Other tax resources are available on our website.
Happy New Year!
Other tax resources are available on our website.
Happy New Year!
I love watching Twilight Zone episodes because it is fun to imagine a world where the usual laws of nature are slightly askew and anything becomes possible. Fanciful minds can do a lot with that. Yet, some of those episodes are a bit creepy, even scary and sometimes disturbing.
Congress’ failure to act timely to provide any kind of certainty about tax law both for 2012 and for future years has definitely defied the usual laws which govern rational behavior. Clearly Republican lawmakers would rather tax the poor and middle class than allow taxes to become progressive again on the top 1%, and it is quite clear that they wish to further the shameful increase in wealth and income inequality in the U.S.
Thanks to this failure, we have wandered across the obscure boundaries of normal reality into twilight zone of taxation. Here is an overview of our current creepy, scary, and disturbing tax system:
According to a recent poll by Atlantic Monthly, none of us really knows the degree of income and wealth inequality in the U.S., nor do we know how it has dramatically worsened in recent times. I think this is partly because each of us (except possibly for a few Buddhists) craves a bit of inequality for ourselves.
How much income and wealth inequality is too much? Here is a chart that shows how income inequality has changed over the last 100 years:
You can see that a dramatic drop in inequality began in the late 1930’s, leveled out in the 1960’s, and then began surging again in the early 1980’s.
There is much dispute among experts as to the cause of this dramatic increase in wealth and income inequality. But generally, the increase in wealth inequality has been attributed to the following: monetary policy, tax policy, deregulation of certain industries, effective lobbying by highly paid interest groups, the greater role of large campaign donations in electoral politics, failures in the public education system, and the simple but true notion that wealth begets wealth.
In fact, once the wealthy have accumulated enough to not care about health care costs, mortgage debt, or even the economy, and once every election is determined solely by campaign spending, then you say goodbye to any semblance of capitalism tempered by democracy, as envisioned by Adam Smith, who not only believed in the invisible hand of the market, but in progressive taxation, stating: “The rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.”
While there is dispute about just how much tax policy has contributed to the increase in wealth and income inequality, there is no question that tax policy is one result of it. Here is a chart showing how our U.S. Senate has in recent times dealt with lobbying efforts on behalf of various income groups:
As you can see, the poor actually were served by our Senators with negative responsiveness. Not only were their efforts useless, they were in fact, better off not making them. Only the wealthy were highly effective in accomplishing their objectives. This is another example of how wealth paves the way for the wealthy to achieve their legislative and policy goals, so that they in turn can become more wealthy. So, if we look at tax policy as a result of wealth and income inequality, the result should be that tax policy helps the wealthy accumulate even more wealth. Clearly, this has been the case, as shown in the chart below:
From this chart you can see that the top .01% (that’s point zero one percent) have seen the most dramatic drop in their income tax rates, with their rates dropping by more than half since the 1970’s. Coupled with this drop in tax rates are special tax breaks that only the wealthy can avail themselves of: a zero percent tax on capital gains under certain circumstances; a low 15% rate on the rest of their dividend and capital gain income; and favorable estate taxes allowing each wealthy couple to pass $10 million tax free to their heirs, and that’s the value after employing costly estate planning strategies that only the wealthy can afford. With favorable tax policy comes a favorable regulatory environment, and with more money to spend on elections, and no one to put a cap on campaign donations, thanks to the Supreme Court, the momentum for wealth and income inequality is fully underway. What can stop it now?
Sources: Wikipedia article: “Wealth Inequality in the United States“, The Wealth of Nations by Adam Smith, The Atlantic Monthly.
Mayor Sam Adams recently announced a tax amnesty for scofflaws who have so far succeeded in not rendering unto the City/County what they owe in business income taxes. While I am not a big fan of amnesty programs, as they reward the wrong behavior and the wrong taxpayers, it is not surprising that businesses and property owners who have “nexus” within the City/County find themselves out of compliance with the tax code. Some do so deliberately, while others may simply be blissfully unaware of their tax obligations.
This is because the City/County tax code, unlike its counterparts among other municipalities, taxes only certain businesses and individuals. It relies on a very narrow tax base, and thus has an extremely high flat rate of 3.65%. It is essentially a payroll tax on successful business owners, and an income/capital gains tax on successful property owners.
But more importantly, the tax punishes privately held companies who do business within City/County borders while rewarding public companies doing the same. How can this be? Well, here’s a real life example from my CPA practice: Locally owned company with 3 shareholders, nets $4 million before owner salaries, and $1 million after owner salaries. In my example, none of the shareholders actually live within the City/County boundaries. What is their City of Portland/Multnomah County Business Tax? The total tab will be $136,500. If this same business were to be bought out by a publicly traded company, and management salaries were the same, the business would now have a tab of $36,500. In this example, that’s a $100,000 punishment for the locally owned company. Outrageous, no?
This strange phenomenon takes place because wages over $87,000 paid to more than 5% owners are “added back” to business net income to determine the tax. Basically, you have a payroll tax on owners who pay themselves more than $87,000 per year, a tax that is not paid by companies who do not have more than 5% owners.
Further, the filing requirements imposed by the City are highly invasive (and perhaps illegal?). Taxpayers who owe no tax whatsoever to the City/County are still required to provide copies of their individual tax returns, along with related Schedules C, D, and E, even though they have no income to report. The TriMet tax, administered by the State of Oregon has no such requirements. If you don’t owe the tax, you simply don’t file.
But, this is not so with the City/County. I have clients who fear their personal financial details are now sitting on some City employee’s desk, and that information that is required by federal law to be kept in strict confidence is being exposed to those who have no need (or right?) to see such information.
But worst of all, the City/County tax is neither a fair tax nor a simple tax. It relies on a narrow tax base (unfair) and it is one of the most complex and arcane municipal tax codes I have ever encountered. A fairer and simpler tax would be a payroll tax/self-employment tax similar to the TriMet tax. It could have a very low rate because of its broad tax base, and would be extremely simple to administer by simply tacking it on to the Oregon quarterly OQ filing.
A broader tax base would also help to discourage local businesses from the practice of fleeing the City/County boundaries to escape the tax. Regardless of what City leaders may say about this practice, every CPA I know has experience with clients who have relocated out of the City/County boundaries to avoid the tax.
In the meantime, if you own property or do business within the City/County borders and have not been filing your tax returns, now is the time to find out if the amnesty program can help you get into compliance.
Update June 20, 2012: This just in from my tax law reporting service:
“Oregon—Income Tax: Portland Confidentiality Provision Amended
Portland has amended its provision regarding confidentiality of business license tax taxpayers to provide that, in addition to existing prohibitions, it is unlawful for any Portland employee, agent, or elected official or any person who has acquired information to divulge, release, or make known in any manner identifying information about any taxpayer applying for tax amnesty, unless otherwise required by law. Ordinance No. 185312, City of Portland, effective May 9, 2012″
So, what is the penalty for unlawfully disclosing taxpayer information? From the City Code:
Contrast this to the penalty on IRS employees for unlawful disclosure of federal tax information (which is the same information the City employees have about its licensees):
“Penalties for Unauthorized Disclosure-Internal Revenue Code
Internal Revenue Code Sections 7213 and 7431 describe the penalties for unauthorized disclosure of federal information.
Under Section 7213 of the Internal Revenue Code, a governmental actor’s unauthorized disclosure is a felony that may be punishable by a $5,000 fine, five years imprisonment or both. Under Section 7213A of the Internal Revenue Code, the unauthorized inspection of federal tax information is punishable by a $1,000 fine, one year imprisonment or both. Section 7431 of the Internal Revenue Code permits a taxpayer to bring suit for civil damages in a U.S. District Court, including punitive damages in cases of willful disclosure or gross negligence, as well as the cost of the action.”
As you can see, City employees are subject to far less punishment than IRS employees who unlawfully disclose the exact same confidential information.
(With apologies to economist and author Joel Slemrod, author of the paper, My Beautiful Tax Reform)
As an accountant, I get involved in the practical and tedious task of applying tax laws (and related loopholes) to our clients’ fact situations. Rarely do accountants get the time to contemplate (or fantasize about) tax reform, nor to consider systems used effectively by other countries. But, before tax season gets truly underway this year, I have been spending some time educating myself about these matters so that I can combine my practical knowledge with the wisdom of economists and policy analysts around the world.
Professor Slemrod has spent many years evaluating our tax system and expresses the view that a business Value Added Tax (VAT), combined with a highly progressive but simplified individual income tax would deliver the best combination of Fairness and Simplicity (my two objectives for tax reform), and would achieve what he calls “elegance”. He proposes an individual income tax that would exempt most individuals from filing returns, basically by eliminating all deductions and credits, thus broadening the tax base, and then relying on wage withholding to create the proper and equally applied tax to all labor income. The VAT tax would apply to ALL business income, and at a flat rate. Shareholders of corporations would be able to get a credit from the portion of their income already taxed at the corporate level, with the goal being to eliminate all double taxes, and to eliminate all preferential treatment now available through special deductions, credits and business entity selection.
Our current system attempts to tax income (roughly defined as increases in consumption power) by dividing it into 3 pots: labor income, business income, and income from the employment of capital. However, there is little consistency in how these different categories actually work. For example, if I am Mitt Romney and earn my income from “carried interest” I get to pay taxes at a flat capital gains rate of 15%. If I am Warren Buffet’s secretary, I get to pay taxes at much higher rates, depending on my income and deductions, and I also have to pay social security taxes. Publicly traded corporations are subject to a double tax whenever they pay dividends to their shareholders, whereas when they pay interest to their bondholders, they are not. If I lose money on a capital transaction, I can’t deduct the loss unless I have made money on other capital transactions. If I sell my home at a profit, I can exclude the gain up to $500,000 if I am (legally) married. If I earn all my income from dividends and capital gains, I might not have to pay ANY taxes. And, if I am a worker earning a good living, I may be subject to the Alternative Minimum Tax and lose the deductions that my neighbor, who earns less, gets to deduct, thus vastly increasing my marginal tax rate. These are just a few, selected examples of the way our tax system is both complex and unfair.
Fairness in taxation by definition would have to include progressivity as its underpinning. In fact, Professor Slemrod rejects consumption taxes outright, as they can never be made progressive enough. By taxing only consumption, such as through a national sales tax, those who would pay the highest effective rate of tax would be the poor and middle classes, who have to consume certain basic amounts in order to survive. That would be highly unfair, but would admittedly be a simpler tax to administer than our current income tax.
One reason tax reform is so hideous is that anything that affects the federal system will also affect all the states who are connected to the federal system for purposes of defining and determining taxable income. Any major reforms at the federal level will require these states to seriously evaluate and reform their own systems of taxation. Another reason is that by trying to achieve simplicity, one may introduce unfairness, and vice versa. For example, it might be fairer to measure and subtract inflation before taxing capital gains, but now you have introduced a highly complex calculation into the system. You can eliminate this problem by using a consumption tax instead of an income tax, but as noted previously, a consumption tax is a regressive tax, and thus, unfair.
In order to restore legitimacy and moral authority to our government and its system of taxation, the current system MUST be reformed, and it must become fairer and simpler, yet still provide adequate funds. Any steps in those directions are to the good, hideous or not. President Obama’s recent budget proposals include some movements in the right direction: indexing and making permanent AMT exemptions, taxation of carried interest as ordinary income (too bad, Mitt), and simplification of the earned income credit. However, when you read the summary of the President’s budget (spanning 215 pages) you start to feel pretty queasy. More and more tax expenditures (credits and deductions) are being proposed in a desperate effort to insert more fairness into the system, but the end result is more, and much more, of the same highly complex and unfair system that we currently have. Can we give up our favorite deductions and tax credits in exchange for lower and more progressive tax rates? What might be beautiful is restoring the portion of total income taxes once borne by corporations in 1950 (30% of total revenues) from the shockingly low 7% today, something which could be achieved through a VAT tax.
There are a number of ideas being parlayed by presidential candidates, policy makers, and politicians regarding how to reform the U.S. tax code. Unfortunately, none of the ideas mentioned recently are new, nor do they address the fundamental reasons to reform the code, those being: Fairness and Simplicity, which I am capitalizing here as a way of elevating these concepts above other policy goals (involving unfairness and complexity).
History can be a great teacher. But, numbers CAN lie, and everyone has an agenda, including me.
But, let’s take a look at history and see if we can put it in today’s context. First, let’s look at tax rates. Currently, the top marginal rate is half of what it was in 1975 on incomes over $375,000 – 70% vs. 35%. All of the other rates are lower as well, but not by nearly as much. So, the bulk of the benefits of the tax bracket “flattening” has gone to those in the top tax bracket (not surprised, are you?)
Now, what about tax deductions and tax credits? These are also known as “Tax Expenditures” in the world of tax policy making. They are special tax breaks designed to benefit only certain taxpayers, such as the oil and gas industry, home owners, or low income workers with families. Tax Expenditures have risen 43% in the 3 years spanning 2006 to 2009 (think: George W.), and have risen 78% over the last 30 years. What this means is that Fairness has gone out the window, replaced by taxation bent on favoring certain taxpayers and disfavoring others. One taxpayer’s tax on the same income may bear no resemblance to another taxpayer with the same income due to the existence of these special deductions and credits.
Now let’s look at where the taxes come from today vs. where they came from 60 years ago. Employment taxes as a share of the total tax burden have risen 400% in the last 6 decades, going from 10% of total revenues in 1950 to a whopping 40% of total revenues today. Conversely, corporate tax revenues as a percent of total revenues have dropped 428%, going from 30% of total revenues to 7% in 2010. Meanwhile, total individual taxes (not payroll taxes) as a percent of total tax revenues have remained fairly steady for the last 60 years, at about 42%. The rest of the tax revenues come from estate, gift, and excise taxes, and these have fluctuated over the years, but overall, contribute a much lower percentage to total revenues than they did in 1950.
It is quite striking to note that despite all the tweaking and complexity of the current tax code, individuals still bear, overall, about the same burden that they did 60 years ago. The difference is in the mix. Working people of all income levels now bear a much larger burden of the total budget than they did 60 years ago. They contribute not only payroll taxes but income taxes as well. Their total federal effective tax rate can easily exceed 45% if they are self-employed and in the middle class. Wealthy individuals who do not work and derive most of their income from capital gains and dividends enjoy a much lower tax rate. Some of them enjoy a ZERO rate. And, in 2009, the top 10% of taxpayers, those with adjusted gross income exceeding $112,000 paid an overall average tax rate of just 18%. It should be noted however, that those with AGI below the median income of $32,000 (the bottom 50%) paid an average rate of only 1.85% (remember this doesn’t include payroll taxes). It is somewhat shocking to note that the incredibly low AGI number of $32,000 represents ½ of the taxpaying population, and it supports the recent census information indicating that nearly 50% of all Americans are living at or near the poverty level. The biggest beneficiary of the tax burden shift among taxpayers has been corporations, however. Maybe now that they are “people” we should tax them as individuals. That would raise a lot of revenue.
Oddly, tax revenue as a percentage of GDP has remained fairly constant at about 18% for the last 30 years. So, while tax revenues have been stable despite all the tweaking (an estimated 4,000 changes to the code just last year), the federal deficit has been skyrocketing, and WHO PAYS is really the question to ask yourself.
We are very far away from Simplicity and Fairness. The recent proposals to lower rates and take away some deductions (charitable contributions and home mortgage interest) would further skew the Fairness meter, being another boon for the super wealthy. However, taking away deductions does move us toward Simplicity.
In my next post, I’ll take on what I would do to bring about tax reform. In the meantime, although I might be using statistics for my “damned lies,” every fact in this blog post was taken from one of three sources: the Congressional Budget Office, the Joint Committee on Taxation, and the Internal Revenue Service.
We all know that it is not fiscally possible to cut the national deficit/debt without raising someone’s tax bill. I’ll include corporations in my definition of someone, since they are now “persons” with free speech rights. The outlandish and bizarre tax code we currently labor under has been tweaked and pummeled into an unrecognizable amalgam of convoluted provisions, some of them well-meaning, but most not thoroughly or even barely understood by experts, much less by taxpayers.
The growing and shameful income and tax inequality in this country is now finally a topic of conversation among policy makers, thanks to the emerging “Occupy” movement. Will this new dialogue impact tax policy?
Before the Occupy movement took hold, the showdown staged by Republican politicians over the debt ceiling sent shock waves and uncertainty throughout the financial markets all over the world. Their insistence on cutting the debt/deficit without “raising taxes” was a frightening spectacle, and its premise was not only cynical and dishonest, but completely out of touch with reality. Every single federal budget report by every single expert in the field points to the stark and frightening realities of the budget debt/deficit–we can’t grow out of it, we can’t spend out of it, and we may not even be able to tax our way out of it. It is that bad.
I have been waiting for decades for real tax reform. I started my career before the advent of the passive activity rules, which I mark as the beginning of the end for sanity in the world of taxation. While it was important to curb the tax shelter abuses of the early 1980’s, the complexity of the passive activity loss rules opened the door to the idea that, with enough rules, regulations, court cases, and private letter rulings, tax planning can become a game only for the wealthy. Any poor schmuck who can’t afford my fees is doomed.
While tax complexity was increasing, the income gap between the super-rich and the rest of the population continued to grow, grow and grow. Then, during the Bush years, the super-rich finally received their blessings from on high. Many multi-millionaires now find themselves in the ZERO percent tax bracket. Also, during this time the Alternative Minimum Tax went out of control and began hitting middle and upper middle income taxpayers. Yet, a family with the just the right mix of tax goodies will have a tax liability that bears no resemblance to another family with the exact same income.
Some people say that fairness is subjective. No, it isn’t. Fairness is something that society can agree on, just as we can agree on what is a crime and what isn’t. The current tax system is patently unfair. Hence, it has no moral legitimacy. When this happens, you get the Occupy movement. So, tonight I’ll count pigs flying while I dream about real tax reform. Maybe pigs can fly.