Tradeoffs in tax policy

Excerpts from Howard Mark’s memo: It’s All Very Taxing

The concept of “paying a fair share” is nebulous at best. It’s very contentious because everyone has a horse in the race. Mark’s memo is my favorite reference for the complexities and competing goals when designing tax policy.

Mark’s published the memo in November 2011 so the specifics are outdated but this doesn’t negate the reasoning. In fact, the changes actually highlight how our tax code evolves to punish or incentivize certain behavior.

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Intro

We have a progressive system of taxation, meaning that higher earners don’t merely pay more in terms of dollars; they generally pay a higher percentage of their incomes in taxes. Most people agree that this is fair. But is it? Why should success be penalized through greater taxation? And if the tax rate for those who earn more should be higher, how much higher?

Under the U.S. system, people in higher income brackets pay tax at higher rates. In large part, the question of fairness primarily surrounds whether the higher rates are high enough. Talk about “the eye of the beholder.” There’s evidence on both sides of this debate: The top 1% of U.S. taxpayers pay 38% of all individual federal taxes.

A breakdown of the numbers

The top 10% pay 70% of all taxes, the top 25% pay 86%, and the top 50% pay 97%. The bottom 50% of all taxpayers paying only 3% of the total.

About half of Americans pay no federal income tax, and almost 25% pay no federal taxes at all. The average federal income tax rate for the top 1% of Americans is 23% (and for the top half it’s 14%), while the average rate for the bottom half is 3%.

They pay at lower rates than they used to and it seems progressivity has declined. . . . the effective federal tax rate, including payroll taxes, for the wealthiest 0.01 percent of earners fell to 31.5 percent in 2005, from 42.9 percent in 1979 [for a decline of 26.6%], according to data from the Congressional Budget Office. Over the same time, effective rates for taxpayers in the center of the range fell to 14.2 percent, a decrease of just 4 percentage points [or 22.0%]. (The New York Times, September 21, 2011). Total revenues from income taxes have declined in the U.S. – they “are at a historic low. of 15.3 percent of the gross domestic product, compared with a postwar average of 18.5. percent” (Financial Times, September 25) – and they’ve declined more for top earners. than for the rest. This is because of both specific rate cuts that have been enacted and the fact that the rates applied to dividends and capital gains – which clearly flow more to people in the upper-income brackets – have declined relative to the rates on salaries and wages.

• On average, higher earners absolutely do pay a higher percentage than those who earn less.
• But the decision as to whether the differential is just right, too little or too great is highly subjective and certainly a valid topic for debate.

A non-exhaustive list of trade-offs to consider

• Are some forms of income more desirable to society and thus deserving of taxation at lower rates?

A discussion about investment vs wage income

• • Long-term capital gains are taxed at reduced rates because of a judgment that long-term investment in things like securities, companies and real estate is beneficial for the economy and should be encouraged. Right now, the top tax rate on long-term investment profit is less than half that on short-term gains and ordinary income.
  • What about interest? Why are dividends taxed at preferential rates and interest at ordinary rates? The explanation may lie in the fact that interest is deductible for corporations, while dividends aren’t. Interest is paid out of pretax income, while in theory dividends are paid out of after-tax income – although the existence of corporate deductions and credits means dividends may, in fact, be paid out of income that hasn’t been taxed by the U.S. Alternatively, the difference in tax treatment may be the result of a desire to encourage investment in “risky” equities rather than “safe” debt. But some companies’ dividends are no doubt safer than some other companies’ interest payments, so this distinction is questionable. If the goal is to encourage risk-bearing, is dividend versus interest the right criterion?
  • While on the subject of gains from investments, it’s interesting to note that, not long ago, dividends were included with interest under the rubric “unearned income.” And it was taxed more heavily than wages.
  • But now things have turned 180 degrees, and returns on capital are taxed at lower rates than wages. It’s worth noting that the Democrats – commonly considered the party of labor – controlled the government for much of the period 1928 to 1980, when earned income was favored. On the other hand, the Republicans – the party of those with capital to invest – have been in control more of the time since 1980, and the taxation of returns on capital has declined in relative terms. The definition of virtuous income that should be encouraged through lower taxes clearly is subjective, impermanent and subject to change with the winds of politics.

• Should we encourage certain expenditures by making them deductible from taxable income?

The drafters called them deductions: provisions that reduce the net income on which taxes are levied. Critics call them loopholes, suggesting there’s something underhanded
about those provisions. And politicians use the laudatory-sounding term tax incentives to describe tax code provisions that reduce tax revenues in order to encourage certain
behavior. It all depends on your point of view.

Interest on mortgages

• • For as long as I can remember, interest on home mortgages has been treated as a desirable expenditure that should be encouraged. Because homeownership is considered part of the American dream, the tax code subsidizes it by reducing the after-tax cost for those who borrow to buy homes (and are able to itemize rather than take the standard deduction). While everything else may be arguable, certainly this seems fair. But is it? Are homeowners more virtuous than renters? If mortgage interest is deductible but rent isn’t, we’re requiring renters to subsidize owners. Is that appropriate?
  • On average, homeowners are from the middle and upper-income brackets. Is it fair that poorer renters provide a benefit for richer owners?
  • And is it desirable that those able to buy more expensive homes should get more of a subsidy than those consigned to cheaper ones?
  • As with the taxation of dividends, judgments on these matters change over time. Until 1987, there was no limit on the amount of mortgage interest that could be deducted. If you could afford to own ten homes with multiple million-dollar mortgages on each one, taxpayers would collectively share the cost by reducing your income taxes due. Today interest is deductible on only a maximum of $1.1 million of debt, and only on first and second mortgages, and only on a primary residence and a second home. So the tax treatment of owners of many homes and more expensive homes has become less generous. But it’s still better than that of renters. Is that proper?

Charitable deductions

• • As I travel the world visiting with clients, I see that two things about the U.S. are quite uncommon: (a) Americans give a lot of money to charity and (b) donations to charity are deductible in calculating taxable income. Everyone tells me the latter is the main reason for the former. In particular, these things are part of the explanation for the existence of the
    many private, non-state-supported colleges and universities in the U.S.
  • Part of this is true because legislators decided at some point to subsidize non-profits by encouraging contributions through the tax code. That’s certainly understandable. And yet, changes were made in recent years to limit upper-bracket taxpayers’ use of deductions in order to ensure that they pay some minimum tax rate. What about the unevenness of the subsidy?
    • The cost of giving $1 to charity is reduced by the amount of taxes it saves the donor, which is equal to $1 times the person’s tax rate. So today, speaking simplistically, it costs a top-bracket taxpayer 65 cents to give a dollar to charity, while it costs a bottom-bracket taxpayer 85 cents. Is that fair? Should the bigger earner receive a greater reward for a dollar of philanthropy than someone who can afford it less easily?
    • And should those who aren’t inclined to give to charity be required to subsidize those who are?

State and local deductions (SALT)

• • Deductibility on the federal tax return somewhat evens out the burden and ensures that (a) the states get first crack at taxing income and (b) the federal government can only tax
    what’s left, in line with federalist principles.
  • This raises a number of questions. Is the deductibility of state and local taxes fair? As with other deductions, the key question is “fair to whom?” Some people pay more state
    and local taxes than others, meaning they get greater deductions than others. As a result, while a person with a given income who lives in a high-tax state pays higher total taxes,
    he or she pays less federal tax than someone in a low-tax state. Is that fair?
  • Should the federal government subsidize spending on the part of high-tax states? That is, should residents in low-tax states bear part of the expenses of high-tax states?
  • While the source of an exemption rather than a deduction, what about interest on “municipal bonds” issued by states, counties, cities and local agencies. This is exempt from federal taxation, under the legal doctrine that the federal government mustn’t tax the operations of the states. But here again, we’re talking about a federal benefit (in the form of a lower cost of capital) for the biggest-spending local governments and their citizens, and a tax break for people who lend to them.

Property and sales taxes

• • Property taxes deductible without limitation. Thus the owner of a mansion – or ten mansions – receives more of a tax benefit than a low-income earner. And it’s another subsidy for homeowners versus renters. Is this right, or should it be changed?
  • Sales tax used to be deductible, too (meaning the buyer of a Rolls Royce got assistance from the federal government). Now it’s not. More fair?

The biggest exclusions of all: employer-provided health care and the deferral of taxation of contributions to pension plans

• • In both cases, those receiving these employer-paid benefits enjoy a substantial benefit not shared by those not fortunate enough to participate. For instance, is it fair that many better-paid workers get thousands of dollars a year in untaxed health-care benefits, while other workers enjoy no such subsidy?

• Just think of how complicated the argument is on “fair” ways to raise taxesThere’s an argument that for the deficit solution to be equitable, all citizens should contribute to it. Though some government spending benefits all citizens alike, such as national defense, national parks and the administration of justice, much spending disproportionately benefits lower earners, in the form of public education and transportation (which are supported by the federal government), unemployment insurance, food stamps, Medicare and Medicaid, etc. Thus the effect of the coming spending cuts will fall more heavily on the poor. Some argue that since they receive less in benefits and are therefore less likely to experience their loss, the wealthy should share the burden of reducing the deficit through increased tax payments.
• Keeping taxes low in general
  • Reduce wastefulness
  • Laffer curve
  • Encourage growth