“The only difference between death and taxes is that death doesn’t get worse every time Congress meets.”
Doing Our Taxes • Paying for Government • Taxing Personal Income • The Personal Income Tax • The Payroll Tax: Paying for Social Security and Medicare • The Corporate Income Tax • Excise Taxes: Taxing Use, Sin, & Luxury • The Estate and Gift Tax: Death & Taxes • The Task Ahead
print this pageDOING OUR TAXES
Each spring, Americans endure the rite of doing our taxes. Grudgingly, we accept that taxes are required to provide for the public services that keep society functioning, even if we are loathe to admit it. Unfortunately, the negativity around taxes that pervades the American psyche leads many to resist or even despise an institution that has a profound, if misunderstood, effect on our lives.
Although taxes are paid at the federal, state, and local levels, for most taxpayers, federal taxes account for the bulk of the taxes they pay. For ordinary taxpayers who are ready to protect their own interests, learning the basics of federal taxation is a good starting point. Even if you are fortunate to have the means to shift the heavy lifting to a lawyer or an accountant, you still stand a better chance at coming out on top if you understand how taxation works.
Having a working knowledge of the tax system should be regarded as a life skill, as important as finding the best deals on cars, vacations, and home mortgages. As with buying consumer goods, uninformed taxpayers often end up paying more than well-informed taxpayers. Regardless of what a buyer is purchasing, anyone seeking to negotiate a better deal must start by knowing the price of what they are buying. Hardly any taxpayers have the slightest inkling of the price tag of their government.
For a glimpse into the cost of government per person, consider the fiscal year ending in 2014 (FY 2014), in which the federal budget showed spending of $3.5 trillion, federal tax receipts of $3.021 trillion, and a budget deficit of $.485 trillion. During this year, each of the 320 million Americans on average benefitted from approximately $10,956 worth of government spending on everything from Medicare to the military. However, on average, each American only paid approximately $9,440 in taxes in exchange for the government’s services. Today’s Americans are free-riding at the expense of tomorrow’s Americans.
In an ideal world, the government would only spend on things in the national interest and tax only in ways that do not retard economic growth or treat taxpayers unfairly, but history shows that this ideal exists only in our imaginations. In the real world, people want to get as much from the government as they can get, while at the same time, wanting to avoid being taxed to pay for it. For current taxpayers, paying only 86 cents for each dollar of government spending beats paying the whole dollar, as paying the whole dollar would require a 16% increase in tax revenues. So, who pays the difference, and how does the current distribution of the tax burden affect you? This book was written to answer those questions.
As things stand now, politicians—influenced by lobbyists and special interest—divvy up the tax burden and decide what taxes Americans will pay when each new session of Congress meets. Lawmaking is too elegant a term to describe the divvying process. It should be likened more to a game: the tax game. Like other games, the tax game produces winners and losers with each round it is played. Winning or losing the tax game has nothing to do with fairness, and everything to do with knowing how to play it. The politicians and those who influence them are the players, and who wins the tax game determines who pays what in taxes.
Even though the odds clearly favor the politically powerful and wealthy taxpayers who can afford to hire influencers, ordinary taxpayers hold a trump card: we still live in a democracy and ordinary taxpayers greatly outnumber the rich ones. Taxpayers that fail to learn about tax policy and how to protect their interests will continue to pay a larger percentage of their income on taxes than those who know how to work the system.
PAYING FOR GOVERNMENT
Since at least the 1930s, taxes on income—the personal income tax, the payroll tax that pays for Social Security and much of Medicare, and the corporate income tax—have been the mainstay of paying for the costs of government.
The personal income tax applies to (1) all individuals, regardless of citizenship, age, or status, who earn income in America, and (2) all individual American citizens, regardless of age or status, who earn income anywhere.
The payroll tax applies to (1) all individuals, regardless of citizenship, age, or status, who earn wage income in America, (2) all individual American citizens, regardless of age or status, who earn wage income anywhere, and (3) all individuals and businesses who pay wages to employees.
The corporate income tax applies to (1) all corporations who earn income in America, and (2) all American corporations who earn income anywhere.
In addition to income taxes, two other categories of taxes pay for the remainder of the cost of government: excise taxes and other miscellaneous taxes.
Excise taxes apply to the sale of goods and services by American businesses anywhere and foreign businesses who sell goods and services in America.
Other taxes include the estate and gift tax which taxes the estates of all Americans and a grab bag of other miscellaneous taxes.
As Table V-1 shows, two taxes—the personal income tax and the payroll tax–account for about 80% of total revenues. For at least the last 30 years or so, there has been little change in the relative percentages (as shown in Table V-1) of the mix of taxes that pay for the cost of government.
TAXING PERSONAL INCOME
After World War I, America switched from using regressive consumption taxes to pay for most of government, to using progressive taxes on personal income. Progressive taxation means taxing those with less income less, and taxing those with more income more. In the tax game, low-income taxpayers have an interest in increasing the progressivity of taxes, and high-income taxpayers have an interest in decreasing it. This conflict—whether taxes should be made more or less progressive—defines most of what the tax game is all about.
Two factors determine the progressivity of income taxes—the tax rate structure and tax preferences. A tax rate structure with graduated tax rates—in which marginal tax rates rise at least as fast as income increases the progressivity of taxes, and conversely, any tax rate structure in which marginal tax rates rise slower than income rises—decreases progreassivity. Tax preferences result from special political deals in which certain types of income and expenditures get preferred treatment under the tax laws. Tax preferences enable certain preferred types of (a) income to be either excluded from taxation or taxed at reduced tax rates and (b) expenditures to be either deducted from or credited against taxes. Most types of income and expenditures that get special political treatment are attributable primarily to high-income taxpayers. Taken as a whole, tax preferences greatly reduce the progressivity of taxes.
Progressive taxation requires striking a balance between how much those with low income and those with high income should pay and doing it in a way that maximizes economic growth. Economic growth means more money for both consumption and investment—the types of expenditures that drive the economy and set the standard of living for most Americans. The economic fate of America’s middle class depends on taxing in a way that both strikes the right balance in progressivity and simultaneously maximizes growth.
The Parameters of Progressivity
Taxing those with high income at higher rates than those with low-income leaves open the question of just how much more: progressivity without parameters offers little guidance for taxing. Two principles bracket how much those at the low end and the high end of the income scale should be taxed:
- No taxpayer who works full time should be taxed into or near poverty; and
- No taxpayer should be taxed so much that they have no reasonable incentive to earn the next dollar either through their own labor or through the investment of their capital.
Taxing full-time, low-wage workers at a level that draws them close to (or deeper into) poverty discourages them from working and invites both social and political unrest. If poverty is x, then how much after-tax income above x—10%, 15%, 20%, 25%, or higher—should a full-time worker be allowed to keep? This question gets answered in the tax game by politicians, not non-partisan tax experts. The less after-tax income those with low-income can keep, the more after-tax income those with high-income can keep.
Taxing high-income taxpayers’ income at a level so high that it unreasonably discourages them from working or investing to make the next dollar results in slowing economic growth and also invites social and political unrest. At what level of taxation—30%, 35%, 40%, 45% or higher—would a taxpayer with $1 million or more income be unreasonably deterred from working or investing to make the next dollar? This question also gets answered in the tax game by politicians, not non-partisan tax experts. The less after-tax income those with high-income can keep, the more after-tax income those with low-income can keep.
Once these outer parameters are set, the politicians who preside over the tax game still must answer thousands of questions about who pays what, like the following examples:
- What rate should a family of four with an income of $90 thousand pay versus what rate a single 23-year old taxpayer with an income of $25 thousand pay?
- Should ordinary workers who have had no real wage increase in years get a break on their rates versus highly educated professionals who are on the fast track to success?
- Should the old get a tax break simply because they are old?
- Should homeowners get a tax break at the cost of increasing taxes on renters?
- Should a single mother of three who works full time and earns a poverty wage pay any taxes?
- If Tom Brady’s taxes are increased by 5 percentage points would his game suffer because of a lack of financial incentive due to paying more taxes?
- Should high-income entertainers pay more so that ordinary workers can pay less?
- Should a billionaire’s wastrel kid pay tax on the money he or she inherits?
- Should those who want to give to charity get a tax break paid for by those who do not want to give?
- Should those who get their income from their own labor pay more in taxes so that those who get their income from investing and saving can pay less?
- Should successful stock speculators get a tax break for successful speculation?
- Would a billionaire be less likely to invest his money if his effective tax rate increased from 22% to 42%?
Many of these questions go far beyond how much money a taxpayer makes and get into social matters like marriage and size of families, personal spending choices, and whether a taxpayer earns his money by the sweat of his brow or by investing his or someone else’s capital.
At any point in time, the cost of government is a fixed amount set by law based on duly authorized appropriations and other legal commitments made by Congress and the President. Like it or not, the taxpayers are legally bound to pay for all cost that the government has legally incurred. Taxing, therefore, becomes a zero-sum game in that, if one taxpayer gets a break, some other current or future taxpayer must make up the difference. So, how the politicians answer these questions determines what each taxpayer’s after-tax income will be and whether tax policy will help or hinder economic growth.
Progressivity and Types of Taxable Income
Of the two taxes on personal income, the personal income tax (despite the proliferation of tax preferences) is much more progressive than the payroll tax.
Unlike the payroll tax, which taxes only wage income from the first dollar earned, the personal income tax taxes many more (though not all) types of income and does not tax the first dollar earned. By taxing only wage income, the payroll tax hits those with low income (who depend on wages for all, or almost all, their income) much harder than those with high income (who oftentimes derive much of their income from non-wage sources). As shown on Table V-2, the percentage of non-wage income relative to wage income increases dramatically as taxpayers’ income increases.
Table V-2 shows that for those with incomes over $1 million less than one half of their income is subject to the payroll tax, and, as their income increases, their percentages of income subject to the payroll tax falls. Also, Table V-2 shows that for those with incomes under $100,000 more than three-fourths of their income are subject to the payroll tax, and, as their income falls, their percentages of income subject to the payroll tax rises. If you are a high-income taxpayer, you like a tax that does not tax a big chunk of your income, but, if you are a low-income taxpayer, you do not like getting stuck with a bigger tax bill to make up for other taxpayers’ income that was not taxed.
Progressivity and Income Tax Rates
The personal income tax is more progressive than the payroll tax because it has a progressive rate structure, as shown in Tables V-3, V-4, and V-5, while the payroll tax has a flat-rate structure, as shown in Table V-6. As an integral part of the rate structure, the personal income tax allows a “standard deduction” and “personal exemptions,” each of which is deducted from the income to be taxed. In 2017, a change in the personal income tax eliminated the personal exemption by adjusting the standard deduction to reflect the number of dependents in a household.
Table V-3Form of Tax Rate Schedule |
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| Source: IRS |
Table V-3 shows that personal income tax rates for all categories of taxpayers—single, head of a household, married filing jointly or qualified widower, or married filing separately—increase as income rises and can easily be made more progressive by increasing rates on those with relatively more income and/or decreasing rates on those with relatively less income. Tax rates change each year, and in 2017 were revised to cut marginal rates.
The standard deduction, as shown in Table V-4, is available to all taxpayers who choose not to itemize their deductions. Within each category of taxpayers who chose the standard deduction, all are treated the same without any taxpayer being favored over any other. The standard deduction is changed each year to reflect inflation.
Table V-4Standard Amounts |
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| Source: IRS |
The personal income tax also can easily be made more progressive by increasing the standard deduction for taxpayers in one or more of the categories.
Personal exemptions, as shown in Table V-5, are available to all taxpayers except for those with very high income. Personal exemptions were eliminated in 2017, and the standard deduction was increased to reflect the number of dependents in each household.
Table V-5Personal Exemptions |
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| Source: IRS |
Unlike the personal income tax which has higher rates for those with higher income, the payroll tax has only a single 7.65% rate for employees on their wage income and a single 15.65% rate for the self-employed on their net business income, as shown on Table V-6.
Table V-6Payroll Tax Rate and Maximum Taxable Earnings. |
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| Source: Social Security |
In addition to the rates and caps shown in Table V-6, in 2013, the payroll tax was increased by .09% on all wage income above $200,000 for individuals and above $250,000 for married couples. Also, there is no cap on the amount of income that can be taxed under the personal income tax, but there is a $118,500 cap on the amount of wage income that can be taxed under the Social Security portion of the payroll tax. Each year the cap is increased to reflect inflation. Caps on the amount of income that can be taxed favor high-income taxpayers and make a tax less progressive.
For taxpayers who are employed, their employer pays a separate employer payroll tax equal to the employee tax. Even though employers pay a payroll tax for their employees, there is a broad consensus among tax experts that it is the employees who bear the burden of the tax in that the tax reduces the compensation that the employees would have received but for the tax.
Taxing only a capped amount of wage income from the first dollar earned at a single rate makes the payroll tax much less progressive than the personal income tax.
Progressivity of the Personal Income Tax vs. the Payroll Tax
Comparing how much a middle-income taxpayer pays under the personal income tax, and payroll tax with how much a high-income taxpayer pays under those taxes proves that the personal income tax is many times more progressive than the payroll tax.
A self-employed, married taxpayer with two minor children, whose total net self-employed income was $60,000, who qualified for a $28,600 standard deduction would have had taxable income of $31,400 ($60,000 – $28,600) and would have owed $3,787.50 in personal income tax in 2015. This same taxpayer would have owed $9,180 in payroll taxes. To most middle-income taxpayers, the personal income tax is small potatoes compared with the payroll tax.
A self-employed, married taxpayer with two minor children, whose total net self-employed income was $2,500,000 and whose non-wage income was $7,500,000, and who qualified for a $12,600 standard deduction would have had taxable income of $9,987,400 ($10,000,000 – $12,600) and would have owed $3,900,926.30 in personal income tax in 2015. This same taxpayer would have owed $72,905 of payroll taxes.
The middle-income taxpayer’s payroll tax was 15.65% of his income, and his personal income tax was only 6.3% of his income, while the high-income taxpayer’s payroll taxes were only .07% of his income, and his personal income tax was 39% of his income. To middle and low-income taxpayers, their payroll taxes are the primary taxes they pay, while to very high-income taxpayers, they are only a little more than an afterthought.
Progressivity and Tax Preferences
Tax preferences are the hundreds of special deals that the politicians stick in the tax code to do favors for politically preferred groups. Three government agencies, the OMB, and three in Congress (the JCT, the CBO, and the GAO), all track and report on the effects of tax preferences (also called “tax expenditures” by the tax professionals) on taxation, the budget, and the economy. The effects of tax preferences on taxes and the budget are tremendous. The CBO in its Budget Outlook for 2016-2026 estimated that “the more than 200 tax expenditures [tax preferences][…]will total almost $1.5 trillion in fiscal year 2016[…][which][…]equals nearly half of all federal revenues projected for 2016 and exceeds projected spending on Social Security, defense, or Medicare.”
Tax preferences fall into four distinct categories, as follows:
- first, “income exclusions” that exclude certain politically favored types of income, such as employer contributions to employee health care and health care and long-term care insurance premiums, contributions to and earnings on pension funds, and the interest on certain types of municipal bonds from being taxed;
- second, “itemized deductions” that enable some taxpayers to deduct from their income subject to being taxed a percentage of various types of politically favored personal expenditures, such as home mortgage interest, state and local taxes, and charitable contributions;
- third, “preferred rates” that enable some high-income taxpayers to pay low rates on certain types of politically favored income, such as long-term capital gains and qualified dividends; and
- fourth, “tax credits” in two forms: (1) “non-refundable tax credits” that enable some taxpayers to credit against their taxes up to 100% of their tax liability for certain types of politically favored types of personal expenditures, such as renewable energy projects, miscellaneous housing expenditures, qualifying tuition expenses, and many others; and (2) “refundable tax credits” that enable some taxpayers to be refunded more than 100% of their tax liability to supplement their income through credits such as the earned income credit (aka EIC, earned income tax credit) and the child credit, and health insurance credits.
Almost all tax preferences other than refundable credits make the personal income tax less progressive in that they benefit those with higher income more than those with lower income.
The JCT’s analysis of tax expenditures shows that each tax preference is a story in terms of who it helps, its effect on the economy, and its cost to other taxpayers who must pay higher taxes to make up for the revenue loss. Each year OMB, on behalf of the executive branch, prepares a federal budget and details the cost of tax preferences over a 10-year period, and shows their effect on the overall budget. Any politician who claims that they do not know what the effects of tax preferences are is admitting to laziness because all they need do is read the reports of OMB, JCT, and CBO.
THE PERSONAL INCOME TAX
As the personal income tax has become cluttered with tax preferences, it has become so complex only very few tax professionals can understand it, and as the clutter continues, so too does complexity.
Form 1040, the Starting Point
Form 1040 (see figure 1), the form on which almost all individual taxpayers report their income and pay their income taxes, illustrates the complexity.
| Figure 1
IRS Form 1040 – 2015 |
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Although form 1040 is only 2 pages, it is supplemented by numerous schedules and worksheets that add many, many pages for most taxpayers. Underlying form 1040 are many hundreds of pages of instructions, which in turn are distilled from many more hundreds of pages of laws and regulations. Even for individual taxpayers with the simplest taxes who have only wage income and claim the standard deduction, most will still need professional help to complete form 1040, and for those taxpayers with substantial income from sources other than wages, almost all will need very sophisticated tax accountants and lawyers to complete it.
Frequent changes are made to the tax laws which require updating the tax forms periodically. For most wage-earning taxpayers, changes in the tax forms are not significant, but for high-income taxpayers with significant non-wage income, changes in the tax forms are often quite significant and complex. Most wage-earning taxpayers can either complete their tax returns themselves or hire a non-professional tax preparer to do it, but almost all high-income taxpayers who have signficant non-wage income must hire highly paid tax professionals to prepare their tax returns.
Completing Form 1040: A Mind-Bending Ordeal
For all but a very few taxpayers, filling out form 1040 is a mind-bending ordeal.
Step 1 is to fill out the taxpayer contact and demographic data on lines 1-6, which is the simplest part of the process.
Step 2 is to report all income, as shown on lines 7-22, to come up with the taxpayers “total income,” which includes, among other things, compensation for services, such as wages, salaries, commissions, and fees, all income derived from business, gains from dealings in property (real, tangible, and intangible), interest, rents, royalties, dividends, alimony, pensions, and annuities. Tax preferences, however, exclude certain categories of income—income exclusions—from being included in total income, among which are the proceeds of life insurance paid to a beneficiary as a result of the death of the person who took out the policy, the proceeds of most inheritances or gifts, the interest on tax-exempt municipal bonds, employer-paid premiums for health insurance, contributions to employer-sponsored cafeteria health care plans, and the amount paid as benefits on health insurance.
Although all income is made up of fungible dollars, form 1040 breaks it down into 16 separate categories, one of which is a catchall, “other income.” For wealthy taxpayers, two lines, 9b and 13, are especially important because it is on these lines that “qualified dividends” and long term “capital gains” are reported. To qualify as a long-term capital gain, an investment must be held for more than one year, and to qualify as a qualified dividend, the corporate stock on which the dividend is paid also must be held for more than one year. Qualified dividends and capital gains are the subject of two leading tax preferences, both of which confer almost all their benefits on very high-income taxpayers, as shown on Table V-7.
Contrasted with all other forms of income, rates applicable to capital gains and qualified dividends—preferred rates—are capped at a maximum rate of 20%. From time to time capital gains are raised or lowered. These tax preferences add great complexity to the personal income tax, take up hundreds of pages of laws and regulations, and enable those with the greatest wealth to pay lower rates on qualified dividends and capital gains, aka “unearned income,” than many wage earners pay on wage income, aka “earned income.”
Each category of income that gets special treatment is the subject of a tax preference. If there were no tax preferences, there would be only one line for total income.
Step 3 is to specify all special deductions on lines 23-36, known by tax professionals as “above-the-line-deductions,” which are deductible by all taxpayers. “Adjusted gross income,” as shown on line 37, is total income less the sum of above-the-line-deductions. Above-the-line-deductions are so named because tax professionals draw a line at adjusted gross income in that all deductions on lines above line 37 apply to all taxpayers while all deductions below line 37 apply only to those who itemize their deductions.
Just as with income exclusions, each above-the-line-deduction gets special treatment because it is the subject of a tax preference. If there were no tax preferences, lines 23-37 would not be needed, and total income and adjusted gross income would be the same.
Step 4 is to determine the larger of “itemized deductions,” or the standard deduction, and to do that, taxpayers must fill out schedule A (see Figure 2) to form 1040.
| Figure 2 – IRS Form Schedule A, Itemized Deductions 2015 |
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Itemized deductions are also known as below-the-line-deductions because they appear on line 40 below adjusted gross income on line 37. Leading itemized deductions include, among others, interest paid on home mortgages, certain medical and dental expenses, charitable contributions, state and local taxes, certain unreimbursed job expenses, and a mishmash of miscellaneous deductions. As a taxpayer’s income goes up, the value of itemized deductions is curtailed. Each itemized deduction is the subject of a tax preference. If there were no tax preferences, there would be no need for schedule A, and all taxpayers would take the standard deduction.
Step 5 is to take the larger of the standard deduction or itemized deductions, enter it on line 40, and deduct the sum on line 40 from adjusted gross income on line 38. Just as the tax preferences for qualified dividends and capital gains favor high-income taxpayers, so too do the tax preferences that relate to itemized deductions. Table V-8 shows by income group just how much more high-income taxpayers got out of itemized deductions than low-income taxpayers.
Table V-8 shows the following:
- only about 30% of all taxpayers benefit from itemized deductions,
- as taxpayers adjusted gross income rises, so too does their itemization,
- on average, most taxpayers whose adjusted gross income is less than $100,000, do not get much more out of itemized deductions than they would from the standard deduction,
- on average, middle to high-income taxpayers (i.e. married taxpayers filing jointly whose adjusted gross income is $75,000 to $100,000) get an itemized deduction worth 1.67 times more than their standard deduction, and
- on average very high-income taxpayers (i.e. married taxpayers filing jointly whose adjusted gross income is $10 million or more) get an itemized deduction worth 384 times more than from the standard deduction.
Itemized deductions add hundreds of pages to tax laws and regulations, tremendous complexity to taxpaying, do not do much for most middle-income taxpayers, and do a huge favor for very high-income taxpayers.
Step 6 is to list the number of personal exemptions for which the taxpayer qualifies.
Step 7 is to deduct the amount on line 42, the sum of personal exemptions, from the amount on line 41, the net of adjusted gross income less total deductions, to come up with the taxpayer’s “taxable income.”
Step 8 is to complete line 44, which opens a whole new world of complexity. Line 44 refers taxpayers to a page of detailed instructions referencing forms 8814, (relating to a child’s interest or dividends), 4972 (relating to lump sum distributions), tax due to a section 962 election, form 8863 (relating to recapture of an education credit), form 8621 (relating to a section 1291 fund), form 8615 (relating to tax tables), the Foreign Earned Income Tax Worksheet, and the Qualified Dividends and Capital Gain Tax Worksheet. After reading these instructions, most taxpayers will turn to a tax professional to tell them “what the hell it all means.”
Assuming a taxpayer (by hook or crook) figures out what these instructions mean, then he or she enters their tax on line 44 and girds up for the next step.
Step 9 is to complete line 45 relating to any tax due under the alternative minimum tax (the AMT), which applies only to certain high-income taxpayers. The AMT is a story in and of itself, more of which will be told later. Meanwhile, a brief perusal of the instructions for form 6251 shows how difficult it is to figure out how much AMT to pay for those high-income taxpayers who are fortunate to make enough money to have the privilege of paying it.
Step 10 is to complete lines 46-56 to report a few miscellaneous credits, each of which requires the completion of yet more forms, to determine if the taxpayer qualifies for each credit, and if so, how much the credit is.
Step 11 is to pay any additional taxes on lines 57-62 that may apply to some taxpayers such as the self-employment tax, unreported Social Security and Medicare taxes, additional tax on IRAs, the household employment tax (aka the “nanny tax”), and other miscellaneous taxes. Each of these taxes has its own form and set of instructions.
Step 12 is to complete line 63, which carries the promising (but somewhat misleading) label “total tax.” Recapping, total tax is the sum of tax (on line 44), the AMT (on line 45), and an odd lot tax credit (on line 46) less applicable credits (on lines 48-54) plus the sum of other miscellaneous taxes (on lines 57-62). Even after coming up with total tax, there is still more to do.
Step 13 is to complete lines 64-74, which relate to administrative matters, including withholding and estimated payments (on lines 64-65), a few additional miscellaneous credits (on lines 69 and 72-73), and most importantly, several very important refundable credits targeted to benefit low-income taxpayers. These targeted refundable credits, more of which will be told later, include the EIC, the additional child credit, and the American opportunity credit (which aids low-income students to pay the cost of higher education). While the EIC is targeted to help those with low income, those with low income must first be able to read the instructions to see if they qualify. Line 74 is the total of all credits to which the taxpayer is entitled.
Step 14 is to complete line 75 by totaling up the amounts withheld or paid as estimated payments along with the credits (on lines 66a-73) to determine how much the taxpayer owes the IRS or how much the IRS owes the taxpayer. With the completion of line 75 the taxpayer completes the ordeal of figuring their taxes and is left with filling out the administrative details below line 75.
Although it is difficult to imagine, form 1040 is about as simple as it can be given the proliferation of tax preferences. If there were no tax preferences, form 1040 would still be about two pages, but it would have about half as many lines, very few if any schedules and worksheets, and accompanying instructions that could be understood by average taxpayers.
How the Normal Tax Became Abnormal
According to government tax professionals (most notably the JCT) the personal income tax is in reality two separate taxes—the “normal tax” and (for lack of a better term to describe the other tax) the “abnormal tax.” Under the normal tax, taxpayers get no special favors, while under the abnormal tax, those taxpayers who can qualify, get the benefit of the many special favors conferred by tax preferences.
Congress has defined tax expenditures (tax preferences) as “revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” Congress has gone on to point out that “Tax Expenditures include any reductions in income tax liabilities that result from special tax provisions or regulations that provide tax benefits to particular taxpayers. Special income tax provisions are referred to as Tax Expenditures because they may be considered to be analogous to direct outlay programs, and the two can be considered as alternative means of accomplishing similar budget alternatives.”
Simply put, this means that Congress recognizes that reducing the amount of tax owed by a taxpayer because of a tax preference is the same as if an appropriation were made for the benefit of that taxpayer in the same amount as the tax reduction attributable to the tax preference.
Every time a group successfully lobbies Congress to create a new tax preference, the beneficiaries of the tax preference and the successful lobbying group wins, but everyone else loses. If the politicians wanted to cut taxes for everyone, as opposed to various politically favored groups, they could easily do so by lowering tax rates, increasing the standard deduction, and/or increasing the personal exemption—actions that would apply to all taxpayers.
In the tax experts’ view, it should be the “normal” practice to take the standard deduction and personal exemption, and an abnormal practice to benefit from tax preferences, regardless of whether they take the form of income exclusions, itemized deductions, tax credits, and/or preferred rates. So, under the normal tax, there would be no tax preferences, but, under the abnormal tax, tax preferences would be available for those taxpayers who can successfully lobby Congress to get them.
The following examples compare the taxes paid by two typical families:
The Normal Tax Example
Consider a middle-class family, the Smiths, which includes John and Mary, in their late 30s, with two children, Mike, 7, and Jane, 6. John is employed at a local fast-food restaurant as a day manager and earns $24,000 a year as a full-time employee. Mary is employed at a local flower shop and earns $20,000 a year as a full-time employee. Additionally, John moonlights at Home Depot and earns $6,000 a year as a part-time employee. The Smiths do not have health insurance because neither employer offers it. John and Mary own a house worth $105,000 with a home mortgage in the amount of $100,000. The annual property tax on the Smith home is $2,000 and the annual amount of mortgage interest is $4,900. Although Mary and John scraped together $850 to contribute to John’s IRA, they have had to spend it, and a bunch more, on medical expenses for Mike’s chronic asthma condition.
On these facts, it is easy to see what tax preferences do for the Smith family, as shown on Table V-9.
In the case of the Smiths, a typical middle-class family, tax preferences did nothing for them because their standard deduction was larger than their itemized deductions. For the Smiths, as a middle-class family, the normal tax works just fine.
The Abnormal Tax Example
Consider the Jones family, which includes Robert and Jane, in their late 30s, with two children, Bobby, 7, and Amy, 6. Robert is employed by an investment-banking firm as a vice president and earns $140,000 a year as a full-time employee. Jane is employed as a schoolteacher and earns $30,000 a year as a full-time employee. Robert invested $30,000 of his non-retirement savings in a municipal bond fund and earned $1,800 in tax-exempt interest. The Jones family has employer-paid health insurance through Robert’s employer whose value is $15,000 annually. Robert and Jane own a house worth $400,000 with a home mortgage in the amount of $320,000. The annual property tax on the Jones’ home is $8,000 and the annual amount of mortgage interest is $17,000. Robert contributed $15,000 to an employer-sponsored 401(k) retirement plan.
On these facts, it is easy to see what tax preferences do for the Jones family, as shown on Table V-10.
The Jones family took full advantage of all available tax preferences, and it worked out just fine.
However, had the Jones family taken the standard deduction as the Smith family did, its taxable income would have been $158,200, or $44,200 more than if it did not benefit from any tax preference, as shown on Table V-11.
Taking advantage of tax preferences enabled the Jones family to cut what its taxes would have been under the normal tax from $31,348 to $20,088, resulting in a savings of $11,260. This tax savings for the Jones family would be fine but for the need to make up the $11,260 in lost revenue from some other taxpayer.
Lesson: Most tax preferences do nothing for a $50,000 a year income family like the Smiths but do a lot for a $186,000 a year income family like the Joneses.
Why Most Tax Preferences Benefit High-Income Taxpayers
A pristine personal income tax base would include (1) all income in all forms being counted, (2) no personal expenses being deducted from income, (3) all income in whatever form being taxed at the same tax rate applicable to each tax bracket, and (4) no tax offset especially benefitting any particular group of taxpayers—in short, the “normal tax.” The personal income tax base, unfortunately, has become infected with an ever-growing list of viral tax preferences each of which benefits some politically favored group.
For those who like life simple, who do not like having the government tell them how to spend their money, and who do not like paying tax preparers, ending tax preferences would be welcome. But for most high-income taxpayers and others who have had their lifestyles blessed by the politicians in the form of beneficent tax preferences, cutting back on tax preferences would be unwelcome. For the most part, however, taxpayer ignorance and apathy, particularly among the least well-off, can be counted on to continue the practice of more rather than fewer tax preferences.
Table V-12 shows how much taxpayers in each tax bracket save in personal income taxes for each $1,000 of itemized deductions more than the standard deduction and how much more (in percentage terms) taxpayers in the higher brackets saved than taxpayers in lower brackets.
Table V-12 shows that the politicians have decided that the best-off taxpayers should save up to $396 in personal income taxes for each $1,000 of income exclusions and itemized deductions for which they qualify while the worst-off taxpayers should save only $100 in personal income taxes for each $1,000 in itemized deductions and income exclusions for which they qualify.
Putting the best spin on why the politicians create tax preferences—i.e. to promote taxpayer ownership of housing, expand the availability of health insurance, and encourage charitable donations—the politicians have decided that the better-off taxpayers should be rewarded a lot more for having tax preferences than the less well-off.
Tax Credits Targeted to Help those with Less Income
On very rare occasions, the politicians who control the tax game do something for those with low income, and so it is with the creation of a few tax credits. Breaking with tradition, the politicians (primarily the left, but more than a few of the right) granted tax preferences in the form of refundable tax credits for the working poor, most notably the EIC and the child tax credit, and a number of non-refundable tax credits for those who provide child and dependent care, for the disabled elderly, for those who adopt, and for certain educational purposes.
With few exceptions, tax credits targeted for those with low income are intended to benefit only those who are needy and unable to fend for themselves in today’s economy. These types of tax credits should be considered to be a part of the social safety net. Although most tax credits targeted for those with low income are intended to help the needy, there are many esoteric ones that are designed to encourage the purchase of things that the politicians deem socially useful such as hybrid vehicles, solar power devices, and other environmentally friendly products. Tax credits intended to influence a taxpayer’s purchasing decisions underscore the belief of many politicians that they know better than the taxpayer how the taxpayer should spend his or her money.
Since income exclusions and/or itemized deductions only reduce a taxpayer’s taxable income, tax credits are more valuable to a taxpayer, particularly refundable tax credits.
Tax credits have the tax effects as follows:
- A taxpayer who qualifies for a nonrefundable tax credit of $3,000 and whose taxes owed on taxable income is $2,000 will owe no tax.
- A taxpayer who qualifies for a refundable tax credit of $3,000 whose taxes owed on taxable income is $2,000 will be entitled to a $1,000 refund from the government.
- A taxpayer whose taxable income is reduced by $3,000 because of his income exclusions and itemized deductions will have his taxes reduced by as little as $400 if he is a low-income taxpayer whose marginal tax rate is 10% and by as much as $1,400 if he is a high-income taxpayer whose marginal tax rate is 35%.
Targeting
Spending public money on taxpayers who can take care of themselves and have no special needs both wastes scarce resources and makes it more difficult to help those who are in need. To avoid waste, most tax credits (especially refundable tax credits) are targeted in an effort to identify those taxpayers who are most in need. Targeting, however, comes at a cost. The more numerous and precise the conditions are for a taxpayer to qualify for a tax credit, the more complex the tax laws become. Complexity is the friend of the sophisticated, and the enemy of the unsophisticated. Most taxpayers who qualify for refundable tax credits are unsophisticated and need the help of tax advisors to qualify. Unfortunately, it is likely that many unsophisticated taxpayers who do not bother to try to qualify for refundable tax credits could qualify if they knew how to go about it.
Targeting begets an anomaly in that refundable tax credits are too complicated for the taxpayers for whom they are intended to help. But, if the qualifications for refundable tax credits were streamlined, the streamlining might result in some taxpayers who either had too much income or did not have sufficiently serious needs to warrant receiving a grant from the government jumping on board the gravy train. But if most taxpayers view refundable tax credits as a gravy train for the undeserving, it is likely they will die a quick political death. So, refundable tax credits must be complex, and someone must help qualifying taxpayers claim their due.
The Inspiration for Refundable Tax Credits
In 1962, Milton Friedman, the most prominent of all American economists of the right, proposed a negative income tax in his book, Capitalism and Freedom. Since governmental welfare programs, laden with bureaucracy and notoriously ineffective, were anathema to Friedman, he proposed replacing welfare by using a negative income tax to provide an economic safety net for the working poor. Friedman urged, with respect to those among the working poor who did not earn enough to meet certain income thresholds, that the government should pay them an amount that would enable them to have a decent standard of living.
The mechanics of Friedman’s plan were simple. Since everyone who works and earns any income (even if not enough to have to pay taxes) is required to file a personal income tax return, the tax system could be used to pay the working poor the difference between what they earned and the threshold. As an example, if the threshold for positive tax liability for a family of four was $10,000, a family with only $8,000 of annual income would, given a negative tax rate of 25 percent, receive a check from the government worth $500 (25% of the $2,000 difference between its $8,000 income and the $10,000 threshold). A family with zero income would receive $2,500. As with the personal income tax, the politicians would set the thresholds and the rates for the negative income tax.
Although the EIC and the child tax credit are pale imitations of the negative income tax, they are a step forward toward enabling certain of the working poor to have a decent standard of living. The EIC and the child tax credit are not predicated on replacing in-kind welfare programs but on encouraging the poor to work. Under the EIC, a taxpayer whose income falls below certain thresholds is given a refundable tax credit in the form of a cash payment, and under the child tax credit, a taxpayer with children is given a refundable tax credit of $1,000 per child, which phases out as the taxpayer’s income reaches certain thresholds. The income thresholds vary depending on the size of the taxpayer’s family.
In 2014, married couples with three or more minor children who had a combined income of $52,427 would be entitled to an EIC benefit of as much as $6,143. The amount of the EIC varies depending on family size and the amount of earned income in which large families with the least earned income getting the most relative to others. Also, in 2014, married couples with minor, dependent children with incomes of up to $130,000 were entitled to all or some portion of the per child $1,000 child tax credit. Both the EIC and the child tax credit represent efforts to redistribute after-tax income to low-income and middle-income families. As with other provisions of the tax laws, the terms of the EIC vary depending on the direction the political winds blow.
Some economists regard using tax credits targeted to benefit the working poor as an alternative to increasing the minimum wage. These economists regard the minimum wage as a deterrent to hiring inexperienced workers, but they also recognize, as did Friedman, that many low-skill, full-time workers will not be able to live on market income. Rather than let the workers subsist in poverty or impose a minimum wage on their employers that is high enough to take the workers out of poverty, these economists favor using targeted tax credits to supplement market wages as a means of keeping the working poor out of poverty.
While this approach has surface appeal, it comes at a cost. As with all tax preferences, targeted tax credits clutter and complicate the tax laws and rely on taxpayer funds to subsidize low wage businesses by paying a portion of their employees’ after-tax wages. Using taxpayer funds to subsidize business results in (1) artificially increasing business profits and/or (2) keeping consumer prices below what the market would otherwise allow. Politically, targeted tax credits encourage both (1) many low wage businesses to keep wages low and (2) low wage workers to seek higher and higher tax credits, in each case with taxpayers footing the bill.
In coping with what to do about low wages, it is a fair question to ask why a viable business needs a subsidy to pay its workers a living wage. To suggest that taxpayers should subsidize any business to help pay its rent, utilities, insurance, or other expenses would be silly. So, a good case can be made that for a business to be viable, it should be able to pay its full-time workers a living wage, and if not, maybe the business is not viable.
Having businesses become dependent on government subsidies of any kind violates capitalistic principles and invites gaming the tax laws. It is likely that a well thought out combination of increases in the minimum wage, and increasing the progressivity of the personal income tax and payroll taxes that help pay for social insurance, could address the low wage challenge in ways that would not require making the tax laws more complex, and forcing taxpayers to pay for taking care of low-wage businesses and low-wage workers.
An Alternative to Refundable Tax Credits to Help the Working Poor
Replacing the payroll tax with the personal income tax would be a simpler way to help the working poor than using the EIC and child tax credits. A cruel fact of capitalism is that many Americans, perhaps a majority, will not be able to earn enough market income to enjoy an American style standard of living and be able to send their kids to college, pay their own medical bills, and retire on their own resources. Like it or not, for most Americans to live the American Dream, they will need government subsidies to a greater or lesser extent.
Before figuring out the subsidies, either through (1) expanding social insurance programs like Social Security, Medicare, and food stamps and/or (2) tinkering with the personal income tax to expand targeted tax credits like the EIC and the child tax credit, it would make sense to start with not taxing the working poor, either into or deeper into, poverty. The payroll tax can justly be named as the “poverty tax” because it taxes all low-wage earners—no matter how little they earn—at a rate of 15.3% on every dollar they earn and forces millions of low-wage working Americans into poverty.
Imagine a single mother of three who is working as a self-employed nanny for 2,000 hours a year at $9 an hour. On $18,000 of income, the single mom pays $2,754 in payroll taxes, which plunges her family deeper into poverty. To make up for the harm done by the payroll tax, the personal income tax grants the single mom access to the EIC and child tax credit, if she is aware of it and can figure out how to do her taxes. Rather than undoing the harm, it would be better to avoid the harm by not subjecting low-income Americans to a poverty tax.
Replacing the poverty tax (the payroll tax) with the personal income tax and taking the working mom off the tax rolls altogether would address the problems of the working poor far more simply and efficiently than using the personal income tax to undo the harm done by the payroll tax. Mandating a living wage and not taxing the nanny deeper into poverty would go a long way to eliminating the need for government anti-poverty programs and adding more refundable tax credits to the personal income tax. One would think that those who can afford a nanny should be able to pay their nanny a living wage so that the taxpayers do not have to come up with enough money through targeted tax credits to enable the nanny to get by.
Complexity, Hypocrisy, and the AMT
As tax preferences proliferated over the years, many of the best-off taxpayers and their tax professionals became so expert in exploiting them that they slashed their effective tax rates well below what most middle-income taxpayers were paying and in some instances zeroed-out their taxes altogether. Politically, tax breaks for the rich were one thing, but zeroing-out was quite another. In 1969, the politicians (including some on the right and more on the left) finally attempted to restrict the worst abuses of tax preferences by enacting the AMT (alternative minimum tax). The AMT, a product of the tax game, was and is no less awkward, inefficient, and feckless in achieving its goal of reining in the exploitation of tax preferences than if a person bothered by flies chose to swat them with a hammer.
Instead of either eliminating or at least narrowing the most inefficient tax preferences or cutting all of them across the board by a given percentage within the existing tax laws, the politicians added what some tax experts politely call a “parallel tax.” This parallel tax has added exponentially to the complexity of the tax laws for many upper-income taxpayers without doing much to redress the worst abuses of tax preferences. The two of the most effective tax savings devices that enable the highest income taxpayers to keep their tax rates lower than those for many taxpayers with much less income—(1) preferred rates on capital gains and qualified dividends, and (2) excluding from income the interest on certain types of municipal bonds—have been left largely unscathed by the AMT.
Relying on complexity instead of simplicity, the AMT requires upper-income taxpayers to first compute their taxes under the abnormal tax (virtually all taxpayers who pay the AMT would otherwise pay the abnormal tax), second, compute their taxes under the AMT, and third, if their taxes under the AMT are higher than under the abnormal tax, add the amount by which their AMT tax exceeds their taxes under the abnormal tax to their tax due.
The following is the Tax Rate and Bracket Schedule for the AMT in 2013:
Determining the AMT requires that a taxpayer make a new computation of their taxable income for AMT purposes after having made a computation of their taxable income under the abnormal tax. Generally, AMT taxable income adds in certain tax preference items of income (both certain above-the-line-deductions and income exclusions) not included in adjusted gross income and cuts or eliminates many itemized deductions.
The following steps are required to determine each taxpayer’s AMT taxable income:
| Step 1: | Determine the taxpayer’s taxable income under the abnormal tax before personal exemptions. | |
| Step 2: | Re-compute the value of each of over 30 tax preferences (subject to the AMT) in accordance with AMT rules and determine the aggregate total of all such re-computed tax preferences [this re-computation is extremely complex and almost always requires a tax accountant to do it.] | |
| Step 3: | Compute the sum of (a) the taxpayer’s taxable income under the abnormal tax (as described in Step 1), (b) the aggregate total of all re-computed tax preferences (as described in Step 2), and (c) the taxpayer’s AMT exemption. |
The taxpayer’s AMT taxable income is the sum described in Step 3.
Generally, except for taxpayers with substantial income from capital gains, qualified dividends, and tax-exempt municipal bonds, a high-income taxpayer’s AMT taxable income will be only a little less than what their taxable income would be under the normal tax. While the AMT does chip away at a few tax preferences, it leaves many of the most important ones—preferred rates on capital gains and qualified dividends as well as tax-exempt bond interest—largely undisturbed. No tax preferences are allowed under the normal tax. After determining a taxpayer’s AMT taxable income, a taxpayer must go on to determine their AMT tax by applying AMT taxable income to the AMT tax rate and bracket schedule, as follows:
| No-Tax Scenario: | If a taxpayer’s AMT taxable income is no greater than their exemption, $51,900 (for a single taxpayer) and $80,800 (for a married taxpayer filing jointly), then the taxpayer has no AMT tax. | |
| Low Tax Scenario: | If a taxpayer’s AMT taxable income is greater than their exemption but not greater than the high rate mark amount of $179,500, then their AMT tax is the amount that their AMT taxable income exceeds their exemption multiplied by (in the case of ordinary income) their low tax rate of 26%, and (in the case of capital gains) 15%. | |
| Low/High Tax Scenario: | To the extent that a taxpayer’s AMT taxable income is greater than the exemption phase-out mark of $115,400 (for a single taxpayer) and $153,900 (for a married taxpayer filing jointly) but not greater than the high rate mark of $179,500, then the taxpayer’s exemption is reduced by $250 for every $1,000 in income above the exemption phase-out mark and their AMT tax is the amount that their AMT taxable income exceeds their exemption (as adjusted) multiplied by (in the case of ordinary income) the low tax rate of 26%, and (in the case of capital gains) 15%. | |
| High Tax Scenario: | If a taxpayer’s AMT taxable income is greater than their exemption ceiling of $323,000 (for a single taxpayer) and $477,100 (for a married taxpayer filing jointly), then their AMT tax is the amount that their AMT taxable income multiplied by (in the case of ordinary income) the high tax rate of 28%, and (in the case of capital gains) 15%. |
If a taxpayer’s AMT tax exceeds their abnormal tax, then the amount of the excess is added to the taxpayer’s abnormal tax. If a taxpayer’s AMT tax is no greater than the taxpayer’s abnormal tax, then the taxpayer has no additional tax over and above the abnormal tax.
In 2013, under the normal tax, a married couple filing a joint return with two dependent children whose adjusted gross income was approximately $450,000 would have paid taxes at an effective tax rate of about 28%, and if that couple’s adjusted gross income had been $10 million or more, it would have paid taxes at an effective tax rate of about 39%. The extent to which those taxpayers whose adjusted gross income is $450,000 and who pay taxes at an effective tax rate less than 28%, and those taxpayers whose adjusted gross income exceeds $10 million and who pay taxes at an effective tax rate less than 39%, shows the power of tax preferences in avoiding taxes and the fecklessness of the AMT in curtailing the use of tax preferences by very, very high-income taxpayers.
According to the IRS, in 2013, those taxpayers with an adjusted gross income of $500,000 paid an average effective tax rate of only about 16%, or at least 12 percentage points less than what their effective tax rate would have been under the normal tax, and those taxpayers with an adjusted gross income of $10,000,000 paid an average effective tax rate of only about 20%, or at least 19 percentage points less than what their effective tax rate would have been under the normal tax. So, notwithstanding the AMT, tax preferences were worth (in terms of reduced taxes) on average about (1) $60,000 to taxpayers with incomes of $500,000, and (2) $1,900,000 to taxpayers with income of $10,000,000.
Also, in 2013, the top 400 taxpayers (whose adjusted gross income is not less than $100 million and which averaged $265 million) paid an average effective tax rate of 23%, or 16 percentage points less than what their effective tax rate would have been under the normal tax. So, notwithstanding the AMT, tax preferences (in terms for reduced taxes) were worth on average $42.4 million to those in the top 400.
The effective tax rates for the top 400 taxpayers were as follows:
Table V-14Average Effective Tax Rates for Top 400 Taxpayers in Terms of Adjusted Gross Income for 2013 |
||||||
| 0% > 10% | 10% > 15% | 15% > 20% | 20% > 25% | 25% > 30% | 30% > 35% | > 35% |
| 12 | 31 | 71 | 127 | 61 | 55 | 43 |
| Source: IRS, Data extracted from Table 3, The 400 Individual Income Tax Returns Reporting the Largest Adjusted Gross Incomes Each Year, 1992-2013. | ||||||
Many Americans would be astounded to know that there were even 12 taxpayers with incomes more than $100 million who paid personal income tax at an effective tax rate no greater than 10% and another 229 who paid tax at an effective tax rate no greater than 25%. For perspective, compare the effective tax rates paid by the top 400 taxpayers with the tax rate paid by the single mom who paid the payroll tax at a rate of 15.3% on every dollar of her income, and with each tax dollar she paid, falling deeper into poverty.
Market Income and the Personal Income Tax
Americans chose progressive income taxation over regressive consumption taxation as the primary source of funding government early in the 20th century because enough Americans decided that those with high incomes should pay more in taxes and those with low incomes should pay less. For over a generation, capitalism—driven by the inexorable forces of globalization and technology—simultaneously has driven down the wages of a majority of America’s workers while driving up the income and wealth of America’s top 1%, and there is not the slightest hint of this trend changing.
As long as the market income of most Americans at best remains static and at worse falls, the pressure will increase to make the personal income tax more, not less, progressive. While the politicians who oversee the playing of the tax game are more responsive to the best-off who pay and play, they cannot forever ignore the interests of the clear majority of Americans who feel the effects of static and falling wages. Until the market after-tax income of most American workers rises substantially, political pressure to use taxpayer subsidies to enable American workers to live the American Dream will grow.
THE PAYROLL TAX: PAYING FOR SOCIAL SECURITY & MEDICARE
Since the early 20th century, virtually all Americans have accepted that social insurance programs—most notably Social Security, Medicare, Medicaid, unemployment insurance, food stamps, and many more—are essential parts of American social, economic, and political life. Social insurance came to America in the form of Social Security in 1935 and in the form of Medicare in 1965, and neither was native to America.
Social Insurance
Social insurance was born in the late 19th century of conservative, not leftist, ideas, and was inspired by Bismarck, the archconservative Iron Chancellor of the German Empire. Bismarck realized that market income in an emerging industrial economy would not provide enough resources for German workers to pay for their own medical care and a decent retirement without government help. Mindful that Germany could not have political stability without social equity, Bismarck convinced most of his fellow conservatives to undertake an extensive program of government-sponsored social insurance. After taking hold in Germany, social insurance spread throughout most of Western Europe in the late 19th century and the early 20th century, and eventually, it came to America as a part of President Roosevelt’s New Deal.
With millions of Americans out of work during the Great Depression, it became apparent to President Roosevelt and a majority of Congress that, unless the government provided some form of social insurance, millions of low-income Americans would spend their old age in dire poverty and millions more middle-class Americans would look to retirement with dread. What was true in the mid-1930s is also true today. Given the economic trends of at least the last 30-plus years, today only very few Americans earn enough market income to save for their own retirement, pay their own medical bills, and send their kids to college while enjoying an American style standard of living.
Social Insurance Contrasted with Private Insurance
Private insurance is where an insured individual or business pays a private insurer a premium to manage a particular economic risk as contrasted with social insurance where the government as insurer charges its citizens, the insured, a premium (usually in the form of taxes) to manage certain types of economic risks. Private insurance and social insurance each share in common the management of economic risks in exchange for a premium, but they differ in the type of risks they manage and the way premiums are charged.
With respect to the types of risks to be managed, the risks in private insurance are the subject of a contract between the insurer and the insured and, among others, include (1) the death of a breadwinner resulting in lost income, (2) damage to, or the theft of, property resulting in the diminished value of an asset, and (3) certain types of events that cause a business to suffer loss. The risks in social insurance to be managed are the subject of a social contract (memorialized in law) between the government (as insurer), its citizens (as the insured), and, among others, include the inability of workers to earn enough income to pay for (1) their own annuity in retirement, (2) their and their family’s access to health care, (3) the post-secondary education of their children, and (4) their cost of living during periods of unemployment.
With respect to the price of premiums in private insurance, they are (1) based on what the insurer believes is sufficient to cover the cost of insuring the risk and return a profit and (2) have nothing to do with the insured’s ability to pay. The price of premiums in social insurance (1) is set by the government (in the political process), (2) is not necessarily based on covering the cost of insuring the risk of returning a profit, and (3) almost always is related to the insured’s ability to pay. Private insurance premiums are paid from private funds just as with other goods and services in the private marketplace while social insurance premiums are paid directly or indirectly as taxes.
Unlike the terms of private insurance which are defined in a contract between the insured and insurer, the terms of social insurance are a social contract between the government and its citizens memorialized in law. The terms of the social contract that prescribes which types of risk are to be covered, and the extent to which the taxes that pay for it will be based on a taxpayer’s ability to pay, are determined in the political process in accordance with the voters’ wishes.
Since the adoption of Social Security in 1935, the voters have decided that social insurance should be expanded to insure millions of Americans against the risk of, among other things, not being able to (1) retire in dignity, (2) pay for their own health care, (3) afford decent housing, and (4) pay for their children’s post-secondary education. As the market income of millions of working Americans has remained stagnant or fallen and, as their jobs have increasingly become insecure, the political pressure to expand social insurance has increased.
Expanding social insurance means increasing taxes, and if taxes are to be increased, those who want to expand social insurance must get in the tax game and win it. For the millions of workers who worry about their wages remaining stagnant or falling, or losing their jobs and being unemployed for an extended period of time, imagine how the politicians who run the tax game would answer the following questions posed by a worried American worker:
- If I do not make enough money, or if I lose my job and can no longer afford it, should I have to forget about having a decent retirement?
- If I do not make enough money, or if I lose my job and can no longer afford it, should my family have to do without decent health care?
- If I do not make enough money, or if I lose my job and can no longer afford it, should my kids have to forget about college even if they are bright and hardworking?
- If I lose my job, cannot get another for six months, and run out of savings, should I lose my house and fall into bankruptcy?
Without social insurance, the answer to each of these questions will be “yes.” If most voters are satisfied with “yes,” then social insurance will be narrow, but if enough voters are not satisfied with “yes,” then social insurance will have to be expanded.
The Existing Parameters of Social Security and Medicare
Social Security—Old-Age, Survivors, and Disability Insurance—provides retirement and disability benefits for the elderly who qualify and their dependent spouses and children. Eligibility depends on how many calendar quarters a worker pays a certain amount of payroll taxes into the program, as follows:
- Workers who earn a threshold amount in a calendar quarter (at least $1,220 in 2015 and indexed for future years) for a minimum of 40 quarters become fully insured and entitled to a retirement annuity for themselves and their spouses upon the taxpayer reaching 65 to 67, depending upon when they were born, and to disability payments for themselves and their dependents if the taxpayer becomes disabled.
- Workers who become disabled before becoming fully insured may also qualify to be insured depending on how many quarters they paid payroll taxes.
The amount of benefits payable to each beneficiary depends on the amount paid by the beneficiary in payroll taxes. Those who qualify for retirement benefits are given the option to start receiving benefits at 62 at a discounted amount.
Those who qualify for Social Security and meet certain other requirements are eligible for Medicare. Medicare provides insurance through (1) Part A, covering hospital, home health, skilled nursing facility, and hospice care, (2) Part B, covering physician, outpatient hospital, home health, and other services, (3) Part C, offered as an alternative to Part A and Part B in which beneficiaries choose to receive their care from private insurance companies which contract with Medicare, and (4) Part D, covering prescription drugs. Although participation in Part A is mandatory for all, participation in Parts B, C, and D are optional.
Since 1935, in the case of Social Security, and since 1965, in the case of Medicare, these social insurance programs have prevented millions of America’s elders from falling into poverty and doing without medical care.
The Payroll Tax and the Need to Do More
The payroll tax, authorized by the Federal Insurance Contributions Act (FICA), pays for all of both (1) Social Security, and (2) Medicare Part A and is broken down into ten different components, each of which is dedicated to pay for specific programs, namely (1) under Social Security (a) old age and survivors insurance and (b) disability insurance and (2) under Medicare Part A hospital insurance, as shown on Table V-11.
Social Security and Medicare Part A are not payable from general revenues. Medicare Parts B and D are not payable from the payroll tax, instead they are paid from a combination of general revenues and individual premiums. Medicare Part C (as a comprehensive alternative program that covers the same expenses that are included in Medicare Parts A, B, and D) is payable proportionately from the same revenues that pay for Part A, on the one hand, and Parts B and D, on the other.
Since Medicare Parts B and D are payable from both general revenues and premiums, neither is at risk of becoming unable to pay full benefits. If there is a shortfall in general revenues, the Treasury makes up the difference by borrowing.
However, if the payroll tax fails to generate enough revenue to pay for benefits under Social Security and Medicare Part A then Congress and the President have three options, as follows:
- first, increase the payroll tax by increasing (1) the rate on some or all workers and/or (2) the wage cap to require those with high wages to pay more;
- second, cut benefits; and
- third, use general revenues to make up the shortfall.
The tax game is the arena in which the politicians would decide which of the three options (or any combination thereof) is to be chosen. It is quite likely that any increase in the payroll tax (other than raising the cap) or any cut in benefits (other than to those with high income) would fall harder on those with low income, and any use of general revenues to maintain benefits and avoid a payroll tax increase would fall harder on those with high income.
For over a generation, pressure has been building to do something about both Social Security and Medicare Part A because neither is adequately funded over the long term. Both of these programs are the victims of demographics—an inexorable force—in which the number of beneficiaries has grown and is growing faster than the number of workers who pay the payroll tax, as shown in Table V-12.
Table V-16 shows that the worker/beneficiary ratio has fallen from 16.5 to 1 in 1950 and from 2.8 to 1 in 2014, resulting in imposing intense pressure on the payroll tax.
Fewer payroll taxpayers being asked to pay for more beneficiaries is not a formula likely to please either workers or beneficiaries. The demographics of Social Security and Medicare Part A will force a Hobson’s Choice on the politicians who set taxes in the tax game: Either (1) require that the people who depend on Social Security for their income and Medicare Part A for their hospitalization take a cut in their benefits or (2) raise taxes.
Social Security
The board of trustees for Social Security is required by law to report on the actuarial status of Social Security for the next 75 years. In its 2015 Annual Report, the report warned that if nothing is done to increase Social Security revenues or cut benefits before 2034, then benefits either will have to be cut or paid from general revenues. Given current finances, the report projected that for Social Security to continue to meet its obligations the following actions will have to be taken:
- revenues would have to be increased by an amount equivalent to an immediate and permanent payroll tax rate increase of 2.62 percentage points (from its current level of 12.40% to 15.02%); or
- scheduled benefits would have to be cut by an amount equal to an immediate and permanent reduction of 16.4% applied to all current and future beneficiaries; or
- some combination of the above alternatives would have to be adopted.
Every year that goes by without a permanent fix makes coming up with a fix that much harder—meaning that when the time comes to either increase taxes or cut benefits, the tax increase would be steeper, or cut in benefits would be deeper.
Medicare
The board of trustees for Medicare is required by law, as with Social Security, to report on the actuarial status of Medicare for the next 75 years. In its 2015 Annual Report, the report warned that if nothing is done to increase Medicare Part A revenues or cut benefits before 2030, then its benefits either will have to be cut or paid from general revenues. Given current finances, the report projected that for Medicare Part A to be able to pay benefits at current levels over the next 75 years, revenues would have to be increased by an amount equal to a 1.70 percentage point increase in the Medicare Part A payroll tax.
Although Medicare Parts B and D are not in danger of running out of funds, the costs of these programs will increase substantially over the next 75 years. The 2015 Annual Report projects that the overall costs of Medicare will increase (as a percentage of GDP) from 3.5% in 2014 to somewhere between 6% and 9.1% by 2089. The rising cost of Medicare will place great strain on both beneficiaries and taxpayers, and it will be up to the politicians to decide whether beneficiaries or taxpayers should take the biggest hit.
Social Insurance: A Discounted Lunch
A stark (but rarely mentioned reality) underlies both Social Security and Medicare, the reality being that all beneficiaries get more out of these programs than they have contributed, and most beneficiaries get a lot more.
Table V-17 contains data extracted from an Urban Institute study, “Social Security and Medicare Taxes and Benefits Over a Lifetime,” June 2011, authored by C. Eugene Steuerle and Stephanie Rename, which compares the lifetime contributions to the lifetime benefits of various categories of Social Security and Medicare beneficiaries.
Table V-17 highlights how Social Security and Medicare skew the value of their benefits in favor of those who began receiving benefits the earliest and who are the least well-off. Even though the least well-off fare the best under social insurance, NO beneficiaries (regardless of when they began receiving their benefits or how well-off they are) pay full fare for their retirement—not a bad consolation prize for the well-off. Getting old in America is not all bad.
Paying for a Discounted Lunch
While social insurance is not a free lunch, it is a discounted lunch with those beneficiaries who got in early and contributed only pocket change paying as little as seven cents on the dollar for their lunch as other beneficiaries who got in late and contributed folding money paying as much as 93 cents on the dollar. Since no current beneficiaries are paying the full tab for their social insurance benefits, these benefits can continue at current levels only if the best-off future beneficiaries suck it up and agree to contribute more and continue to take no more than they are now getting.
Social Insurance Premiums
With the exception of social insurance taxes, all other significant taxes are applied to pay for the general cost of government or some specific activity that uniquely benefits certain classes of Americans—i.e. drivers benefit from highways and passengers benefit from airports and air traffic control. Social insurance taxes paid by and on behalf of individuals are dedicated by law to provide social insurance to those who pay it. In that sense, taxpayers are paying for specific insurance benefits for themselves and their dependents just as if they were paying insurance premiums to a private insurer.
All states mandate in some form that drivers obtain auto liability insurance. All mortgage lenders require homeowners who owe mortgages to maintain property and casualty insurance. There is nothing odd about individuals being required to carry and pay for various kinds of insurance. Social Security and Medicare are social insurance programs that the people acting through government have decided that everyone must have. For the most part, the programs have reduced poverty and the lack of any health care for the elderly.
THE CORPORATE INCOME TAX
Businessmen form corporations, partnerships, trusts, limited liability companies, and similar types of legal entities, to own businesses primarily for the purpose of shielding the owners from personal liability in connection with the financing and operation of their businesses. For example, if an individual owns a restaurant that serves contaminated food, the individual owner can be sued by customers who are harmed. However, if the individual owner arranges for the restaurant to be owned by a legal entity that in turn is owned by the same individual, then only the legal entity that owns the restaurant can be held liable.
The type of legal entity—corporation, partnership, limited liability company, or trust—that is appropriate to own a business depends on, among other things, the type and size of the business, the number of owners and whether the owners will actively manage the business, the ease of the organization under and ongoing compliance with state laws, and whether the owners wish to be taxed directly on the profits generated by the business or have the business taxed on its profits. While how business profits are taxed is important, other factors often dictate what type of legal entity is best suited to own a business.
C-corps and S-corps
Under federal tax law, all legal entities other than corporations that own businesses pass-thru their profits to the owners to be taxed as income under the personal income tax. By default, corporations are taxed under the corporate income tax unless they opt out by filing IRS form 2553 and choose to pass-thru their income to their owners to be taxed under the personal income tax. Corporations that pay federal taxes under the corporate income tax are designated as C-corps; and corporations that pass-thru their income to be taxed to their owners are designated as S-corps.
Double-Taxation of C-corp Income
Not only are C-corps the only business entities that pay the corporate income tax, but corporate income that is distributed to the owners as dividends is also subject to the personal income tax. This results in double-taxation—taxing first corporate profits under the corporate income tax, and second, the dividends (from which they are derived) under the personal income tax.
Taxation of Pass-Thru Business Entities
For years C-corps were the predominant entity through which business was done in terms of net income, but increasingly S-corps and other pass-thru entities are being used. A result of this trend is that a growing percentage of business net income is being taxed under the personal income tax instead of the corporate income tax. Given the burden of paying higher taxes, it is curious why any owner of a business would not choose to be taxed as an S-corp or some other type of pass-thru entity and avoid double taxation. The phantom income problem explains why submitting to double taxation makes sense in some instances.
The Phantom Income Problem
All business entities, other than C-corps, have to cope with the phantom income problem, and if not for the phantom income problem, all business entities (including C-corps) could be taxed on a pass-thru basis.
Phantom income is the income earned by a business in each tax year that is not distributed by the business to its owners. Many businesses (including almost all C-corps) routinely use some or all of their earnings as both working capital and investment capital.
It would be folly for a business to distribute all of its earnings while at the same time needing to either borrow back some of the distributed earnings or issue more stock or partnership interests to finance its needs for working capital and/or investment capital. It is essential for many businesses to be able to retain some of their earnings to finance their cash needs instead of distributing all of their earnings to their owners.
Among the worst things that can happen to many taxpayers, however, is for the taxpayer to have to pay personal income taxes on income that the taxpayer did not receive in cash. Suppose that a business earns $1 million in taxable income of which $100,000 is reported as income to a taxpayer who owns 1/10th of the business, but the business decides to use $50,000 of the taxable income as working capital and only distribute $50,000, or ½ of the $100,000, of income to the taxpayer. Here, the taxpayer has $50,000 in phantom income—the taxpayer’s share of the income earned by the business that is retained as working capital—on which the taxpayer is required to pay personal income taxes.
From the taxpayer’s point of view, the taxpayer should not be taxed on $50,000 of phantom income because the taxpayer received no cash. But from the government’s point of view, someone must pay taxes on the $50,000 of phantom income. If no personal income tax is paid on the phantom income, then the business entity must pay tax on the phantom income—hence, the necessity for the corporate income tax. Since many taxpayers refuse to own an interest in a business in which phantom income is taxed, practicality dictates that a certain type of business entity (a C-corp) be permitted to pay taxes on business income so that the owners will not have to.
Given that many businesses do not want to organize as pass-thru entities, the corporate income tax exists as a means of taxing business income inside the business.
Solving One Problem and Creating Another
Businesses have a choice on how they cope with the phantom income problem—businesses can organize as either a pass-thru entity or a C-corp. Most businesses that are owned by only a few organize as pass-thru entities and almost all businesses that are owned by public shareholders organize as C-corps. Businesses that are owned by a few can control their own fate in terms of whether and how much phantom income the business will generate in any tax year while businesses that are publicly owned generally operate their businesses without regard to issues relating to phantom income.
Taxpayers who are worried about phantom income can invest exclusively in C-corps, and taxpayers who are not can invest in pass-thru business entities. As with many things, solving one problem frequently creates another. Investing in a C-corp avoids the taxpayer’s phantom income problem at the cost of the taxpayer accepting the burden of double-taxation.
The Corporate Income Tax Base
A C-corp’s taxable income is its receipts less its current expenses (including wages and interest), deductions for the cost of inventory when goods are sold, and depreciation of capital investments. American C-corps who do business in other countries pay tax on their worldwide profits, but tax on the profits of their foreign subsidiaries is deferred until those profits are paid as dividends to their parent. American C-corps are entitled to a tax credit, subject to various limitations, for foreign income taxes associated with their foreign-source income.
As with the personal income tax, the corporate income tax is riddled with tax preferences. In a 2013 study, “Corporate Tax Expenditures,” the Government Accountability Office, the GAO, found that 80 corporate tax preferences deprived the government of approximately $181 billion in 2011. Each corporate tax preference favors some businesses (winners) over other businesses (losers) and causes overall corporate income tax rates to be substantially higher than they would be if there were no tax preferences.
Almost all economists agree that corporate tax preferences violate capitalistic principles in that they distort the return on capital and encourage investments that skew the market. From the winning businesses standpoint, corporate profits won in the tax game spend the same as profits won in the marketplace.
Corporate Income Tax Rates
For tax year 2015, corporate tax rates for most C-Corps are as shown on Table V-19.
As with individual personal income tax rates, the nominal corporate rates are misleading in that the effective corporate rates are much lower. In a 2013 study, “Corporate Income Tax,” the GAO found (using the most conservative assumptions) that the average effective corporate rate was only 22.7% or 12.3% less than the nominal rate. Tax preferences account for the difference between the corporate effective rate and the nominal corporate rate.
Who Bears the Burden of the Corporate Income Tax?
Unlike the personal income tax, which is a direct tax, the corporate income tax is an indirect tax. Although C-corps write the checks to the IRS for their corporate income taxes, the economic burden, or the incidence, of the tax falls upon someone other than the C-corps.
A C-corp is not a real person—it is a fictional person. As one lawyer with a wry sense of humor put it, “a corporation does not have a body to burn or soul to damn.” The only embodiment that a C-corp has is a piece of paper, called a charter, issued by the government to document its existence as a fictional person. Fictional persons, unlike flesh and blood persons, do not bear the economic burden of taxes. Since C-corps do not pay taxes, who does? Well, there are several possibilities, and no one knows for sure.
If a C-corp has market power in that it can raise its prices without losing business, then its consumers bear the burden of the tax; if a C-corp can cut its employees’ wages without losing its workforce, then its employees bear the burden; but if the C-corp cannot either raise its prices or cut its labor cost, then its shareholders bear the burden. Which group—consumers, workers, or owners—bears the economic burden of paying the corporate income tax most likely depends on the circumstances such as the size and market power of the C-corp and its accessibility to capital and labor.
After much analysis and argument, no one can state with certainty who actually bears the burden of the corporate income tax.
The Corporate Income Tax, the Darling of Most Politicians
One thing that most politicians secretly agree upon is that the corporate income tax is too important to lose. Pro-consumer politicians (who are skeptical of big business) raise campaign funds by telling their supporters that they will eliminate or curtail corporate tax preferences, and pro-big business politicians (who are friendly to big business) raise campaign funds by telling their supporters that they will protect and expand existing tax preferences and create more. As the tax game is played, both sets of politicians exploit the opportunity to scare or entice their supporters, as the case may be, into making generous contributions to protect their interest. No matter which businesses win or lose, almost always the politicians win.
As the tax game plays out, the pro-big business and the corporate lobbyists conspire to scare large corporate donors by telling them that (if they do not get involved in the tax game) they are going to be taxed into penury. Having been spurred to action, the money starts rolling in to both lobbyists and politicians. Not infrequently, a few otherwise uncommitted politicians who have a pet corporation in their bailiwick join the pro-big business politicians at the tax preference trough to support a tax preference for a home-town corporation—all politicians revel in bringing home the bacon.
EXCISE TAXES: TAXING USE, SIN, & LUXURY
Excise taxes are taxes payable with respect to the purchase of goods or services and are usually levied as a percentage of the price of the goods or services being sold. Although the amount of the excise tax is passed on to the consumer of the goods or services as a part of the price, it is almost always paid to the government by the manufacturer or service provider.
Excise taxes serve two purposes—first, they raise revenue, and second, they change consumer behavior. The oft quoted maxim, “the more something is taxed, the less of it there’ll be,” applies to excise taxes. At the margin, there will be less of all items that are subject to the excise tax than if there were no tax. Excise taxes are always regressive because, since the tax is the same on any given goods or services to all purchasers, it necessarily results in the less well-off paying a higher percentage of their income for whatever is being purchased than the better-off.
There are three major categories of excise taxes—use taxes, sin taxes, and luxury taxes. Beyond these categories, there is a mishmash of odd-lot taxes—none of which are particularly significant to most consumers and taxpayers. Every few years, the politicians toy with excise taxes by adding a few, deleting a few, and changing the rates on others.
Use Taxes
Gasoline and other motor fuels, tires, and airplane fuels, and related taxes, account for about 45% of all excise tax revenue. Of these taxes, the gasoline tax which is 18.4 cents per gallon, is the most significant excise tax paid by individual consumers. For the past several years, the gasoline tax has been earmarked for use to construct and maintain interstate highways and mass transit facilities. There is a sort of rough justice in having motor fuel users pay for transportation facilities.
Another tax of interest to most consumers are taxes levied on flying, in particular an array of taxes for both domestic and international flights. In the past, excise taxes have been charged on telephone services and passenger autos, but since consumers, manufacturers, and auto unions rebelled against them, the politicians of both the left and right happily repealed many of these excise taxes.
Sin Taxes
Alcohol and tobacco taxes account for about 24% of all excise tax revenue, and wagering taxes account for a small amount of revenue. When looking for a few extra dollars to close a revenue gap, the politicians (particularly the sanctimonious kind) frequently turn to taxing the sins of drinking and smoking. Many of the poor, if they thought about it, might complain that drinking and smoking are sins that are more costly to them than to those who consume expensive cigars and fine wines. Taxing a beer by a few cents and a pack of cigarettes by over $0.50 is more burdensome to the poor than the well-off.
The sin taxes operate at cross-purposes by raising revenue on the one hand, and discouraging sin (drinking and smoking) on the other hand. It is difficult to know the extent to which fewer revenues are being collected because these sin taxes have increased the price of smoking and drinking and thereby reduced consumption of tobacco and alcohol.
Luxury Taxes
Luxury taxes are older than Solon’s time. When the politicians of the Roman Republic wanted to chastise the well-off for conspicuous consumption in the face of economic hard times, the Roman politicians of the left routinely passed Sumptuary Laws (the old name for laws prohibiting ostentation), and when times got better, the politicians of the right repealed them. Taxing the ostentation of the wealthy almost always proves futile in terms of either raising revenue or changing behavior.
Anyone who wants to know why laws against ostentation are futile should read the 1st century A. D. letter of the Emperor Tiberius to the Roman Senate, as reported in The Annals, Book III, Chapters 53–55, by Tacitus. Tiberius argued that, despite good intentions, government has no practical ability to ban ostentation by law.
The rationale regarding luxury taxes in America has not progressed beyond the wisdom of Tiberius. When economic times are tough, the politicians of the left frequently turn to luxury taxes as old standbys for political pandering to their base to rant against the ostentation of the rich, and conversely, in better economic times, the politicians of the right pander to their base by preaching that luxury taxes are examples of class warfare.
In the past when politicians of the left were on top, excise taxes were levied against yachts, expensive autos, jewelry, furs, and other similar types of luxuries, and later, when the worm turned and politicians of the right gained control, most luxury taxes were repealed.
One lesson learned the hard way regarding luxury taxes was that the yacht tax, enacted in 1986 as a part of that year’s tax reform effort, resulted in devastating the domestic yacht industry. The rich did not abandon ostentation—they just indulged themselves by buying their yachts from foreign manufacturers or buying other trinkets. It was the less well-off workers toiling away in the yacht industry who, joined by the well-off yachtsmen and manufacturers, had the tax repealed.
One additional luxury tax of note is the tax on gas guzzlers. This tax requires those who want to buy autos that guzzle gas to pay an excise tax that increases with the quantity of gas guzzled. At one end of the spectrum, an excise tax of $1,000 is levied on autos whose mileage rating is less than 22.5 miles per gallon, and at the other end of the spectrum, an excise tax of $7,700 is levied against autos whose mileage rating is less than 12.5 miles per gallon.
Excise Taxes as Tools
Excise taxes offer an opportunity to have the users of certain governmentally-provided facilities and services and governmentally-controlled products pay all or a portion of the cost of such facilities, services, and products. Having the users pay for what they use makes more sense than having income taxpayers pay these costs. Also, having the users pay such costs will awaken them to an understanding that these facilities, services, and products are not free.
As any parent of an adult child leaving home can testify, knowing what things cost and paying for them yourself changes behavior. As long as someone else (parents in the case of an adult child and the government in the case of users) pays for things, everyone is happy to have all that is provided free, but when users themselves have to pay, they tend to question if what they are getting is worth what they are paying.
These three examples show how excise taxes can allocate the costs of government more fairly and impose spending discipline upon the politicians.
Excise taxes generally require that users pay for transportation facilities, sinners pay for consuming alcohol and tobacco, and the wealthy pay for ostentation. Complaints about regressivity, particularly pertaining to the gasoline tax, ignore the fact that the poor use the highways too, and all users should pay some share for their use. Taxing sin works at cross-purposes in that the more sin is discouraged through high taxes the less likely it is that substantial revenues will be raised. However, because taxing sin is usually a political winner, sin taxes are not likely to go out of fashion. Luxury taxes come and go depending on economic conditions and whether the politics of the time are dominated by the right or the left. Right now, luxury taxes have gone and show no sign of returning soon.
Making the Gasoline Users Pay for Highways
Since the 1950s, the federal government has assumed responsibility for the interstate highway system. There is no fairer way of paying for all or a portion of the cost of this system than having those who use it pay for it. Consumption of motor fuels fairly measures use of interstate highways and the amount of income taxes paid by a taxpayer does not. The excise tax on motor fuels practically and equitably allocates among users the burden of paying for the costs of interstate highways.
In a rare act of political wisdom, the politicians have dedicated motor fuel taxes to a trust fund restricted to the payment of transportation facilities. Anytime those who pay motor fuel excise taxes conclude that these taxes are too high relative to what they are getting in return, this is as good an indication as the politicians will ever have that too much is being spent on highways.
Making Sinners Pay for Their Sins
Smoking and drinking are commonly known to increase health risk, particularly for Medicare recipients. Dedicating the excise taxes on tobacco and alcohol, amounting in 2013 to about $40 billion, could help make up a portion of the Medicare deficit. Under Medicare, it is possible to track with precision the costs of treating patients suffering from the effects of smoking and alcohol. Requiring the sinners to pay for medical costs attributable to smoking and drinking would more fairly allocate the Medicare burden than increasing the payroll tax for those who are not guilty of those particular sins.
If preaching does not seriously discourage drinking and smoking, increasing the sin taxes might. So, what if the price of driving, drinking, and smoking increases and harms the poor more than the rich? Making drivers, drinkers, and smokers pay for the cost of their behavior most likely would be opposed by politicians of the right and left.
Many politicians of the right will object to any taxes for any reason even if it means requiring drivers to pay the cost of interstate highways. Many politicians of the left will object to the regressive effect of an increase in excise taxes.
All politicians should remember that there is nothing in the Declaration of Independence or the Constitution guaranteeing drivers the right to have highways and cheap gasoline, and smokers and drinkers the right to have cheap medical care, in each instance, without paying for it. If these things are not paid by excise taxes, they most likely will have to be paid from the income tax. Many types of governmental services should be paid for by use taxes as a means of allocating the tax burden fairly and forcing users to tell politicians anytime the taxes outweigh the benefits.
THE ESTATE AND GIFT TAX: DEATH AND TAXES
Under the category of other revenues and taxes, the estate and gift tax is the only tax of consequence from the standpoint of raising revenue. For 2014, the estate and gift tax generated approximately $19.3 billion in revenues, down from an all-time high of $29.1 billion in 2000 before the Great Recession. Put in perspective, taken together with other tax revenues, the estate and gift tax accounts for about 3% of the personal income tax revenues, about 5% of the social insurance tax revenues, and accounts for a little more revenue than either the gasoline tax or the alcohol and tobacco tax. The gift tax is a necessary accompaniment to the estate tax to prevent a decedent from giving away his or her estate prior to death as a means of escaping paying the estate tax. As a result, the two taxes are treated for most purposes as a single tax.
Paying the Estate Tax
Upon death, a decedent’s gross estate becomes subject to the estate tax. The gross estate includes all property in which the decedent had an interest (including real property outside the United States), and it also includes the following:
- Certain transfers made during the decedent’s life without adequate and full consideration of money or money’s worth,
- Annuities,
- The includible portion of joint estates with right of survivorship,
- The includible portion of tenancies by the entirety,
- Certain life insurance proceeds (even though payable to beneficiaries other than the estate),
- Property over which the decedent possessed a general power of appointment,
- Dower or curtsy (or statutory estate) of the surviving spouse, and
- Community property to the extent of the decedent’s interest as defined by applicable law.
The estate tax is payable on Form 706, which is longer and even more complex than Form 1040 for the personal income tax. And, like Form 1040, it comes with a detailed set of instructions that can only be understood by tax professionals.
Similar to the personal income tax starting with total income and working its way through a maze of tax preferences to get down to taxable income, the estate tax starts with the gross estate and also works its way through its own maze of deductions and credits to get down to the net taxable estate. Among others, the types of deductions from the gross estate include the decedent’s funeral expenses, the expenses incurred in administering and distributing the estate, the debts that have claims against the estate, all unpaid mortgages secured by property comprising the estate, the decedent’s bequest to the decedent’s spouse, the amount paid as taxes under state laws to the decedent’s beneficiaries, and most importantly, the decedent’s bequests to charities.
In addition to all of the deductions and credits that are applied, the gross estate is further reduced by the amount of what the tax code calls the unified credit and by the sum of all individual credits given from amounts paid by the decedent under the gift tax regarding gifts made during the decedent’s lifetime. For 2015, the uniform credit is $5,430,000, and for subsequent years, it is indexed for inflation. As an analogy, the uniform credit for the estate and gift tax is similar to the standard deduction under the personal income tax.
Estate Tax Rates
Once all deductions and credits are applied to reduce the gross estate to the net taxable estate, the following rates, as shown on Table V-15, determines the amount of estate tax owed.
The Gift Tax
Similar to the personal exemption under the personal income tax, the gift tax has an annual gift tax exclusion which enables a person to give a certain amount to any number of individuals each year without incurring any gift tax liability. Gifts made in any year in excess of the gift tax exclusion are subject to the gift tax. For 2015, the gift tax exclusion is $14,000 per person and is indexed for inflation. Upon the death of the donor, all gift taxes paid in connection with gifts given from what would have been the donor’s estate are credited against the estate tax. For statistical purposes, revenues attributable to the estate tax and gift tax are treated as a single item.
Avoiding Paying the Estate Tax and the Gift Tax
Avoiding the estate tax can be done but it is complicated and expensive. If and to the extent that a decedent is willing to donate the assets in his or her gross estate to a qualified charity, then the donor will not have estate tax liability for an amount equal to the donation. Unlike the personal income tax where there are limits on the amount of charitable donations certain high-income taxpayers can use to reduce their taxable income, there are no limits under the estate and gift tax on the amount of charitable donations that can be used to avoid taxes.
No matter how wealthy, a decedent so inclined can zero-out estate and gift tax liability by arranging to donate to a charity all remaining assets in his or her gross estate after paying all the deductible expenses and making a bequest to his or her spouse. For those who want to zero-out, they have to decide how much to bequeath to their spouse and how much to give to charity.
Estate planning—a pleasant term that translates in many instances to tax avoidance—costs money and lots of it. In 2014, 6,925 estates paid over $548 million in legal fees, averaging almost $80 thousand per estate, and for those estates whose gross estate was $20 million or more, their legal fees averaged about $139 thousand. These fees do not take into account tax accounting fees and other administrative costs. Instead of being merely a business, estate planning has become an industry.
For the largest estates that are willing to pay the most, there are ways for those among the very wealthy who are so disposed to donate their money to a charity while at the same time letting their families and friends control it and benefit from it: Eating one’s cake and having it too.
Donating to Charity, Eating One’s Cake and Having it Too
A decedent who wants to donate to charity and qualify for a charitable deduction has a choice: donate to a public charity or donate to a private foundation.
Generally, a public charity is a non-profit corporation organized to carry out a charitable purpose, such as churches, private schools, hospitals, homeless and battered-wives shelters, animal shelters, helping the disabled and disadvantaged, and numerous other such activities. To qualify for tax purposes as a public charity, an organization must raise most of its funds from the public, be governed by a diversified board, and not be under the control of any group of interested directors. Public charities are required to meet a number of tax requirements and file annual forms reporting on their income and activities. The IRS maintains a list of all public charities which meet the tax requirements for their contributions to be deductible. According to the IRS, as of April 2016, about one million charities qualified.
Private foundations are also usually non-profit corporations organized to carry out a charitable purpose, which is, subject to certain tax requirements, limited to making grants to various types of public charities. If certain tax requirements can be satisfied, private foundations may also make grants to individuals and to charities other than public charities. Unlike public charities, private foundations can be under the control of anyone chosen by the donor and hire family members and friends as employees as long as they are paid reasonable compensation. To deter self-dealing and other abuses, private foundations are subject to a number of restrictions regarding governance, fundraising, investing, and mandatory grant-making as well as being required to file a number of annual reports regarding their ongoing operations, grant-making, and expenditures. In 2012, there were 93,542 private foundations with assets aggregating about $698.6 billion and which made about $42.6 billion in grants.
Prominent examples of private foundations include the Bill and Melinda Gates Foundation and a foundation established by Warren Buffet, each worth billions. Private foundations offer the wealthy the ability to set up a non-profit corporation under the control of their immediate family and/or friends and enable them to control, subject to tax requirements, how the foundation’s money is spent, and receive reasonable compensation for their services. Reasonable compensation depends on the facts and circumstances of each case and can be an elastic concept. The foundation may also hire (as consultants) anyone the board determines will assist it in carrying out its mission and pay them reasonable compensation and reimburse them for their expenses. For some foundations, travel includes first-class accommodations.
The full deductibility of charitable contributions to private foundations enables the wealthy to avoid millions in taxes, assure well-compensated employment (and oftentimes first-class travel on official business) for their children and friends, and make donations to any types of public charities that catch their fancy, regardless of any objective test as to need. What the wealthy do with their money is their business, but what they do with taxpayer-subsidized funds should be the business of all taxpayers.
A Choice: Pay Down the National Debt and/or Cut Taxes or Fund Charities
But for the charitable deduction (a product of the tax game) as much as 40%—the top rate applicable to both the personal income tax and the estate and gift tax—of deductible charitable contributions would have been taxed and the revenues attributable to them could have been used to pay down the national debt and/or lower taxes. The charitable deduction, however, diverts what would have been tax revenue to public charities and private foundations. Taxpayers (other than those who take advantage of the charitable deduction) should ask those who control the tax game if it would be better for America if the diverted revenues were used to either (1) pay down the national debt and/or (2) lower taxes instead of funding charities. With America’s national debt at the highest level in three generations and headed upward to even more dangerous levels, diverting revenues to fund charities instead of using them to pay down the national debt or cut everyone’s taxes seems dubious.
Farming out to the Wealthy the Right to Say Who Gets Diverted Revenues
The charitable deduction has the effect of substituting the whims of the very wealthy for that of the American people in deciding what to do with diverted revenues. If there were no diversion, Congress and the President would set the priorities regarding how these revenues should be spent, but because of the diversion, those who run charities set such priorities. In the case of private foundations, a small group of individuals (almost always chosen by the very wealthy who create them) decide who should benefit from these diverted revenues. While philanthropy is good, it can be unfocused and even wasteful.
The most sound philanthropy is that which is done by philanthropists with their own after-tax dollars with no involvement from the government.
Included among the approximately one million public charities (as reported by the IRS on its list of public charities) are the following: the Middlesex Barbarians R F C Inc., the Hanover Soccer Club Inc., the Agamenticus Yacht Club of York| Harbor, the Healing and Deliverance Ministry Inc., the Church of Cosmic Consciousness Gospel of Awareness, and the Liberty County Historical Society Inc. No doubt each of these charities serves a good purpose, but most taxpayers might find it doubtful that funding these charities with diverted revenues is better for America than paying down its national debt and/or lowering taxes. If most taxpayers thought about it, they might well doubt the wisdom of using diverted revenues to support many organizations, merely because they qualify as public charities.
The Charitable Deduction, Charity, or a Tax Dodge?
No one doubts that the charitable deduction encourages some to make donations to charity and that donations to charity are good, but the charitable deduction comes at a steep price. Not only does the charitable deduction divert substantial revenue from paying down the national debt and/or lowering taxes, but it also channels most of these revenues to charities favored by the very wealthy. So, imagine what the effect on charities would be if the charitable deduction was eliminated.
The total elimination of the charitable deduction would not affect the charitable giving of an overwhelming majority of Americans. Most Americans who give to charity get no tax benefit from their donations because only a few thousand taxpayers who die each year have estates large enough to have estate and gift tax liability and the overwhelming majority of taxpayers do not qualify for a deduction under the personal income tax. With respect to the personal income tax, only about 25% of all taxpayers qualified in 2015 for the charitable deduction. Subsequent changes in the tax laws have reduced the number of taxpayers who qualify for the charitable deduction to an estimated 10%. So, given that only a small number of taxpayers, primarily those with high incomes, benefit from the charitable deduction, it affects the charitable giving of only a relatively few taxpayers, overwhelmingly those with high incomes.
No group benefits more from the charitable deduction than the very well-off, and, among the very well-off, no group benefits more than the wealthiest of the wealthy. Eliminating the charitable deduction would leave the very wealthy in the same position as most other Americans who get no tax benefit from donating to charity. Eliminating the charitable deduction also would put all taxpayers on the same footing in that all taxpayers could donate as much as they want to whom they want without any government involvement. As an added benefit, the lawyers, accountants, and lobbyists who populate the estate planning industry could get into another line of business that adds to the productivity of the American economy.
Although no one knows for sure, it is likely that the very wealthy would still give a lot to charity even if the charitable deduction was ended. Once the very wealthy have left unimaginable fortunes to their spouses and families, they have to decide what to do with the rest of their money. During the Gilded Age, when there was no such thing as the personal income tax and either no or inconsequential federal taxing of estates, the robber barons, men like John D. Rockefeller, Andrew Carnegie, J. Pierpont Morgan, and Andrew Mellon, accumulated vast amounts of wealth, and then they or their families donated many millions to charities and their charitable foundations, most notably, the Rockefeller Foundation established in 1913 and the Carnegie Foundation established in 1911. Prior to 1913, there was no personal income tax and there was no federal estate tax between 1902 and 1916. Whether the robber baron donations were made from a belief in altruism, religious conviction, or as penance for misdeeds in business, only they knew, but whatever it was, it was not due to the personal income tax or federal estate tax.
Today, there is no reason to believe that the wealthiest of the wealthy, billionaires like Bill Gates and Warren Buffet, would not still give billions to charity even if there was no tax incentive to do so. Like most ordinary taxpayers, the very wealthy should pay their taxes and donate what they want afterward.
Who Bears the Burden of the Estate Tax and the Gift Tax?
Although the estate and gift tax are a direct tax against the decedent’s estate, the burden of the tax falls upon the decedent’s beneficiaries. Legacies are taxed differently. Many states tax the amount of bequests to each beneficiary through inheritance taxes instead of taxing the decedent’s estate, and such tax laws vary. Since personal income taxpayers are not required to report bequests as income, it is not possible to track the income level of taxpayers who receive bequests.
The number of estates subject to any meaningful estate taxes is infinitesimal. In 2014 only 11,931 estate and gift tax returns were filed listing gross estates totaling $169.5 million of which only 5,158 estates whose gross estates totaled $90.1 million paid any tax. Table V-21 shows how the $16.39 billion in estate taxes was distributed.
In 2013, there were 2.56 million deaths (presumably the deaths in 2014 were about the same), and only 5,158 (or about .20% of all decedents) paid any estate tax in 2014. The estate tax only affects the wealthiest of the wealthy, and then only slightly in that the average effective tax rate for gross estates of $50 million or more was about 18%. The middle class need not worry about the estate tax. For those who are concerned about the decedent’s families losing their family-owned farms and small businesses, there are a number of tax provisions that, among other things, provide both for the special valuation of these assets and, if there is any tax liability, the right to pay the tax over an extended period of time at favorable interest rates.
Replacement of the Estate and Gift Tax
Politicians who rant about repealing the estate tax and gift tax never mention how the lost revenues are to be replaced. Any reduction in estate tax revenues will almost certainly have to be made up by increasing the personal income tax.
Some tax experts, in fact, have suggested substituting a progressive inheritance tax—in effect the personal income tax—for the estate and gift tax. The tax and economic effects of the death of a wealthy decedent should focus on who inherits the estate rather than on the decedent—the decedent is dead and the inheritors are alive.
The Tax Gap, the Child of Complexity
Every year over a third of a trillion dollars of tax revenue is lost to the tax gap, the amount of taxes owed under law less the amount of taxes collected. As some taxpayers avoid or evade paying their taxes, the burden of replacing the lost revenue falls on those taxpayers who voluntarily pay what they lawfully owe.
Almost all tax preferences invite differing interpretations which can result in billions of tax dollars being lost if an improper interpretation is asserted by taxpayers and the improper interpretation goes unchallenged by the IRS. For example, suppose a billionaire improperly claims that he or she is entitled to the benefits of a tax preference which saves them millions in taxes. Unless the IRS audits and disallows the improper claim then the billionaire will save millions in taxes and all other taxpayers must make up the difference. Making sure that millions of taxpayers comply with intensely complex tax laws is a gargantuan task that requires huge resources. Since the IRS is not the most popular agency, the politicians of both parties are not interested in providing it with the resources necessary to enforce proper compliance.
Complex tax laws favor those with the highest income the most because, unlike middle and low-income taxpayers, they can much more easily afford to hire expensive lobbyists to get them favorable tax preferences and professionals who can help them exploit them.
THE TASK AHEAD
The purpose of taxing is to pay for the cost of government, and if done well, it should not discourage economic growth, create social discord, or distort the operation of markets.
Unfortunately for taxpayers (but necessarily for America), the cost of government is going up and up substantially. Since the end of World War II, the cost of government has trended up, ranging from a low of 14.1% of GDP in 1950 to a high of 24.4% in 2009 at the height of the Great Recession. Government costs more now because (1) America is (and will continue to be) the world’s leading power and with that comes having to pay for an ever-growing national security establishment, and (2) economic changes have compelled America to expand social insurance, most notably Social Security and Medicare, but also including programs to assist those with middle and low-income gain access to health care and post-secondary education.
From the end of World War II through about 1980, income disparities were relatively narrow, college was important but not necessary, health care was not as sophisticated or as expensive as it is today, wages were not under nearly as much pressure from technology and globalization as they are today, people did not live so long in retirement, and jobs were much more secure than now. The economic and social changes that began in the 1980s are accelerating at an ever-faster pace and have created an environment which is leading to more (not less) social insurance. With the need to maintain a strong military and expand social insurance, the cost of government for the foreseeable future can be expected in the next few years to approach, and thereafter exceed, 25% of GDP.
From about 1980 to the present, with only a few exceptions, America taxed much less than it spent, which has resulted in its having its largest national debt (as a % of GDP) in over a half century. All of this means that America must increase taxes from about a range of 17% to 19% of GDP to a range of about 22% to 24% of GDP in the next few years if it is to pay for the current cost of government and pay down the national debt to a manageable level. A tax increase of 5% to 6% of GDP (even if it is phased in over a few years) will intensify the tax game. It will be much harder to be a winner and much easier to be a loser.
Early in the 20th century, America switched from consumption taxation (excise taxes and tariffs) to taxing income (the personal income tax, the payroll tax, and the corporate income tax) because income taxes were much more progressive. The same political pressures—too many low and middle-income taxpayers being unwilling and/or unable to pay for the bulk of government—that led to progressive taxation a century ago are no less potent today. For several generations, progressive income taxes have paid for about 90% of the cost of government, and with more and more Americans suffering from job anxiety and stagnant income syndrome, it is likely that more (not less) of the cost of government will be paid from progressive income taxes.
Putting aside individual winners and losers in the tax game, it is worthwhile to ask what would be the best way for the America of the 21st century to tax at a level of about 24% of GDP. So, here are a few suggestions:
- Ways to Promote Economic Growth: Tax rates should be as low as possible for everyone by including ALL income as taxable income; taxation should be simplified by ending ALL significant tax preferences; ALL business income (including C-corp income) should be taxed under the personal income tax as such income is distributed to the business owners and shareholders: and taxes on ALL of a decedent’s assets should be paid by those who inherit such assets.
- Ways to Reduce Social Discord: NO taxpayer (regardless of their wealth) should be taxed at a rate so high that it unreasonably discourages them from making the next dollar; NO taxpayer should be taxed into or near poverty; NO taxpayer who has the same income as another should pay significantly more taxes than the other; and, as income concentrates in a few, taxation should be made MORE progressive.
- Ways to Reduce Distortion in Markets: Ending all significant tax preferences, the corporate income tax, the estate and gift tax, and the payroll tax and replacing them with a single progressive personal income tax would eliminate almost all incentives for investors to invest in tax-driven investments and consumers to spend their money on tax-deductible consumption.
While these suggestions would deprive the tax establishment that rules over and benefits from the tax game of the largess resulting from picking winners and losers, it would be good for America.
As a former card-carrying, deal-doing member of the tax establishment that has foisted the existing system of taxation on America, I cannot think of a single legitimate reason not to implement my suggestions. To me, tax reform boils down to a question of which is to prevail: greed or patriotism.