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Posts Tagged ‘Tax Deduction’

The crowd in Washington has responded to the coronavirus crisis with an orgy of borrowing and spending.

The good news is that the legislation isn’t based on the failed notion of Keynesian economics (i.e., the belief that you get more prosperity when the government borrows money from the economy’s left pocket and then puts it in the economy’s right pocket).

Instead, it is vaguely based on the idea of government acting as an insurer for unforeseen loss of income.

Not ideal from a libertarian perspective, of course, but we can at least hope it might be somewhat successful in easing temporary hardship and averting bankruptcies of otherwise viable businesses.

The bad news is that the legislation is filled with corrupt handouts and favors for the friends and cronies of politicians. Simply stated, they have not “let a crisis go to waste.”

The worst news, however, is that politicians have plenty of additional ideas for how to exploit the crisis.

An especially awful idea for so-called stimulus comes from House Speaker Nancy Pelosi, who wants to restore (retroactively!) the full federal deduction for state and local tax payments.

Pelosi suggested that reversing the tax law’s $10,000 cap on the state and local tax (SALT) deduction… The cap on the SALT deduction has been strongly disliked by politicians in high-tax, Democratic-leaning states such as New York, New Jersey and California… But most Republicans support the SALT deduction cap, arguing that it helps to prevent the tax code from subsidizing higher state taxes.

I’ve written many times on this issue and explained why curtailing that deduction (which basically existed to subsidize the profligacy of high-tax states) was one of the best features of the 2017 tax reform.

Needless to say, it would be a horrible mistake to reverse that much-needed change.

The Wall Street Journal agrees, opining on Pelosi’s proposal to subsidize high tax states.

Democrats are far from finished using the crisis to try to force through partisan priorities they couldn’t pass in normal times. Mrs. Pelosi is now hinting the price for further economic relief may include expanding a regressive tax deduction for high-earners in states run by Democrats. …In the 2017 tax reform, Republicans limited the state and local tax deduction to $10,000. …Democrats have been trying to repeal the SALT cap since tax reform passed. …Blowing up the state and local tax deduction would…also make it easier for poorly governed states to rely on soaking their high earners through capital-gains and income taxes, because the federal deduction would ease the burden. …Mrs. Pelosi’s remarks underscore the potential for further political mischief and long-term damage as the government intervenes… When Democrats next complain that Republicans want to cut taxes “for the rich,” remember that Mrs. Pelosi wants to cut them too—but mainly for the progressive rich in Democratic states.

Maya MacGuineas of the Committee for a Responsible Federal Budget also denounced the idea.

This is not the time to load up emergency packages with giveaways that waste billions of taxpayer dollars… Weakening or eliminating the SALT cap would be regressive, expensive, poorly targeted, and precisely the kind of political giveaway that compromises the credibility of emergency spending. …Retroactively repealing the SALT caps for the last two years would mean sending a check of $100,000 to the household making over $1 million per year, and less than $100 for the average household making less than $100,000 per year. …During this crisis, the Committee implores special interest lobbyists to stand down and lawmakers to put self-serving politics aside.

By the way, I care about whether a change in tax policy will make the country more prosperous in the long run and don’t fixate on whether the change helps or hurts any particular income group. So Maya’s point about the rich getting almost all the benefits is not what motivates me to oppose Pelosi’s proposal.

That being said, it is remarkable that she is pushing a change that overwhelmingly benefits the very richest people in the nation.

The obvious message is that it’s okay to help the rich when a) those rich people live in places such as California, and b) helping the rich also makes it easier for states to impose bad fiscal policy.

Which is why she was pushing her bad idea before the coronavirus ever became an issue. Indeed, House Democrats even passed legislation in 2019 to restore the loophole.

Professor John McGinnis of Northwestern University Law School wrote early last year why the deduction was misguided and why the provision to restrict the deduction was the best provision of the 2017 tax law.

…the best feature of the Trump tax cuts was the $10,000 cap on the deductibility of state and local taxes. It advanced one of the Constitution’s most important structures for good government—competitive federalism. Deductibility of state taxes deadens that competition, because it allows states to slough off some of the costs of taxation to citizens in other states. Moreover, it allows states to avoid accountability for the taxes they impose. Given high federal tax rates in some brackets, high income tax payers end up paying only about sixty percent of the actual tax imposed. The federal government and thereby other tax payers effectively pick up the rest of the tab. …the ceiling makes some taxpayers pay more, but its dynamic effect is to make it less likely that state and local taxes, particularly highly visible state income taxes, will be raised and more likely that they will be cut.

For what it’s worth, I think the lower corporate tax rate was the best provision of the 2017 reform, but McGinnis makes a strong case.

Perhaps the best evidence for this change comes from the behavior of politicians from high-tax states.

Here are some excerpts from a Wall Street Journal editorial from early last year.

New York Gov. Andrew Cuomo…is blaming the state’s $2.3 billion budget shortfall on a political party that doesn’t run the place. He says the state is suffering from declining tax receipts because the GOP Congress as part of tax reform in 2017 limited the state-and-local tax deduction to $10,000. …the once unlimited deduction allowed those in high tax climes to mitigate the pain of state taxes. It amounted to a subsidy for progressive policies. …The real problem is New York’s punitive tax rates, which Mr. Cuomo and his party could fix. “People are mobile,” Mr. Cuomo said this week. “And they will go to a better tax environment. That is not a hypothesis. That is a fact.” Maybe Mr. Cuomo should stay in Albany and do something about that reality.

Amen.

The federal tax code should not subsidize politicians from high-tax states. Nor should it subsidize rich people who live in high-tax states.

If Governor Cuomo is worried about rich people moving to Florida (and he should be), he should lower tax rates and make government more efficient.

I’ll close with the observation that the state and local tax deduction created the fiscal version of a third-party payer problem. It reduced the perceived cost of state and local government, which made it easier for politicians to increase taxes (much as government subsidies for healthcare and higher education have made it easier for hospitals and colleges to increase prices).

P.S. Speaking of fake stimulus, there’s also plenty of discussion on Capitol Hill (especially given Trump’s weakness on the issue) about squandering a couple of trillion dollars on infrastructure, even though such spending a) should not be financed at the federal level, b) would not have any immediate impact on jobs, and c) would be a vehicle for giveaways such as mass transit boondoggles.

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If I had to pick my least-favorite tax loophole, the economist part of my brain would select the healthcare exclusion. After all, that special preference creates a destructive incentive for over-insurance and contributes (along with Medicare, Medicaid, Obamacare, etc) to the third-party payer crisis that is crippling America’s healthcare system.

But if I based my answer on the more visceral, instinctive portion of my brain, I would select the deduction for state and local taxes. As I’ve previously noted, that odious tax break enables higher taxes at the state and local level. Simply stated, greedy politicians in a state like California can boost tax rates and soothe anxious state taxpayers by telling them that they can use their higher payments to Sacramento as a deduction to reduce their payments to Washington.

What’s ironic about this loophole is that it’s basically a write-off for the rich. Only 30 percent of all taxpayers utilize the deduction for state and local taxes. But they’re not evenly distributed by income. Here’s a sobering table from a report by the Tax Foundation.

The beneficiaries also aren’t evenly distributed by geography.

Here’s a map from the Tax Foundation showing in dark blue that only a tiny part of the country benefits from this unfair loophole for high-income taxpayers.

As you can see from the map, the vast majority of the nation deducts less than $2,000 in state and local taxes.

But if you really want to see who benefits, don’t simply look at the dark blue sections. After all, most of those people would happily give up the state and local tax deduction in exchange for some of the other policies that are part of tax reform – particularly lower tax rates and less double taxation.

And I suspect that’s even true for the people who hugely benefit from the deduction. The biggest beneficiaries of this loophole are concentrated in a tiny handful of wealthy counties in New York, California, New Jersey, and Connecticut.

As you can see, they reap enormous advantages from the state and local tax deduction, though I suspect these same people also would benefit if tax rates were lowered and double taxation was reduced.

Regardless of who benefits and loses, there’s a more fundamental question. Should federal tax law be distorted to subsidize high tax burdens at the state and local level?

Kevin Williamson of National Review says no.

…the deduction of state taxes against federal tax liabilities creates a subsidy and an incentive for higher state taxes. California in essence is able to capture money that would be federal revenue and use it for its own ends, an option that is not practically available to low-tax (and no-income-tax) states such as Nevada and Florida. It makes sense to allow the states to compete on taxes and services, but the federal tax code biases that competition in favor of high-tax jurisdictions.

The Governor of New York, by contrast, argues that the tax code should subsidize his profligacy.

It would be “devastating on the state of New York, California, et cetera, if you didn’t allow the people of this state to deduct their state and local taxes,” Cuomo told reporters… State and local governments have been working to preserve the deduction, and they argue that doing away with the preference would hurt states and localities’ flexibility to make tax changes.

By the way, I noticed how the reporter displays bias. Instead of being honest and writing that that the loophole enables higher taxes, she writes that the loss of the preference “would hurt states and localities’ flexibility to make tax changes.”

Gee, anyone want to guess how that “flexibility” is displayed?

Though at least the reporter acknowledged that the deduction is primarily for rich people in blue states.

…the deduction…is viewed as disproportionately benefiting wealthy people. It also tends to be used in areas that lean Democratic.

And that’s confirmed by a 2016 news report from the Wall Street Journal.

Repealing the federal deduction for state and local taxes would make 23.6% of U.S. households pay an average of $2,348 more to the Internal Revenue Service for 2016. But those costs—almost $1.3 trillion over a decade—aren’t evenly spread… Ranked by the average potential tax increase, the top 13 states (including Washington, D.C.), as well as 16 of the top 17, voted twice for President Barack Obama. …And nearly one-third of the cost would be paid by residents of California and New York, two solidly Democratic states. …President Ronald Reagan tried repealing the deduction as part of the tax-code overhaul in 1986, but he was rebuffed by congressional Democrats and state officials. …Republicans argue that the break subsidizes high state taxes, because governors and legislators know they can raise income taxes on their citizens and have the federal government pick up part of the tab. …half the cost of repealing the deduction would be borne by households making $100,000 to $500,000, using a broad definition of income. Another 30% would be borne by households making more than $1 million. Under the GOP plans, residents of high-tax states wouldn’t necessarily pay more in federal taxes than they do now. They would benefit from tax-rate cuts.

Here’s one final image that underscores the unfairness of the deduction.

The Tax Policy Center has a report on the loophole for state and local taxes and they put together this chart showing that rich people are far more likely to take advantage of the deduction. And it’s worth much more for them than it is for lower-income Americans.

How much more? Well, more than 90 percent of taxpayers earning more than $1 million use the deduction and their average tax break is more than $260,000. By contrast, only a small fraction of taxpayers earning less than $50 thousand annually benefit from the deduction and they only get a tax break of about $3,800.

Yet leftists who complain about rich people manipulating the tax system usually defend this tax break.

It’s enough to make you think their real goal is bigger government.

I’ll close by calling attention to the mid-part of this interview. I shared it a couple of days ago as part of a big-picture discussion of Trump’s tax plan. But I specifically address the state and local tax deduction around 3:00 and 4:30 of the discussion.

P.S. In addition to the loophole that encourages higher taxes at the state and local level, there’s also a special tax preference that encourages higher spending at the state and local level. Sigh.

P.P.S. Now, perhaps, people will understand why I want to rip up the current system and replace it with a simple and fair flat tax.

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The tax code is a complicated nightmare, particularly for businesses.

Some people may think this is because of multiple tax rates, which definitely is an issue for all the non-corporate businesses that file “Schedule C” forms using the personal income tax.

A discriminatory rate structure adds to complexity, to be sure, but the main reason for a convoluted business tax system (for large and small companies) is that politicians don’t allow firms to use the simple and logical (and theoretically sound) approach of cash-flow taxation.

Here’s how a sensible business tax would work.

Total Revenue – Total Cost = Profit

And it would be wonderful if our tax system was this simple, and that’s basically how the business portion of the flat tax operates, but that’s not how the current tax code works.

We have about 76,000 pages of tax rules in large part because politicians and bureaucrats have decided that the “cash flow” approach doesn’t give them enough money.

So they’ve created all sorts of rules that in many cases prevent businesses from properly subtracting (or deducting) their costs when calculating their profits.

One of the worst examples is depreciation, which deals with the tax treatment of business investment expenses. You might think lawmakers would like investment since that boosts productivity, wage, and competitiveness, but you would be wrong. The tax code rarely allows companies to fully deduct investment expenses (factories, machines, etc) in the year they occur. Instead, they have to deduct (or depreciate) those costs over many years. In some cases, even decades.

But rather than write about the boring topic of depreciation to make my point about legitimate tax deductions, I’m going to venture into the world of popular culture.

Though since I’m a middle-aged curmudgeon, my example of popular culture is a band that was big about 30 years ago.

The UK-based Guardian is reporting on the supposed scandal of ABBA’s tax deductions. Here are the relevant passages.

The glittering hotpants, sequined jumpsuits and platform heels that Abba wore at the peak of their fame were designed not just for the four band members to stand out – but also for tax efficiency, according to claims over the weekend. Abba…And the reason for their bold fashion choices lay not just in the pop glamour of the late 70s and early 80s, but also in the Swedish tax code. According to Abba: The Official Photo Book, published to mark 40 years since they won Eurovision with Waterloo, the band’s style was influenced in part by laws that allowed the cost of outfits to be deducted against tax – so long as the costumes were so outrageous they could not possibly be worn on the street.

When I read the story, I kept waiting to get to the scandalous part.

But then I realized that the scandal – according to our statist friends – is that ABBA could have paid even more in tax if they wore regular street clothes for their performances.

In other words, this is not a scandal at all. It’s simply the latest iteration of the left-wing campaign (bolstered by tax-free bureaucrats at the Paris-based OECD) to de-legitimize normal and proper tax deductions.

So I guess this means that the New York Yankees should play in t-shirts and gym shorts since getting rid of the pinstripes would increase the team’s taxable income.

And companies should set their thermostats at 60 degrees in the winter since that also would lead to more taxable income.

Or, returning to the example of ABBA, perhaps they should have used these outfits since there wouldn’t be much cost to deduct and that would have boosted taxable income.

Shifting to the individual income tax, another potential revenue raiser is for households to follow this example from Monty Python and sell their kids for medical experiments. That would eliminate personal exemptions and lead to more taxable income.

Heck, maybe our friends on the left should pass a law mandating weekend jobs so we could have more income for them to tax.

Though I’m not sure how that would work since the statists are now saying Obamacare is a good thing because it “liberates” millions of people from having to work.

I’m not sure how they square that circle, but I’m sure the answer is more class-warfare tax policy.

P.S. If you want to a simple rule to determine what’s a legitimate tax deduction, just remember that economic activity should be taxed equally (and at the lowest possible rate). That’s why businesses should have a cash-flow tax, and it’s why households should have a neutral system like a flat tax or national sales tax.

P.P.S. Though it would be nice if we had the very limited government envisioned by the Founding Fathers. In that case, we wouldn’t need any broad-based tax whatsoever.

P.P.P.S. A very low tax rate is the best way of encouraging taxpayers to declare income and minimize deductions. Sweden Individual Income tax ratesWhen ABBA first became famous, the top personal tax rate in Sweden was at the confiscatory level of about 80 percent and the corporate tax rate was about 55 percent. With rates so high, that meant taxpayers had big incentives to reduce taxable income and little reason to control costs.

After all, a krona of deductible expense only reduced income by about 20 öre for individual taxpayers.

Corporate taxpayers weren’t treated as badly, but a rate of 55 percent still meant that a krona of deductible expense only reduced after-tax income by 45 öre.

But if the rate was very modest, say 20 percent, then taxpayers might be far more frugal about costs (whether the cost of uniforms or anything else) because a krona of deductible expense would reduce income by 80 öre.

By the way, the United States conducted an experiment of this type in the 1980s and the rich wound up declaring far more income to the IRS.

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