tax generated by the new 28 percent deduction limitation.Third, they argue that the "proposal is loaded with potential inequities and questionable tax policy." Most important, the new rules would have a cliff effect. They would be "triggered on an all-or-nothing basis when a taxpayer's adjusted gross income is above $250,000 for a joint return and $200,000 for a single taxpayer," potentially resulting "in an enormous addition to tax as a result of as little as $1 of additional income."
Reilly and Solomon provide an example of a family (the Cliff Family) with two parents and two children. The example compares the tax liabilities of the Cliff Family assuming AGI of $250,000 and $250,001, respectively. The authors hold other numbers constant to demonstrate the impact of the 28% Cap Proposal. Based on "middle of the fairway" assumptions, the authors demonstrate that $1 in additional salary income to the Cliff Family would trigger a $5,708 incremental tax liability.
The political left has vehemently argued that the "wealthiest" taxpayers are not paying their "fair share." The Obama administration has consistently defined "wealthy" taxpayers to include a family with $250,001 of taxable income. Does a $5,700 tax liability on $1 of incremental income satisfy the administration's definition of "fairness"? Is there someone on the political left creative enough to defend the "fairness" of the cliff effect? I'll stay tuned for that development.
Friday, November 18, 2011
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.
* * * * *
Interested readers can locate the 1,470 individual taxpayers on page 40 of this report.
Here's the breakdown among the different income groups:
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.
* * * * *
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 | |||
Monday, November 7, 2011
Inequality and U.S. Economic Hegemony
In my last two posts, I've discussed Beale's Law (see here and here). Beale's Law posits that pre-tax income inequality has an "inverse" relationship to top tax rates. Today's post explores the more complex reality underlying the increased economic inequality in the United States.
The Decline of U.S. Economic Hegemony
The political left has convinced itself that inequality of income and wealth is primarily a function of tax rates. The narrative is easy to promote through soundbite politics. It stokes our base emotions (envy) and offers a simple government remedy to economic inequality.
The left clings to this narrative for a several reasons. The narrative is simple and politically expedient. It offers an excuse for failed left-wing policy initiatives that were supposedly enacted to improve equality of opportunity. (If past initiatives have failed to address inequality, why should we trust the same policymakers to implement "new and improved" policies to address inequality?) Most important, the narrative permits left-wing politicians to bury their collective heads in the sand. A simple narrative that 'tax policy drives inequality' fails to acknowledge the decline of U.S. economic hegemony over the last 50 years.
During the second half of the 20th century, the United States had the world's largest, strongest and most stable economy. We had an educated workforce, a developed energy and transport infrastructure, and stable government institutions. Following World War II, we experienced an economic surge associated with the Baby Boom generation. We supported our major trading partners during a period of post-war economic redevelopment. Capital markets activity was largely domestic. Through the 1970s, we ran consistent trade surpluses. From an economic perspective, we were the 'only game in town.'
Fast forward to 2011. The U.S. is now a player on a crowded and competitive international stage. We have no structural advantage relative to our major trading partners (the EU, Canada, Japan and Australia). Developing countries have better educated workforces, and armies of low-skilled workers that cost less than their U.S. counterparts. We have no discernible energy policy, and our dependence on oil imports drives chronic trade deficits. Technology has diminished the economic significance of geography, while promoting the relevance of talent. Financial capital markets are globally integrated. Global capital flows to the most profitable opportunities.
With that historical context, we can isolate on the major causes of U.S. economic inequality:
- On a macro level, the U.S. has been dragged into intense economic competition with its major trading partners and developing economies. We are no longer the 'only game in town.'
- On a micro level, the low-skilled U.S. worker has become far less valuable than his or her counterpart in the mid-20th century. Developing economies have large pools of low-skilled workers, and multinational businesses can access those low-skilled workers at lower costs than U.S. workers.
- Conversely, the best educated and most talented U.S. entrepreneurs have become more valuable than their counterparts in the mid-20th century. Technology has concentrated returns to talent and genius.
- Moreover, the byzantine U.S. regulatory system has created a "lock out" effect. In large sectors of the U.S. economy, only the largest businesses can thrive. If a business requires an army of lawyers or lobbyists to navigate regulatory, commercial or tax issues, it qualifies. The individuals that climb to the top of the pyramid generate economic premiums by "locking out" competitors. In the mid-20th century, how many CEOs depended on armies of lawyers or lobbyists?
Acknowledging the truth about economic inequality requires us to take off the blinders. We aren't going back to a period of U.S. economic hegemony. We are required to compete in markets that are ruthlessly efficient. Our low-skilled workers are at an enormous competitive disadvantage, and will continue to lose ground relative to better educated and more talented peers. The wealth gap will probably get steeper before it flattens out again. We aren't going to reverse the long-term trend by increasing top tax rates on "millionaires and billionaires."
However, all is not bleak. Our country has an extraordinary tradition of innovation and resilience. We need to acknowledge the competitive challenges facing our nation, and coalesce around strategies to align educational opportunities with a knowledge-based economy. We need to re-boot policies and institutions that worked in the mid-20th century to reflect the challenges of the early-21st century. We need to be realists, but realism is not mutually exclusive with optimism.
The Decline of U.S. Economic Hegemony
The political left has convinced itself that inequality of income and wealth is primarily a function of tax rates. The narrative is easy to promote through soundbite politics. It stokes our base emotions (envy) and offers a simple government remedy to economic inequality.
The left clings to this narrative for a several reasons. The narrative is simple and politically expedient. It offers an excuse for failed left-wing policy initiatives that were supposedly enacted to improve equality of opportunity. (If past initiatives have failed to address inequality, why should we trust the same policymakers to implement "new and improved" policies to address inequality?) Most important, the narrative permits left-wing politicians to bury their collective heads in the sand. A simple narrative that 'tax policy drives inequality' fails to acknowledge the decline of U.S. economic hegemony over the last 50 years.
During the second half of the 20th century, the United States had the world's largest, strongest and most stable economy. We had an educated workforce, a developed energy and transport infrastructure, and stable government institutions. Following World War II, we experienced an economic surge associated with the Baby Boom generation. We supported our major trading partners during a period of post-war economic redevelopment. Capital markets activity was largely domestic. Through the 1970s, we ran consistent trade surpluses. From an economic perspective, we were the 'only game in town.'
Fast forward to 2011. The U.S. is now a player on a crowded and competitive international stage. We have no structural advantage relative to our major trading partners (the EU, Canada, Japan and Australia). Developing countries have better educated workforces, and armies of low-skilled workers that cost less than their U.S. counterparts. We have no discernible energy policy, and our dependence on oil imports drives chronic trade deficits. Technology has diminished the economic significance of geography, while promoting the relevance of talent. Financial capital markets are globally integrated. Global capital flows to the most profitable opportunities.
With that historical context, we can isolate on the major causes of U.S. economic inequality:
- On a macro level, the U.S. has been dragged into intense economic competition with its major trading partners and developing economies. We are no longer the 'only game in town.'
- On a micro level, the low-skilled U.S. worker has become far less valuable than his or her counterpart in the mid-20th century. Developing economies have large pools of low-skilled workers, and multinational businesses can access those low-skilled workers at lower costs than U.S. workers.
- Conversely, the best educated and most talented U.S. entrepreneurs have become more valuable than their counterparts in the mid-20th century. Technology has concentrated returns to talent and genius.
- Moreover, the byzantine U.S. regulatory system has created a "lock out" effect. In large sectors of the U.S. economy, only the largest businesses can thrive. If a business requires an army of lawyers or lobbyists to navigate regulatory, commercial or tax issues, it qualifies. The individuals that climb to the top of the pyramid generate economic premiums by "locking out" competitors. In the mid-20th century, how many CEOs depended on armies of lawyers or lobbyists?
Acknowledging the truth about economic inequality requires us to take off the blinders. We aren't going back to a period of U.S. economic hegemony. We are required to compete in markets that are ruthlessly efficient. Our low-skilled workers are at an enormous competitive disadvantage, and will continue to lose ground relative to better educated and more talented peers. The wealth gap will probably get steeper before it flattens out again. We aren't going to reverse the long-term trend by increasing top tax rates on "millionaires and billionaires."
However, all is not bleak. Our country has an extraordinary tradition of innovation and resilience. We need to acknowledge the competitive challenges facing our nation, and coalesce around strategies to align educational opportunities with a knowledge-based economy. We need to re-boot policies and institutions that worked in the mid-20th century to reflect the challenges of the early-21st century. We need to be realists, but realism is not mutually exclusive with optimism.
Friday, November 4, 2011
Higher Taxes, Lower Pre-Tax Incomes?
In Wednesday's post, I debunked Beale's Law. Beale's Law reflects the pseudo-scientific economush advocated by the political left and political right. It provides that "income inequality levels inversely track the top tax rate--as the rate increases, income inequality decreases." Sounds like physics, right? But a close look at the numbers demonstrates that income inequality levels do not track "inversely" to the tax rate.
I'm not picking on Professor Beale. She is a bombastic advocate on behalf of the political left, which provides some counterweight to her counterparts on the political right. When it comes to data manipulation for political purposes, the right and the left are engaged in a long-running tug of war. They both abuse statistics and economic common sense to influence public opinion in the short term. It's great sport for incumbent politicians, blogging left-wing academics and Washington lobbyists. Not so great for the country in the long run.
As I said on Wednesday, this is all about political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses. But enough on data manipulation. One more question about Beale's Law while the topic is fresh.
Pre-Tax Income vs After-Tax Wealth
Beale's Law posits that income inequality is inverse to tax rates. Imagine that we plot a curve with the pre-tax incomes of the lowest-earning taxpayers on the bottom left, and the highest-earning taxpayers on the top right. Beale's Law predicts that, when top tax rates are high, the curve will "flatten out." Conversely, when top tax rates are low, the curve will "steepen up." Put another way, the difference between the pre-tax incomes of the top 400 taxpayers and the bottom 400 taxpayers should decrease as tax rates increase. And vice versa.
My last post demonstrated that Beale's Law doesn't apply in the real world. It reflects ideological and political wishful thinking, not an interpolation of real-world data. However, I remain puzzled by the logic underlying the pseudo-science. Specifically, I find it puzzling that the political left attempts to link the pre-tax income gap to the top tax rate.
The data indicate that we have a pre-tax income gap and an after-tax wealth gap in our country. I follow that increasing tax rates may "flatten" the after-tax wealth gap. If we taxed the highest-earning taxpayers at 90% marginal rates, we would diminish their ability to accumulate wealth.
In response, many of those individuals would ramp up tax sheltering activity -- shifting taxable income into non-taxable perks, relocating to lower-tax jurisdictions, etc. Longer term, such a policy would drain the wealth controlled by the richest Americans. We wouldn't necessarily observe a "redistribution" of wealth. There is no reason to expect an increase the wealth of the bottom 50% of taxpayers or bottom 400 individuals. But the curve plotting the difference between the top 400 wealthiest individuals and the bottom 400 individuals would likely flatten over time, because the wealthiest individuals would become less wealthy and/or relocate to lower-tax jurisdictions.
The fact that we could flatten the after-tax wealth gap does not mean that we could also flatten the pre-tax income gap. In 2010, LeBron James, Chris Bosh and Dwayne Wade signed $100+ million, six-year contracts with the Miami Heat basketball team. If the top tax rate were, say, 70%, would we expect that James, Bosh and Wade would have signed for less money? Or is the theory that higher tax rates at the top would support higher government spending and thus "trickle up" into higher wage rates across the board?
It's very difficult to identify any logical nexus between higher top tax rates and lower pre-tax income inequality. But no surprise -- as noted, Beale's Law is ultimately about ideological and political wishful thinking.
I'm not picking on Professor Beale. She is a bombastic advocate on behalf of the political left, which provides some counterweight to her counterparts on the political right. When it comes to data manipulation for political purposes, the right and the left are engaged in a long-running tug of war. They both abuse statistics and economic common sense to influence public opinion in the short term. It's great sport for incumbent politicians, blogging left-wing academics and Washington lobbyists. Not so great for the country in the long run.
As I said on Wednesday, this is all about political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses. But enough on data manipulation. One more question about Beale's Law while the topic is fresh.
Pre-Tax Income vs After-Tax Wealth
Beale's Law posits that income inequality is inverse to tax rates. Imagine that we plot a curve with the pre-tax incomes of the lowest-earning taxpayers on the bottom left, and the highest-earning taxpayers on the top right. Beale's Law predicts that, when top tax rates are high, the curve will "flatten out." Conversely, when top tax rates are low, the curve will "steepen up." Put another way, the difference between the pre-tax incomes of the top 400 taxpayers and the bottom 400 taxpayers should decrease as tax rates increase. And vice versa.
My last post demonstrated that Beale's Law doesn't apply in the real world. It reflects ideological and political wishful thinking, not an interpolation of real-world data. However, I remain puzzled by the logic underlying the pseudo-science. Specifically, I find it puzzling that the political left attempts to link the pre-tax income gap to the top tax rate.
The data indicate that we have a pre-tax income gap and an after-tax wealth gap in our country. I follow that increasing tax rates may "flatten" the after-tax wealth gap. If we taxed the highest-earning taxpayers at 90% marginal rates, we would diminish their ability to accumulate wealth.
In response, many of those individuals would ramp up tax sheltering activity -- shifting taxable income into non-taxable perks, relocating to lower-tax jurisdictions, etc. Longer term, such a policy would drain the wealth controlled by the richest Americans. We wouldn't necessarily observe a "redistribution" of wealth. There is no reason to expect an increase the wealth of the bottom 50% of taxpayers or bottom 400 individuals. But the curve plotting the difference between the top 400 wealthiest individuals and the bottom 400 individuals would likely flatten over time, because the wealthiest individuals would become less wealthy and/or relocate to lower-tax jurisdictions.
The fact that we could flatten the after-tax wealth gap does not mean that we could also flatten the pre-tax income gap. In 2010, LeBron James, Chris Bosh and Dwayne Wade signed $100+ million, six-year contracts with the Miami Heat basketball team. If the top tax rate were, say, 70%, would we expect that James, Bosh and Wade would have signed for less money? Or is the theory that higher tax rates at the top would support higher government spending and thus "trickle up" into higher wage rates across the board?
It's very difficult to identify any logical nexus between higher top tax rates and lower pre-tax income inequality. But no surprise -- as noted, Beale's Law is ultimately about ideological and political wishful thinking.
Wednesday, November 2, 2011
Beale's Law Debunked
The political left and political right are engaged in a knock-down, drag-out competition. Although they seek to sway public approval numbers, the competition is not about public approval per se. They are competing to see who has the defter hand at data manipulation to suit their respective political objectives.
A post today by Linda Beale provides a suitable case study in data manipulation. Beale links to this CivilAmerican report, which presents a series of graphs plotting (i) top marginal income tax rates over the decades, and (ii) income earned by the top 10% of taxpayers and top 1% of taxpayers over roughly the same time period.
According to Beale, the graphs evidence the fact that "income inequality levels inversely track the top tax rate--as the rate increases, income inequality decreases."
Beale's argument has a intuitive appeal, which reflects the beauty of data manipulation. The use of data to support an ideological argument cloaks the argument with a pseudo-scientific legitimacy. Beale's position evokes the law of universal gravitation ("the gravitational force between two objects is proportional to the mass of each, and inversely proportional to the distance between them"). How could we possibly challenge the foundational concept of gravity? And how can we possibly challenge Beale's Law: that income inequality levels inversely track the top tax rate?
But let's take a harder look at the data in the graphs. How does Beale's Law hold up to a skeptical analysis by a political independent? (Spoiler: not so much.)
The first graph from the CivilAmerican report plots the top marginal tax rate applicable to individual taxpayers over time.
The second graph plots the percentage of total income going to the top 10% of taxpayers for a period ending in 2006.
The third graph plots the share of income reported by the top 1% between 1913 and 2007.
I don't have access to the data underlying these graphs, but let's assume that the underlying data and the graphing tools are accurate. We observe that the graphs are not exactly apples to apples -- the first graph plots data for a period ending 2010; the second graph 2006; the third graph 2007. The use of different time periods is somewhat misleading, but bigger problems emerge when examining Beale's Law against the graphical data. So we'll give a pass to the apples to oranges presentation.
The inclusion of data on the top 10% in graph 2 is outright misleading. The first graph and third graph are focused on the top 1% (rates and income). The second graph creates an inference that the top 10% benefit from the same changes in marginal tax rates as the top 1%. But taxpayers in the 90th income percentile are light years away from taxpayers in the top 0.01% and the top 0.001%. The "tippy top" of taxpayers distorts the income numbers. Meanwhile, we don't have data regarding the tax rates paid by the 90th through 99th percentiles. None of this data supports Beale's Law. The graphical presentation is a mess.
Now, on to the graphical data. If your eyes -- like mine -- have seen better days, crack out the microscope.
[1] First Decade of Income Tax (1913-1923)
The top tax rates jumped from less than 10% in 1915 to around 75% in 1917 or 1918 (first graph). That's an increase of more than 750%. The top rates stair-stepped down from roughly 72% in 1920, to 58% in 1922 or 1923, to roughly 25% from 1925 through 1932.
Despite a 750% increase in the top tax rate from 1915 to 1917 or 1918, the top 1% of taxpayers reported a roughly 20% decrease in income from peak (1918-19%) to trough (1922-15%).
We only have data on the top 10% beginning in 1917. Between 1917 and 1923, the top 10% bounced from a low of 38% in 1921, to a high of 43% in 1923. The reported incomes of the top 10% were not apparently impacted by the 750% increase in top marginal rates.
The data on the top 10% doesn't support Beale's Law. However, I question the credibility of all this early data. I'm guessing that compliance/enforcement was selective and that tax shelters were widely available to the top 1%. Those issues make it very difficult to compare data from the early decades of the income tax (generally unreliable) to more current data (generally reliable).
[2] Second Two Decades (1923-1943)
As noted, the top rates stair-stepped down from roughly 72% in 1920, to 58% in 1922 or 1923, to roughly 25% from 1925 through 1932. They jumped back above 60% in 1933, and were close to 90% in 1943.
The reported income of the top 1% plummeted from its peak of 23.9% in 1928 to approximately 15% in 1931 or 1932. Top tax rates were stable, but 1932 and 1933 were the worst years of the Great Depression. Even the richest Americans are not immune from the forces of wealth destruction. (A similar trend emerged in the wake of the 2007 financial crisis.)
From 1933 through 1937, top rates climbed precipitously, but the top 1% saw their reported incomes rebound to approximately 19% of reported totals. Their reported income then began a period of gradual decline, reaching approximately 12% in 1943.
The top 10% of taxpayers reported approximately 45% of total income from 1923 through 1940. Reported income declined sharply around 1941, hitting 34% in 1943.
Lessons from the period? The top 10% were basically insensitive to the top marginal tax rates for most of the period. Beale's Law does not hold if we focus on that group. The top 1% saw income losses while rates were stable, and income gains during a period of increasing rates. In the early 1940s, Team Roosevelt increased the top rate above 90%. The top 1% began to report a lower share of total pre-tax income. However, we don't know how much of that decrease is attributable to weak compliance/enforcement and tax shelter activity by the ultra-wealthy. My guess is that tax sheltering drove much of the data for the next two decades.
[3] Third Two Decades (1943-1963)
The top tax rate was consistently in the 90% range throughout this period.
The top 1% bounced from peak income of approximately 12.5% (1944) to approximately 10% in the late-1950s and early 1960s. These data are somewhat consistent with Beale's Law. However, Beale's Law would not predict a 20% decline in reported income during a period of rate stability. Remember, Beale's Law suggest that income inequality is inverse to rates. During periods of rate stability, we'd expect to see stable levels of income inequality.
The top 10% bounced from peak income of approximately 37% (1946) to approximately 33% in the early 1950s. The reported incomes of the top 10% were very stable, which is consistent with Beale's Law. However, taxpayers in the 90th to 99th percentiles reported income gains, while the top 1% reported income losses over the period. Guess who can allocate more cash to planning and implementation of tax shelters?
[4] Fourth Two Decades (1963-1983)
President Kennedy slashed the top rate from 90% to 70% in 1964. Reagan chopped the top rate to 50% in 1982.
Despite the top rate decrease, the top 1% reported approximately 10% of pre-tax income throughout the period. The trough was 8.9% in 1976. Reported income began to trend upward around the time of the Reagan tax cut.
Similar to the prior period, the reported incomes of the top 10% were very stable. Again, taxpayers in the 90th to 99th percentiles reported income gains, while the top 1% reported income losses.
Lessons from the period? Under Beale's Law, we would expect to see a jump in income inequality after Kennedy cut the top rate from 90% to 70%. Something else was going on, because the top 1% reported declining incomes through the mid-70s. I smell ... tax shelters!
[5] Fifth Two Decades (1983-2003)
From a historical perspective, this period was relatively volatile. The top rates declined from 50% in 1983 to 28% in 1988. Bucking his predecessors, Clinton raised the top rate to 40%. Bush Jr. cut the top rate to 35% in 2004.
The top 1% reported approximately 15% of pre-tax income in the mid-'80s through about 1994. From 1994 through about 1999 or 2000, the group's reported income spiked to approximately 22%. Reported incomes fell when the dot-com bubble popped (2000-2001), and then rebounded to 23.5% in 2007.
The top 10% largely tracked the top 1%. The group reported approximately 36% of total income in 1983, spiked to approximately 47% in 2000, fell for a couple years, and then rebounded to a high of approximately 50% in 2006.
Lessons from the period? Under Beale's Law, we'd expect to see a decline in income inequality after Clinton raised the top rates. In fact, income inequality continued its sharp ascent notwithstanding the tax increase. History repeats itself. The top 1% took a relative hit when the dot-com bubble popped (compare peak years of Great Depression). They rebounded before the Bush tax cuts took effect.
[6] Conclusion
Beale's Law is a pseudo-scientific assertion seemingly grounded in historical data. When we scrub the numbers, however, the theory crashes and burns. During periods that tax rates changed, we don't see "inverse" reactions in reported taxable incomes of the top 1%. During periods of relative stability, we see patterns that aren't consistent with Beale's Law. For much of the history of the income tax, the top 1% (or perhaps the top 0.01%) were able to exploit tax shelters that were unavailable to taxpayers in the 90th to 99th percentile. When loopholes were tightened, their share of reported income rebounded significantly.
Moreover, Beale's Law disregards the macroeconomic currents that cause income inequality to ebb and flow over time. In the late-'90s, for instance, we see increasing inequality despite the Clinton tax increases (no inverse relationship). The evolution of new technologies and increased fluidity of global capital markets have concentrated the rewards to talented innovators and entrepreneurs. Beale's Law, and other pseudo-science on the political left and political right, is guided by political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses.
Although I've spent too much time debunking Beale's Law, her fundamental argument misses the point. Beale anguishes over the fact that income inequality has ebbed and flowed over time. She yearns for the "good old days" when the top 1% reported a smaller percentage of total income (8.9% in 1976). But the key question is whether the top 1% are paying a fair share of taxes necessary to run the government that Americans desire. The top 1% paid approximately 37% of total income taxes in 2009. Is that enough? Too little? How much would satisfy Professor Beale? And what if we increase taxes and don't cause a dent in income inequality? What's the next step from Professor Beale's perspective?
A post today by Linda Beale provides a suitable case study in data manipulation. Beale links to this CivilAmerican report, which presents a series of graphs plotting (i) top marginal income tax rates over the decades, and (ii) income earned by the top 10% of taxpayers and top 1% of taxpayers over roughly the same time period.
According to Beale, the graphs evidence the fact that "income inequality levels inversely track the top tax rate--as the rate increases, income inequality decreases."
Beale's argument has a intuitive appeal, which reflects the beauty of data manipulation. The use of data to support an ideological argument cloaks the argument with a pseudo-scientific legitimacy. Beale's position evokes the law of universal gravitation ("the gravitational force between two objects is proportional to the mass of each, and inversely proportional to the distance between them"). How could we possibly challenge the foundational concept of gravity? And how can we possibly challenge Beale's Law: that income inequality levels inversely track the top tax rate?
But let's take a harder look at the data in the graphs. How does Beale's Law hold up to a skeptical analysis by a political independent? (Spoiler: not so much.)
The first graph from the CivilAmerican report plots the top marginal tax rate applicable to individual taxpayers over time.
The second graph plots the percentage of total income going to the top 10% of taxpayers for a period ending in 2006.
The third graph plots the share of income reported by the top 1% between 1913 and 2007.
I don't have access to the data underlying these graphs, but let's assume that the underlying data and the graphing tools are accurate. We observe that the graphs are not exactly apples to apples -- the first graph plots data for a period ending 2010; the second graph 2006; the third graph 2007. The use of different time periods is somewhat misleading, but bigger problems emerge when examining Beale's Law against the graphical data. So we'll give a pass to the apples to oranges presentation.
The inclusion of data on the top 10% in graph 2 is outright misleading. The first graph and third graph are focused on the top 1% (rates and income). The second graph creates an inference that the top 10% benefit from the same changes in marginal tax rates as the top 1%. But taxpayers in the 90th income percentile are light years away from taxpayers in the top 0.01% and the top 0.001%. The "tippy top" of taxpayers distorts the income numbers. Meanwhile, we don't have data regarding the tax rates paid by the 90th through 99th percentiles. None of this data supports Beale's Law. The graphical presentation is a mess.
Now, on to the graphical data. If your eyes -- like mine -- have seen better days, crack out the microscope.
[1] First Decade of Income Tax (1913-1923)
The top tax rates jumped from less than 10% in 1915 to around 75% in 1917 or 1918 (first graph). That's an increase of more than 750%. The top rates stair-stepped down from roughly 72% in 1920, to 58% in 1922 or 1923, to roughly 25% from 1925 through 1932.
Despite a 750% increase in the top tax rate from 1915 to 1917 or 1918, the top 1% of taxpayers reported a roughly 20% decrease in income from peak (1918-19%) to trough (1922-15%).
We only have data on the top 10% beginning in 1917. Between 1917 and 1923, the top 10% bounced from a low of 38% in 1921, to a high of 43% in 1923. The reported incomes of the top 10% were not apparently impacted by the 750% increase in top marginal rates.
The data on the top 10% doesn't support Beale's Law. However, I question the credibility of all this early data. I'm guessing that compliance/enforcement was selective and that tax shelters were widely available to the top 1%. Those issues make it very difficult to compare data from the early decades of the income tax (generally unreliable) to more current data (generally reliable).
[2] Second Two Decades (1923-1943)
As noted, the top rates stair-stepped down from roughly 72% in 1920, to 58% in 1922 or 1923, to roughly 25% from 1925 through 1932. They jumped back above 60% in 1933, and were close to 90% in 1943.
The reported income of the top 1% plummeted from its peak of 23.9% in 1928 to approximately 15% in 1931 or 1932. Top tax rates were stable, but 1932 and 1933 were the worst years of the Great Depression. Even the richest Americans are not immune from the forces of wealth destruction. (A similar trend emerged in the wake of the 2007 financial crisis.)
From 1933 through 1937, top rates climbed precipitously, but the top 1% saw their reported incomes rebound to approximately 19% of reported totals. Their reported income then began a period of gradual decline, reaching approximately 12% in 1943.
The top 10% of taxpayers reported approximately 45% of total income from 1923 through 1940. Reported income declined sharply around 1941, hitting 34% in 1943.
Lessons from the period? The top 10% were basically insensitive to the top marginal tax rates for most of the period. Beale's Law does not hold if we focus on that group. The top 1% saw income losses while rates were stable, and income gains during a period of increasing rates. In the early 1940s, Team Roosevelt increased the top rate above 90%. The top 1% began to report a lower share of total pre-tax income. However, we don't know how much of that decrease is attributable to weak compliance/enforcement and tax shelter activity by the ultra-wealthy. My guess is that tax sheltering drove much of the data for the next two decades.
[3] Third Two Decades (1943-1963)
The top tax rate was consistently in the 90% range throughout this period.
The top 1% bounced from peak income of approximately 12.5% (1944) to approximately 10% in the late-1950s and early 1960s. These data are somewhat consistent with Beale's Law. However, Beale's Law would not predict a 20% decline in reported income during a period of rate stability. Remember, Beale's Law suggest that income inequality is inverse to rates. During periods of rate stability, we'd expect to see stable levels of income inequality.
The top 10% bounced from peak income of approximately 37% (1946) to approximately 33% in the early 1950s. The reported incomes of the top 10% were very stable, which is consistent with Beale's Law. However, taxpayers in the 90th to 99th percentiles reported income gains, while the top 1% reported income losses over the period. Guess who can allocate more cash to planning and implementation of tax shelters?
[4] Fourth Two Decades (1963-1983)
President Kennedy slashed the top rate from 90% to 70% in 1964. Reagan chopped the top rate to 50% in 1982.
Despite the top rate decrease, the top 1% reported approximately 10% of pre-tax income throughout the period. The trough was 8.9% in 1976. Reported income began to trend upward around the time of the Reagan tax cut.
Similar to the prior period, the reported incomes of the top 10% were very stable. Again, taxpayers in the 90th to 99th percentiles reported income gains, while the top 1% reported income losses.
Lessons from the period? Under Beale's Law, we would expect to see a jump in income inequality after Kennedy cut the top rate from 90% to 70%. Something else was going on, because the top 1% reported declining incomes through the mid-70s. I smell ... tax shelters!
[5] Fifth Two Decades (1983-2003)
From a historical perspective, this period was relatively volatile. The top rates declined from 50% in 1983 to 28% in 1988. Bucking his predecessors, Clinton raised the top rate to 40%. Bush Jr. cut the top rate to 35% in 2004.
The top 1% reported approximately 15% of pre-tax income in the mid-'80s through about 1994. From 1994 through about 1999 or 2000, the group's reported income spiked to approximately 22%. Reported incomes fell when the dot-com bubble popped (2000-2001), and then rebounded to 23.5% in 2007.
The top 10% largely tracked the top 1%. The group reported approximately 36% of total income in 1983, spiked to approximately 47% in 2000, fell for a couple years, and then rebounded to a high of approximately 50% in 2006.
Lessons from the period? Under Beale's Law, we'd expect to see a decline in income inequality after Clinton raised the top rates. In fact, income inequality continued its sharp ascent notwithstanding the tax increase. History repeats itself. The top 1% took a relative hit when the dot-com bubble popped (compare peak years of Great Depression). They rebounded before the Bush tax cuts took effect.
[6] Conclusion
Beale's Law is a pseudo-scientific assertion seemingly grounded in historical data. When we scrub the numbers, however, the theory crashes and burns. During periods that tax rates changed, we don't see "inverse" reactions in reported taxable incomes of the top 1%. During periods of relative stability, we see patterns that aren't consistent with Beale's Law. For much of the history of the income tax, the top 1% (or perhaps the top 0.01%) were able to exploit tax shelters that were unavailable to taxpayers in the 90th to 99th percentile. When loopholes were tightened, their share of reported income rebounded significantly.
Moreover, Beale's Law disregards the macroeconomic currents that cause income inequality to ebb and flow over time. In the late-'90s, for instance, we see increasing inequality despite the Clinton tax increases (no inverse relationship). The evolution of new technologies and increased fluidity of global capital markets have concentrated the rewards to talented innovators and entrepreneurs. Beale's Law, and other pseudo-science on the political left and political right, is guided by political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses.
Although I've spent too much time debunking Beale's Law, her fundamental argument misses the point. Beale anguishes over the fact that income inequality has ebbed and flowed over time. She yearns for the "good old days" when the top 1% reported a smaller percentage of total income (8.9% in 1976). But the key question is whether the top 1% are paying a fair share of taxes necessary to run the government that Americans desire. The top 1% paid approximately 37% of total income taxes in 2009. Is that enough? Too little? How much would satisfy Professor Beale? And what if we increase taxes and don't cause a dent in income inequality? What's the next step from Professor Beale's perspective?
Monday, October 31, 2011
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.
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.
Wednesday, October 26, 2011
Searching for the Elusive "Fair Share"
On Monday, David Logan of the Tax Foundation issued a report summarizing the individual income tax data from 2009. Highlights (or lowlights, depending on your perspective):
For today, the data inspire several questions. President Obama and his cheerleaders on the political left want to "spread the wealth" around. They believe that "millionaires and billionaires," defined as working professional married couples with $250,000 in taxable income, aren't contributing their "fair share" to the federal government.
Three questions for the political left:
- Nationally, average effective income tax rates were at their lowest levels since the IRS began tracking them in 1986. The average tax rate for returns with a positive liability went from 12.24% in 2008 to 11.06% in 2009.Logan's report is particularly timely, in the midst of ongoing Occupy Wall Street protests. However, that's a post for another day, if the protesters keep plugging away despite the blizzard approaching the East Coast.
- Incomes reported by tax returns at the high end of the income spectrum fell from 2008 to 2009, as did their share of the nation's income and income taxes paid. In 2009, the top 1% of tax returns paid 36.7% of all federal individual income taxes and earned 16.9% of adjusted gross income (AGI), compared to 2008 when those figures were 38.0% and 20.0%, respectively.
- Each year from 2005 to 2007, the top 1%'s constantly growing share of income earned and taxes paid set a record. The 2008 reversal of this trend continued in 2009. In fact, the income share for the top 1% of tax returns was lower in 2009 than in 2000, largely due to differences in capital gains.
- In 2009, as in 2008, the top 1% no longer pays a larger percentage of total income tax than the bottom 95%. This trend was exacerbated by the aforementioned precipitous drop in AGI in 2009. During 2009, the bottom 95% (AGI under $154,643) paid 41.3% of the total collected, a larger share than the 36.7% paid by the top 1% (AGI over $343,947).
- The top-earning 5% of taxpayers (AGI equal to or greater than $154,643), however, still paid far more than the bottom 95%. The top 5% earned 31.7% of the nation's adjusted gross income, but paid approximately 58.7% of federal individual income taxes.
- Since 2001, the IRS has also been presenting data on a small subset of the top 1%, the top 0.1%. In 2009, this top 0.1% filed 137,982 tax returns, reporting 7.8% of all adjusted gross income earned and paying approximately 17.1% of the nation's federal individual income taxes. The average income for a tax return in the top 0.1% was $4.4 million in 2009, while the average amount of income tax paid was $1.07 million, indicating an average effective individual income tax rate of 24.3%.
- Overall, these data on high-income tax returns appear to confirm that the continued economic stagnation had the same diminishing effect on income inequality that most recessions have, and that it occurred for the same reason: a sharp decline in income at the high end. This appears to contradict reports based upon Census data suggesting the opposite that the recession increased income inequality.
For today, the data inspire several questions. President Obama and his cheerleaders on the political left want to "spread the wealth" around. They believe that "millionaires and billionaires," defined as working professional married couples with $250,000 in taxable income, aren't contributing their "fair share" to the federal government.
Three questions for the political left:
[Q1] In 2009, the top 0.1% of taxpayers paid 17.1% of all individual income taxes, the top 1% of taxpayers paid 36.7% of all individual income taxes, and the top 5% of taxpayers paid 58.7% of all individual income taxes.Tax bloggers on the political left, I look forward to seeing the answers to these straightforward questions.
What percentage of individual income taxes should be paid by each sub-group to be considered their "fair share"? The answer should be a simple percentage, for example, 25% for the top 0.1%, 45% for the top 1% and 65% for the top 5% (numbers are illustrative only, not my view).
[Q2] If we increase taxes on the top 5% as you recommend in A1, will that solve the short-term or long-term budget gaps associated with current spending projections? Or will we also be required to increase taxes on the bottom 95% of taxpayers to solve the fiscal imbalance?
[Q3] Do you really believe that increasing taxes as set forth in A1 and A2 will address the wealth imbalance between the wealthiest 1% and the remaining 99%? Note that increased taxes on the bottom 99% or bottom 95% will decrease their ability to accumulate resources and "catch up" to the top 1%.
Friday, October 21, 2011
Bill Bradley on Tax Reform
This year marks the 25th anniversary of the Tax Reform Act of 1986. Whether you liked it, hated it, or come down in the middle, TRA 1986 was a monumental event in the history of U.S. tax policy.
To commemorate the anniversary, the editors of Tax Notes profiled several veterans of the 1986 tax reform effort this week. Nearly all of the interviews and personal recollections are worth a quick read. However, I wanted to spend a few minutes summarizing Meg Shreve's interview with Bill Bradley.
Bill Bradley is a former Senator (D-NJ) and Democratic presidential candidate. His popularity traces back to his career as a hall of fame basketball player with the New York Knicks. He was no intellectual slouch, attending Oxford as a Rhodes Scholar after a basketball career at Princeton.
Highlights from the interview:
[1] We need to define "tax reform."
Bradley emphasized that we can't do tax reform without defining tax reform. Do we close loopholes and use all the revenue from to lower rates? Or do we close loopholes and use only some of the revenue to lower rates (with some of the revenue dedicated to deficit reduction or new programs)? Alternatively, do we shift the paradigm by lowering income tax rates and offsetting the revenue shortfall with a consumption tax or some other source of revenue (e.g., a carbon tax)?
In 1986, political leaders defined tax reform as revenue-neutral loophole closers. Republicans wanted lower rates, and Democrats wanted fewer loopholes. In a sense, the stars were aligned to permit a political consensus. The Code was riddled with loopholes that were exploited by the highest earners, and top marginal tax rates were high. By eliminating loopholes, TRA 1986 increased taxes on the individuals and businesses that exploited the loopholes. The increased tax revenue was used to "pay for" lower tax rates across the board. The result was that "the top 5 percent paid a higher percent of the income tax revenue after tax reform than before tax reform even though the rate dropped from 50 to 28 percent."
Unfortunately, defining tax reform is more difficult today. Today's "loopholes" are tax expenditures that benefit tens of millions of middle-class taxpayers. Top marginal tax rates are lower today than in 1985. Even without the rancorous climate in Washington, it would be heavy lift for political leaders to adopt the 1986 definition of tax reform.
[2] We need a president that is "full square" behind tax reform and a Treasury Secretary with the gravitas to cut a deal.
Bradley recounted President Reagan's commitment to tax reform. Reagan "gave a couple of speeches," but delegated broad authority to former Treasury Secretary James Baker to cut a deal. Reagan "made it acceptable and led the charge." Baker ultimately brokered a tax reform deal with Bradley himself.
If Bradley is correct, we aren't going to see tax reform before 2013 or 2017. Meaningful tax reform is not a priority for President Obama. His priorities range from socialized health care and "spreading the wealth around" to green jobs and hybrid vehicles that will run 120 miles on a gallon of fuel. His Treasury Secretary, Timothy Geithner, is a bookish technocrat who has struggled to tread water due to economic conditions outside his control.
Bradley did not put a grade on Obama's efforts to drive tax reform. He suggests that Obama has been evasive for political reasons ("If the answer is 'we need to close loopholes to raise revenue and we don't touch rates' -- if that's what you mean, then say it.").
[3] Tax reform is too complicated for most people and will never be a "mainstream" issue. But political leaders need to articulate the principles guiding reform.
Bradley explains that the 1986 reforms were motivated by three simple principles. First, equal incomes should pay equal taxes. Second, the income tax should be progressive (those with higher incomes should pay more). Third, the market is more efficient at capital allocation than the Ways and Means Committee.
Team Obama has struggled to articulate clear, simple principles in respect to tax policy. Obama wants to increase taxes on "millionaires and billionaires," but defines millionaires as married working professionals with taxable income of $250,000. The income tax is steeply progressive, with the top 1% of taxpayers contributing 37% of income tax revenues. But he wants to "spread the wealth around" further, without defining what constitutes a "fair share." He has caught the "Buffett Bug," and become obsessed with the effective tax rates paid by the 400 top earning individual taxpayers. He sniffs at Bradley's quaint notion that the market is better at capital allocation than legislators and bureaucrats in Washington.
No wonder that individual Americans are confused and frustrated by the rhetoric around tax reform.
To commemorate the anniversary, the editors of Tax Notes profiled several veterans of the 1986 tax reform effort this week. Nearly all of the interviews and personal recollections are worth a quick read. However, I wanted to spend a few minutes summarizing Meg Shreve's interview with Bill Bradley.
Bill Bradley is a former Senator (D-NJ) and Democratic presidential candidate. His popularity traces back to his career as a hall of fame basketball player with the New York Knicks. He was no intellectual slouch, attending Oxford as a Rhodes Scholar after a basketball career at Princeton.
Highlights from the interview:
[1] We need to define "tax reform."
Bradley emphasized that we can't do tax reform without defining tax reform. Do we close loopholes and use all the revenue from to lower rates? Or do we close loopholes and use only some of the revenue to lower rates (with some of the revenue dedicated to deficit reduction or new programs)? Alternatively, do we shift the paradigm by lowering income tax rates and offsetting the revenue shortfall with a consumption tax or some other source of revenue (e.g., a carbon tax)?
In 1986, political leaders defined tax reform as revenue-neutral loophole closers. Republicans wanted lower rates, and Democrats wanted fewer loopholes. In a sense, the stars were aligned to permit a political consensus. The Code was riddled with loopholes that were exploited by the highest earners, and top marginal tax rates were high. By eliminating loopholes, TRA 1986 increased taxes on the individuals and businesses that exploited the loopholes. The increased tax revenue was used to "pay for" lower tax rates across the board. The result was that "the top 5 percent paid a higher percent of the income tax revenue after tax reform than before tax reform even though the rate dropped from 50 to 28 percent."
Unfortunately, defining tax reform is more difficult today. Today's "loopholes" are tax expenditures that benefit tens of millions of middle-class taxpayers. Top marginal tax rates are lower today than in 1985. Even without the rancorous climate in Washington, it would be heavy lift for political leaders to adopt the 1986 definition of tax reform.
[2] We need a president that is "full square" behind tax reform and a Treasury Secretary with the gravitas to cut a deal.
Bradley recounted President Reagan's commitment to tax reform. Reagan "gave a couple of speeches," but delegated broad authority to former Treasury Secretary James Baker to cut a deal. Reagan "made it acceptable and led the charge." Baker ultimately brokered a tax reform deal with Bradley himself.
If Bradley is correct, we aren't going to see tax reform before 2013 or 2017. Meaningful tax reform is not a priority for President Obama. His priorities range from socialized health care and "spreading the wealth around" to green jobs and hybrid vehicles that will run 120 miles on a gallon of fuel. His Treasury Secretary, Timothy Geithner, is a bookish technocrat who has struggled to tread water due to economic conditions outside his control.
Bradley did not put a grade on Obama's efforts to drive tax reform. He suggests that Obama has been evasive for political reasons ("If the answer is 'we need to close loopholes to raise revenue and we don't touch rates' -- if that's what you mean, then say it.").
[3] Tax reform is too complicated for most people and will never be a "mainstream" issue. But political leaders need to articulate the principles guiding reform.
Bradley explains that the 1986 reforms were motivated by three simple principles. First, equal incomes should pay equal taxes. Second, the income tax should be progressive (those with higher incomes should pay more). Third, the market is more efficient at capital allocation than the Ways and Means Committee.
Team Obama has struggled to articulate clear, simple principles in respect to tax policy. Obama wants to increase taxes on "millionaires and billionaires," but defines millionaires as married working professionals with taxable income of $250,000. The income tax is steeply progressive, with the top 1% of taxpayers contributing 37% of income tax revenues. But he wants to "spread the wealth around" further, without defining what constitutes a "fair share." He has caught the "Buffett Bug," and become obsessed with the effective tax rates paid by the 400 top earning individual taxpayers. He sniffs at Bradley's quaint notion that the market is better at capital allocation than legislators and bureaucrats in Washington.
No wonder that individual Americans are confused and frustrated by the rhetoric around tax reform.
Tuesday, October 18, 2011
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!
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!
Friday, October 7, 2011
Moe Money, Moe Problems
In today's Wall Street Journal, Randy Noonan offers a portrait of an American success story, Moe the Millionaire.
Moe is an insurance salesman with a minority equity interest in his employer, a mid-size insurance business organized as a C corporation for tax purposes. Moe is retirement age (around age 65, having worked in the insurance business for 40 years). His ending salary, including bonus, was $200,000. In the year he retired, Moe tagged along with a sale of the insurance business, selling his minority interest at an $850,000 gain.
Moe's net worth in the year before retirement was:
The year of his retirement, Moe recognized $1,050,000 in total income: $200,000 in salary and bonus; and $850,000 in capital gain from the sale of his interest in the insurance business. Noonan inquires:
A few observations:
[1] Big picture, Noonan is framing the correct issues. The political left believes that we should increase taxes on the "wealthy." The left sometimes defines the "wealthy" as "millionaires and billionaires" (the Buffett view). President Obama takes it further, consistently defining the "wealthy" as married couples earning $250,000 and single individuals earning $200,000 in a year.
I'm unaware of any data that suggests a high proportion of married couples earnings $250,000 (or individuals earning $200,000) are "millionaires and billionaires." I'm sure that Obama would concede that an individual's taxable income during a given year is not a proxy for his or her "wealth." And an individual's "wealth" is not necessarily reflected in his or her taxable income during a given year. I will explore this basic theme in a later post (or posts).
[2] Back to Moe the Millionaire. I believe that Noonan was mistaken in assuming a 25% tax rate on the $850,000 capital gain. President Obama wants to tax a millionaire's entire income at a 30% or higher federal effective tax rate. Tack on another 5% to reflect state income taxes, and the tax leakage on $1,050,000 in income is around $368,000. In other words, Moe would bring home around $683,000 after the payment of taxes on his retirement-year income.
When the dust settles, Moe is still a millionaire, but not by much. His liquid assets of $783,000, if invested conservatively, might yield around $40,000 annually before taxes. Almost everyone on both sides of the political would agree that this is a modest pre-tax income, even if the recipient is a "millionaire" on paper.
From a tax perspective, the main "problem" here is the lack of income averaging. Arguably, Moe should not be penalized for an extraordinary one-time gain. I'm sympathetic to Moe's plight, but I'm hesitant to endorse income averaging because I favor tax reform that will streamline -- not further complicate -- the tax code.
[3] Despite framing the correct issues, Noonan's hypothetical contains a couple of flaws. The first relates to his assumed savings balance upon retirement. Noonan stipulates that Moe earns $200,000 in salary and bonus after 40 years in the insurance business. Let's assume his salary increased no slower than the rate of inflation between year 1 and 40. He purchased a modest home for $95,000 decades ago, and had a $100,000 bank account the year before retirement.
Moe must have suffered from a drug or shopping addiction, because he should have had more than $100,000 in a bank account upon retirement. Noonan stipulates that Moe made "regular but modest" charitable contributions at church (deductible for tax purposes). Moe would have paid taxes at an effective tax rate around 20% (perhaps 25% including state income taxes). During the decade before retirement, with a six-figure income, 20% effective tax rate, "modest" charitable donations and negligible housing costs, Moe's savings account should have increased substantially.
Moe's net wealth is foundational to Noonan's analysis, so Noonan should have been more careful with his assumptions about Moe's spending and savings profile.
[4] Noonan also fumbles with respect to Moe's pension benefits. According to Noonan, the insurance company's defined benefit plan will provide Moe with $75,000 annually. Noonan characterizes $75,000 as "enough to live on but only just."
We know that Moe lives in a relatively affordable community, because his home value in the year of retirement is $450,000. Moe owns his home outright, so has relatively low costs associated with outright home ownership (maintenance and property taxes). He's retired, so he won't have commuting expenses and a number of other expenses associated with life as a working stiff. He's presumably eligible for Medicare and Social Security. All in all, $75,000 in annual pension benefits should provide a comfortable existence for our retired friend.
Morever, the pension benefits reflect a substantial "asset" that we should not disregard in computing Moe's net wealth. However, in fairness, the political left disregards the value of defined benefit pensions when focusing on "income as a proxy of wealth." So I can't be too critical in this instance.
[5] Enough tax for a Friday post. Noonan's portrait of an American success story was almost certainly moe-tivated by a success story from the 1990s. Let's kick it to Notorious B.I.G:
Moe is an insurance salesman with a minority equity interest in his employer, a mid-size insurance business organized as a C corporation for tax purposes. Moe is retirement age (around age 65, having worked in the insurance business for 40 years). His ending salary, including bonus, was $200,000. In the year he retired, Moe tagged along with a sale of the insurance business, selling his minority interest at an $850,000 gain.
Moe's net worth in the year before retirement was:
Cash in bank: $100,000. Investment in business to be sold: $950,000 [cost basis $100,000]. Value of Moe's home: $450,000 [cost basis $95,000]. Total assets: $1,500,000.*
* Noonan posits that Moe would receive $75,000 in annual pension benefits from the insurance company's defined benefit pension plan, but does not include the "value" of the pension benefit in the calculation of Moe's net worth in the year before retirement.
Is Moe the "millionaire" that Obama wants to tax? Is it "fair" that his once-in-a-lifetime capital gain of $850,000 be taxed at top tax-bracket rates? Even assuming that the current 15% capital-gain rate would be raised to only 25% for this one-time millionaire (so that his tax rate would not be less than those "middle class" taxpayers), the tax would still be $212,500, more in tax than Moe ever made in salary and bonus in any one year.
[1] Big picture, Noonan is framing the correct issues. The political left believes that we should increase taxes on the "wealthy." The left sometimes defines the "wealthy" as "millionaires and billionaires" (the Buffett view). President Obama takes it further, consistently defining the "wealthy" as married couples earning $250,000 and single individuals earning $200,000 in a year.
I'm unaware of any data that suggests a high proportion of married couples earnings $250,000 (or individuals earning $200,000) are "millionaires and billionaires." I'm sure that Obama would concede that an individual's taxable income during a given year is not a proxy for his or her "wealth." And an individual's "wealth" is not necessarily reflected in his or her taxable income during a given year. I will explore this basic theme in a later post (or posts).
[2] Back to Moe the Millionaire. I believe that Noonan was mistaken in assuming a 25% tax rate on the $850,000 capital gain. President Obama wants to tax a millionaire's entire income at a 30% or higher federal effective tax rate. Tack on another 5% to reflect state income taxes, and the tax leakage on $1,050,000 in income is around $368,000. In other words, Moe would bring home around $683,000 after the payment of taxes on his retirement-year income.
When the dust settles, Moe is still a millionaire, but not by much. His liquid assets of $783,000, if invested conservatively, might yield around $40,000 annually before taxes. Almost everyone on both sides of the political would agree that this is a modest pre-tax income, even if the recipient is a "millionaire" on paper.
From a tax perspective, the main "problem" here is the lack of income averaging. Arguably, Moe should not be penalized for an extraordinary one-time gain. I'm sympathetic to Moe's plight, but I'm hesitant to endorse income averaging because I favor tax reform that will streamline -- not further complicate -- the tax code.
[3] Despite framing the correct issues, Noonan's hypothetical contains a couple of flaws. The first relates to his assumed savings balance upon retirement. Noonan stipulates that Moe earns $200,000 in salary and bonus after 40 years in the insurance business. Let's assume his salary increased no slower than the rate of inflation between year 1 and 40. He purchased a modest home for $95,000 decades ago, and had a $100,000 bank account the year before retirement.
Moe must have suffered from a drug or shopping addiction, because he should have had more than $100,000 in a bank account upon retirement. Noonan stipulates that Moe made "regular but modest" charitable contributions at church (deductible for tax purposes). Moe would have paid taxes at an effective tax rate around 20% (perhaps 25% including state income taxes). During the decade before retirement, with a six-figure income, 20% effective tax rate, "modest" charitable donations and negligible housing costs, Moe's savings account should have increased substantially.
Moe's net wealth is foundational to Noonan's analysis, so Noonan should have been more careful with his assumptions about Moe's spending and savings profile.
[4] Noonan also fumbles with respect to Moe's pension benefits. According to Noonan, the insurance company's defined benefit plan will provide Moe with $75,000 annually. Noonan characterizes $75,000 as "enough to live on but only just."
We know that Moe lives in a relatively affordable community, because his home value in the year of retirement is $450,000. Moe owns his home outright, so has relatively low costs associated with outright home ownership (maintenance and property taxes). He's retired, so he won't have commuting expenses and a number of other expenses associated with life as a working stiff. He's presumably eligible for Medicare and Social Security. All in all, $75,000 in annual pension benefits should provide a comfortable existence for our retired friend.
Morever, the pension benefits reflect a substantial "asset" that we should not disregard in computing Moe's net wealth. However, in fairness, the political left disregards the value of defined benefit pensions when focusing on "income as a proxy of wealth." So I can't be too critical in this instance.
[5] Enough tax for a Friday post. Noonan's portrait of an American success story was almost certainly moe-tivated by a success story from the 1990s. Let's kick it to Notorious B.I.G:
Monday, October 3, 2011
Are All Taxes Created Equal?
On Friday, I discussed a Citizens for Tax Justice report advocating for the Buffett Rule. I'm officially done wasting time on the Buffett Rule itself. Today I'll discuss a collateral issue raised by the CTJ report.
[1] CTJ argues that any comparison of effective tax rates paid by individuals must include payroll taxes. Some critics of the Buffett Rule have solely focused on income taxes paid by individuals in various tax brackets. I haven't studied the issue in enough detail to draw a firm conclusion. However, the CTJ argument would be considerably weaker if payroll taxes were excluded from the math.
Are payroll taxes equivalent to other income taxes? Where do we draw the line between taxes that should be included in the computation of effective tax rates, and taxes that should not?
Payroll taxes primarily fund Social Security and Medicare payments. Social Security and Medicare are "social insurance" programs. An individual's payments into Social Security and Medicare resemble insurance premiums (albeit mandatory insurance). Most notably, an individual's Social Security benefits during retirement depend on the amount of "premiums" paid during his or her working career. The "premiums" are pooled into trust structures; the trusts "invest" net cash inflows into Treasuries; and the trusts will redeem the Treasuries to cover net cash outflows.
If payroll taxes are (effectively) insurance premiums, then they should be excluded from the effective tax rate computations. The fact that government "collects" the social insurance premiums does not transmute them into the equivalent of income taxes. Ultimately, social insurance results in a direct payment to an individual beneficiary. Social insurance premiums which support direct payments to individuals are not comparable to income tax revenue that fund other government operations. Sure, we all derive some indirect benefit from government expenditures on defense and transportation and agriculture. But there seems to be a qualitative difference between payroll and income taxes that justify excluding the former when computing the effective tax rates paid by different income groups.
Note that Social Security and Medicare may be "insolvent" under current projections, meaning that government receives an "F" for its stewardship of the social insurance programs. We might have solvent programs if we handed the keys over to actuaries and sent the politicians home. However, an insolvent social insurance program is still social insurance.
[2] All that said, the political right generally discusses payroll taxes as if they are income taxes borne by the employee or self-employed individual. They certainly "feel" like taxes to me. If the right presses that argument, then I agree with CTJ that payroll taxes should be included in the effective tax rate computation. Let's compare apples to apples, not apples to oranges.
[3] Some economists theorize that labor bears a portion of -- and perhaps all of -- the corporate income tax. Two interesting observations.
First, under CTJ's methodology, the effective tax rates paid by all taxpayers would increase if we assume that employees bear a portion of the corporate income tax. I'm not sure how the burden would be shared among low-, middle- and high-income employees. Food for academic thought.
Second, if the theory is correct, it dismantles the argument underlying the 15% tax rate for qualified dividends and capital gains. If labor, and not capital, bears the burden of corporate income taxes, then the owners of capital should not receive preferential tax treatment upon a corporation's distribution of previously-taxed earnings. I'll wait patiently for a counter from the Wall Street Journal editorial board.
[4] Back to CTJ's premise that payroll taxes should be included in effective tax rate computations, because they are economically borne by employees (not employers). As discussed above, payroll taxes are equivalent to social insurance premiums. If we include social insurance premiums in the effective tax rate computation, how about other amounts paid by an employer for the benefit of employees?
For example, many employers offer generous health insurance benefits for employees on a pre-tax basis. Absent the tax preference and historical legacy of U.S. health care, employers would increase wage income to employees, and employees would use the increased wages to purchase individual health insurance policies. Like social insurance premiums (payroll taxes), employees bear the economic burden of employer-sponsored health insurance premiums.
Obamacare mandates that all individuals must obtain health insurance or pay a penalty. Should the payment of health insurance premiums be viewed as a "tax" for the same reason that social insurance premiums are viewed as a "tax"? Does the fact that a federally-mandated insurance program is administered privately really matter? Wouldn't that be a triumph of form over substance? If we include health insurance premiums in the effective tax rate computation, middle-class effective tax rates would skyrocket, and effective tax rates for higher-income taxpayers would also increase dramatically. However, the political left might not be enthusiastic to highlight this fact in public debate.
[1] CTJ argues that any comparison of effective tax rates paid by individuals must include payroll taxes. Some critics of the Buffett Rule have solely focused on income taxes paid by individuals in various tax brackets. I haven't studied the issue in enough detail to draw a firm conclusion. However, the CTJ argument would be considerably weaker if payroll taxes were excluded from the math.
Are payroll taxes equivalent to other income taxes? Where do we draw the line between taxes that should be included in the computation of effective tax rates, and taxes that should not?
Payroll taxes primarily fund Social Security and Medicare payments. Social Security and Medicare are "social insurance" programs. An individual's payments into Social Security and Medicare resemble insurance premiums (albeit mandatory insurance). Most notably, an individual's Social Security benefits during retirement depend on the amount of "premiums" paid during his or her working career. The "premiums" are pooled into trust structures; the trusts "invest" net cash inflows into Treasuries; and the trusts will redeem the Treasuries to cover net cash outflows.
If payroll taxes are (effectively) insurance premiums, then they should be excluded from the effective tax rate computations. The fact that government "collects" the social insurance premiums does not transmute them into the equivalent of income taxes. Ultimately, social insurance results in a direct payment to an individual beneficiary. Social insurance premiums which support direct payments to individuals are not comparable to income tax revenue that fund other government operations. Sure, we all derive some indirect benefit from government expenditures on defense and transportation and agriculture. But there seems to be a qualitative difference between payroll and income taxes that justify excluding the former when computing the effective tax rates paid by different income groups.
Note that Social Security and Medicare may be "insolvent" under current projections, meaning that government receives an "F" for its stewardship of the social insurance programs. We might have solvent programs if we handed the keys over to actuaries and sent the politicians home. However, an insolvent social insurance program is still social insurance.
[2] All that said, the political right generally discusses payroll taxes as if they are income taxes borne by the employee or self-employed individual. They certainly "feel" like taxes to me. If the right presses that argument, then I agree with CTJ that payroll taxes should be included in the effective tax rate computation. Let's compare apples to apples, not apples to oranges.
[3] Some economists theorize that labor bears a portion of -- and perhaps all of -- the corporate income tax. Two interesting observations.
First, under CTJ's methodology, the effective tax rates paid by all taxpayers would increase if we assume that employees bear a portion of the corporate income tax. I'm not sure how the burden would be shared among low-, middle- and high-income employees. Food for academic thought.
Second, if the theory is correct, it dismantles the argument underlying the 15% tax rate for qualified dividends and capital gains. If labor, and not capital, bears the burden of corporate income taxes, then the owners of capital should not receive preferential tax treatment upon a corporation's distribution of previously-taxed earnings. I'll wait patiently for a counter from the Wall Street Journal editorial board.
[4] Back to CTJ's premise that payroll taxes should be included in effective tax rate computations, because they are economically borne by employees (not employers). As discussed above, payroll taxes are equivalent to social insurance premiums. If we include social insurance premiums in the effective tax rate computation, how about other amounts paid by an employer for the benefit of employees?
For example, many employers offer generous health insurance benefits for employees on a pre-tax basis. Absent the tax preference and historical legacy of U.S. health care, employers would increase wage income to employees, and employees would use the increased wages to purchase individual health insurance policies. Like social insurance premiums (payroll taxes), employees bear the economic burden of employer-sponsored health insurance premiums.
Obamacare mandates that all individuals must obtain health insurance or pay a penalty. Should the payment of health insurance premiums be viewed as a "tax" for the same reason that social insurance premiums are viewed as a "tax"? Does the fact that a federally-mandated insurance program is administered privately really matter? Wouldn't that be a triumph of form over substance? If we include health insurance premiums in the effective tax rate computation, middle-class effective tax rates would skyrocket, and effective tax rates for higher-income taxpayers would also increase dramatically. However, the political left might not be enthusiastic to highlight this fact in public debate.
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