Saturday, May 18, 2013

The Case of the Disappearing Taxpayer

Throughout most of the first century of the Republic, there was no income tax. Government was paid for by taxes on whiskey, tobacco, corporate bonds, carriages, and property sold at auction – including, unfortunately, slaves.

The first sales taxes appeared with “Madison’s” War of 1812 when gold, jewelry, and watches. But in the years following that war, Congress abolished all taxes but tariffs on imports.

The Civil War brought the first income taxes in 1862. In the year following the war’s end, tax receipts were $300 million – the highest since the founding of the Republic. Congress wisely abolished the income tax in 1872 and relied on whiskey and tobacco taxes once again to fund government operations.

The 16th Amendment made the income tax the law of the land in 1913 giving Congress the authority to tax both individual and corporate income. Federal tax receipts surpassed a billion dollars in 1918, the last year of WW I. Then in 1943, the withholding tax on wages was instituted. Income taxes were broad-based and 60 million taxpayers – virtually the entire US workforce – paid $43 billion in taxes in 1945, the last year of WW II.

Federal spending in the 60 years following the war – from 1948 to 2008 – tracked a remarkably stable 20% of the GDP. Tax receipts were likewise stable at 18%. The country was prosperous and, with the collapse of the Soviet Union, the US was the world’s only superpower.

In 2008 Barack Obama was elected president and given bullet-proof majorities in both the Senate and House. Both the White House and Congress had the most left-leaning governing ideology in the history of the country. Spending as a percentage of GDP increased to almost 26%. The recession beginning in 2008 caused unemployment to rise and tax receipts to fall. And yet the Obama administration continued spending, borrowing 40% of every dollar it spent.

To provide political cover for the fiscal deficit and growing national debt, Obama launched a class warfare campaign to overturn the Bush 43 tax cuts, relying on the theme that the rich were not paying their fair share of taxes. While the White House kept up the pressure on Congress to raise taxes despite the recession, “low information” voters ignored a trend that had been underway since Lyndon Johnson’s landslide election of 1964: the growing number of wage earners who paid no taxes. This was the legacy of Johnson’s Great Society. Readers may click on the link here to see how the percentage has grown since the launch of Johnson’s welfare scheme in 1968.

The number of people who paid no taxes has grown from 12% in 1968 to 50% of the workforce in 2009. And with fewer people paying federal income taxes, those who pay the cost of government have to shoulder not only their share but also the non-paying half’s share. This has resulted in a very progressive tax system – one that is unsustainable.

No longer is the income tax broad-based because 58 million in the workforce pay no tax. Under current law, deductions and credits exempt most of this number from taxes. A family of four earning $45,000 would pay no tax and could receive a payment from the government of $300 after taking the standard deduction, personal exemption, credit for two children, and an Earned Income Tax Credit. The latter operates like a negative tax when the EITC exceeds the taxes owed.  Some non-payers aren’t even required to file returns.

In recent years the federal government has reduced the number of taxpayers by providing them tax credits. Unlike deductions, which reduce taxable income (like charitable contributions and mortgage interest) tax credits reduce the taxes owed dollar for dollar. So a taxpayer who owes $1,000 in taxes and has a $200 credit will pay $800. A taxpayer who owes $100 and has a $200 credit will receive $100 – a negative tax. In the last two decades the cost of these credits has increased from $20 billion to over $230 billion. Since the government has no money to pay out these credits, they are paid in additional taxes on taxpayers.

In fact, the fastest growing segment of government spending is transfer payments rather than spending on government operations. Transfer payments, as the name implies, takes money from one group and grants it to another group. Social Security and Medicare/Medicaid are examples of transfer payments. Current beneficiaries of these programs pay nothing close to the actual cost of these payments. Even their historic payments, if they had been retained and compounded, would still require subsidies by current taxpayers because services have become more generous. But the fact is historic payments into the “system” were not retained and compounded. The government spent them in exchange for an IOU, leaving the current generation of workers to pick up the tab with their payments into the “system.” Transfer payments for some government services are not dollars paid over to the beneficiary, but in-kind transfers of goods and services, such as healthcare.

Anyone who understands basic economics knows that when the price of a good goes down, the demand for it increases. People are aware of the “price” of government through their taxes. When they pay no taxes, their perception is that government is “free” and thus they demand more services and payments. Of course, government is not free, and when half of the workforce does not pay for it, the cost of increased demand is shifted to taxpayers further exacerbating the demand for more government services and payments.

The shrinking size of the taxpayer class, as well as their income which is subject to tax, cannot sustain the current level of government spending on operations and transfer payments. Predictably, government borrows the balance – currently 40 cents per dollar spent. That problem will only get worse as the number of taxpayers shrink because more workers pay no tax as a consequence of deductions, exemptions, and credits. It has been estimated that for every 1% increase in non-payers, the debt-to-GDP ratio increases seven-tenths of one percent.

From a 10,000-foot view we can see a catastrophe in the making. In order to buy more votes to sustain themselves in power, politicians remove more of the workforce from paying taxes. Because government costs them nothing, they demand more of its “goodies,” and because their number is growing, they become more powerful as a voting bloc. In contrast the taxpayers who are paying more of the cost of government operations and transfer payments are shrinking in number and thus becoming less of a voting bloc. This makes their voices less heard in Washington.

Moreover, within the taxpaying workforce, the tax take is highly progressive. The highest income earners – the top 1% – pay almost 40% of the taxes. The top five percent pay over 60% of the taxes and the top 10% pay over 73% of the taxes. When the top 10% pay almost three-quarters of the taxes, the welfare state which current and past administrations and congresses have created simply isn’t sustainable.

Morally, more people must have skin in the taxpaying game. More people must feel the cost of government and carry that feeling to the ballot box. And morally, no one should be exempted from taxes. Everyone ought to pay something – i.e. everyone should be denied keeping some share of their hard won income however small so that they pay attention to government excesses.

A nation’s tax code should be the voice of the people not the voice of the politicians. It should encourage current thrift for future consumption, reducing the amount of welfare a society requires. The tax pain rather than the tax liability should be equally distributed – e.g. pain for a family earning $45,000 per year requires fewer dollars than the same degree of pain for a family earning $450,000 per year. Taxes should never be used for social engineering or to favor the well-connected and political cronies. Green energy comes to mind.

Most important: the tax system should be easily understood and unimpeachably equitable.

None of these qualities exist in the current tax system. Personal and business decisions are influenced as much by their tax consequences as by their motive. Saving and investment are discouraged; consumption is not. Charitable contributions are currently a deduction. Arguably they should be a tax credit, minimizing government involvement in charitable activities that can be demonstrably delivered more efficiently by private organizations and individuals than government. Votes and political influence is curried with one group that is paid for by another. Loopholes are engineered for interest groups that aren’t available to others. The current tax system is arcane and easily manipulable by politicians.

My friend, Willis Cook, Tax Partner for the CPA firm of Brooks, Cook & Associates, and I have had many discussions about the inequities of the current tax system – usually around April 15 when I am protesting that the government’s take is too much. We have bandied about the merits of the flat tax, the alternative maximum tax, recently put forward in a Wall Street Journal op-ed, and other tax schemes that would achieve the social fairness the Founders intended, not the class warfare Obama provokes.

It seems unlikely that the pygmies in Washington have the courage to create a system with the attributes above, because they would have to abandon the current one and start over. Even then, one wonders if they can be trusted. Ronald Reagan’s 1986 Tax Reform Act promised to forever lower rates if Americans would give up certain deductions and loopholes. We gave them up. The tax rates were raised before he left office. His successor – George “No New Taxes” Bush – broke his pledge and voters rewarded him with permanent retirement.

If the proposal Willis has in mind could be enacted, it would be simple, fair, and favorable to saving and investment. The questions that must be answered are what is income, when is it taxed, what is expense, and when is it deducted?

For example, is income money that is received or money that is owed when title transfers? In the first case you have the cash. In the second case you own an obligation but not the cash. On which is the tax computed?

Personal taxes are calculated differently than business taxes. Should personal taxes be paid on gross income or income net after allowable expenses (deductions) as in our present system? Should taxes be calculated differently for different types of income – wages, interest income, capital gain income, and passive income from a business in which you are not employed but it pays you a share of the profits?

In business a sale can be made and it may be months before the cash is received. A purchase may be made, which is considered an expense, but it too may not be paid for months. When is it income? What is income – the gross amount or net after expense?

The American taxpaying public spends billions of dollars in tax compliance dealing with these questions. Those that compute their own taxes spend millions of hours preparing them. The tax code is so byzantine that it requires accountants like Willis to prepare all but the simplest returns. This becomes a frustrating dance between client and accountant. Willis asks for the required information to prepare the return. The client has no clue what or why that piece of information is needed unless the taxpayer is quite sophisticated. “Did you sell any stocks this year?” asks Willis. “Yes,” answers the client. “Well?” asks Willis. “Huh?” answers the client. “What was your sale price and what was the cost basis?” asks Willis. “What’s a cost basis?” asks the client. This goes on for about an hour until one of them surrenders.

Perhaps I’ve exaggerated a bit. But not much.

In a desperate act of self-preservation, if not the retention of sanity, Willis has proposed a new model. This one permits a relatively unsophisticated taxpayer to escape the hand to hand combat with his accountant each year in a reenactment of Wily Coyote and the Road Runner. Currently clients have neither the interest nor understanding of the records to keep, especially if an extraordinary event occurs during the year, like an inheritance, property sale, or business transaction in another state.  

Willis’ solution is a national sales tax, but a progressive national sales tax, not the flat, or nearly flat, sales tax that funds a great deal of our government at the state and local level.  A progressive sales tax would be one whose rate is increased as the size of the sale increases.  For example, a $10 sale could be taxed at zero, a $100 sale, 5%, a $1 million sale, 20%, etc.  The major decisions would consist of what not to tax, for example medicine, and when to tax a transaction.  The “when to tax” decision addresses primarily the issue of whether an item is taxed when title changes hands, or when it is paid for.  For example, would the tax on a $100 million building be collected upon closing the sale or taxed as money changes hands, e.g. the down payment and debt payments.

If Congress had any interest in true tax reform, it could create a committee to answer the questions posed above. The objective would be to produce the structure of a progressive sales tax law that would fund the treasury at current levels and distribute the tax burden in roughly the same proportion as now distributed.  Their challenge would be to determine what would be taxed, when it would be taxed, and the appropriate tax rate scale. 

The intent in replacing the current tax law would not be to increase or decrease the tax receipts or to increase or decrease the burden on any particular group.  The objective is a simpler system not a political one. A simpler system would encourage thrift, reduce welfare (because people have incentives to prepare for their future retirement,) it would distribute equitably the pain of supporting a central government so everyone pays attention to its efficiency, and it would avoid social engineering and cronyism for special interests. It would collect the money government needs to operate but it could not be manipulated by politicians.

For all of these reasons, true tax reform will never happen.

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