Tuesday, April 18, 2017

Today Is Tax Day

In thinking about taxes we often focus on the wrong issue.

Levels aren't the be-all and end-all.

There are a few glaring structural deficiencies in our tax code

Some should be recognizable by any objective observer.

This posting introduces two examples of structural deficiencies in US tax code. They are only examples. There are many other structural deficiencies and each of the topics discussed below introduces a raft of subsidiarity issues. However, the broad issues these two topics raise are badly in need of focused attention and rational political discourse.

1. Tax Reform Is Bigger Than a Bread Basket: Personal Income Taxes.

It's an incredible mess because it's treated as if it were a bread basket.

It is unfortunate that a substantial portion of the voting population approaches tax reform and taxes in general from a totally selfish “what's in it for me” perspective. They pursue that selfish objective from the narrow perspective of how much they are going to have to pay in taxes if nothing else changes. By so doing, they often defeat their true self-interest. Taxes have broad economic and social implications that are often far more important to an individual's future than the narrow issue of what their tax bill will be next year if nothing else changes. One of the most perverse of those broad economic and social implications results from the inefficiency of the tax system in the US.

Keep them in the dark

No one can ensure that taxpayers understand the difference between their marginal tax rate and their average tax rate, and even if they do, it's easy enough for politicians to make statements about tax rates without saying which they're talking about. Add deductions to the mix and changes in income levels at which different marginal rates apply; then the calculations are more complicated. Just to round things out, add in different tax rates for capital gains, dividends, wages, and transfer payments received from the government.

If that isn't burdensome enough for taxpayers, create a totally separate tax system called the Alternative Minimum Tax. To really make it opaque, hide some taxes some by calling them contributions, and then tax income used to pay the contributions. Add some negative taxes and tax credits so that taxes can be something you pay or something the government pays you. For good measure, have some taxes that are paid by entities other than the individual but are passed on to the individual. Just in case someone does figure it out, wait till the end of the year, or better yet, the beginning of the next year, and change everything retroactively.

Provide lots of opportunities for theater

The personal tax system doesn't look like a system designed to efficiently raise revenue for the government. The only things it does efficiently are to allow lots of opportunities for political theater, grandstanding and raising revenue from lobbyists. By making personal income taxes so confusing, politicians can focus on minor changes that appeal to a particular group they are addressing. In addition, the system is so complicated that any changes can be presented in a way that appeals to any particular group. Tax changes can be presented in terms of dollar impact, the impact on the percent of all taxes paid, the impact on the portion of income paid in taxes, the impact on marginal rates, the impact on average rates, the total impact on revenue, or the impact on individuals with a particular interest.

If you can’t provide benefits, fan envy

Paying taxes is not a benefit of government. It's a necessity in order to have the benefits of government. So, changing the personal tax system doesn't provide benefit to anybody unless it leads to a more efficient system for raising the revenue the government needs. However, honest politicians won't get reelected if they put their faith in the public's willingness to accept efficiency as an objective. Few politicians are willing to point out that it's always in the government's interest to raise more revenue; after all, it gives them more power and money. But, they can derive benefit from changing the tax system by claiming that they are protecting a particular group from, depending upon your attitude, the burden or responsibility of paying taxes. It's a perfect issue to use to fan a class warfare mentality and cultivate destructive envy.

Implications for serious tax reform advocates

It's unfortunate that personal income taxes are such a convenient way to cultivate class warfare and envy. But, given that that is the case, it's an issue that is best skipped if one wants to accomplish serious tax reform. So, for this tax day don’t focus on whether personal income taxes are too high or too low, too regressive for to progressive, or administered fairly or not. Instead, think about the drag on the economy the results from the system that's taken on a life of its own and develop the ability to defend its own inefficiency. That's the tax code of the US.

2. Tax Reform: Corporations Are Not All Businesses

Price the value of incorporation whether for business or pleasure.

There are advantages to incorporating regardless of the purpose of the corporation. Principal among those benefits is limited liability. That limited liability applies to an investment in the business or a donation toward a nonprofit corporation.

Price the benefit

The law treats corporations as having certain rights as individuals. All individuals should pay taxes. The object of the tax code should include pricing the benefits of incorporation. It should not be dependent upon a judgment about the objective of the corporate individuals.
However, we place a much higher cost to incorporating based upon totally irrelevant criteria. We don't tax the benefit of incorporation directly. Rather, we tax it indirectly by taxing the income of a small subset of all corporations. It would be more appropriate to tax the benefit of limited liability than to discriminate under the law based upon the objective and financial performance of the corporation.

Corporate individuals receive benefit from offering limited liability to those who participate in the corporation. The benefit to the corporation can be either priced directly by charging the corporation or indirectly by charging the participant. In the interest of simplicity, it may be much easier to price that benefit by charging the participant. That charge to the participant could take a multitude of forms, but a simple option for consideration would be to levy a fee on the participant at the time they participate. So, for example, there could be a charge of 1/10 of a cent per dollar of participation. In this example, a $20 donation to a nonprofit corporation would require payment of two cents. Similarly, a $20 investment in a bond or equity of a for-profit corporation would also involve a fee of two cents. Revenue raised by the levy could either be treated as a cost of the corporation or as an expense of the individual.

Keep it simple and efficient

The levy could be made very efficient by having it collected and paid by the nonprofit in the case of nonprofits, and collected and paid by brokers in the case of for-profit corporations. For nonprofits, consideration would have to be based either on the input of the participant or the expenditures of the Corporation. In most cases, a levy on the participant input would be appropriate. The only exception would be instances where the activity of the corporation is intentionally biased away from the input of the money and toward the expenditure. An example would be an individual who funnels all expenditures through a corporate entity without acknowledging that the use of the income automatically implies the participant’s income is being treated as income for the corporation in the first place. Funds received from an endowment would be treated the same as any other participation. The intent of pricing the benefits of incorporation suggests that the levy should be uniform and universal. It would apply to any and all incorporated activities.

There is considerable evidence that many nonprofits, especially charitable foundations, act as fronts for personal aggrandizement for their founders. The IRS also expends a fair amount of effort (i.e., taxpayer money) to ensure that nonprofits are only nonprofit for that portion of their activity that “qualifies” for nonprofit status. Neither problem would be eliminated by the presence of the levy. However, the incentive to abuse the tax codes related to nonprofits would be reduced to the extent the levy is substituted for current taxes on profits. It would also reduce the need for the government to essentially regulate the activity of the nonprofits through IRS examination and rulings.

Acknowledge the alternative

Nonprofit corporations know they benefit from limited liability. If they are unwilling to pay for it, an alternative is unlimited liability applied both to the nonprofit corporation and to those who contribute to it. The alternative of unlimited liability is analogous to businesses that are not incorporated. It's a perfectly legitimate way to operate.

Stop adding a subsidy to the existing benefit of incorporation

Participants in a corporation received the benefit of limited liability regardless of whether they participate by contributing or by taking partial ownership. Equal treatment under the law suggests that providing tax deductions for participation in the limited liability corporation should either be tax-deductible or not tax deductible. If participation in a corporation through a charitable donation is tax-deductible on personal income taxes, the same should apply to participation by stock or bond ownership. However, making neither tax-deductible is appropriate. Both the donor and the investor are receiving the benefit of limited liability. Congress should eliminate the charitable deduction on personal income taxes.

Scoring consistence

Eliminating the charitable deduction and charging a fee for the privilege of enjoying limited liability status would raise revenue. The revenue could be used to offset reductions in reliance on taxes on profits of profitable for-profit corporations. Profitable for-profit corporations are, after all, a very small portion of the total number of corporate individuals. All corporations benefit from the limited liability of corporate status.

The fee for the privilege of enjoying limited liability would obviously be set based on negotiations within Congress. It could be 1/10 of the penny per dollar as in the example above or at 100th of a penny or any other level. But, the level selected should, to the extent possible,   reflect the benefit of limited liability. The total amount of the fee should be larger or smaller based upon the size of the organization as reflected by the revenue being raised. 

Scoring, that is estimating the revenue implications of these measures, can be done in two ways. Static scoring assumes nothing changes other than the tax. Dynamic scoring estimates both the change in the taxes and the change in behavior the results from the taxes. Whichever technique is used for one tax measure should be used for all other components of these tax changes.

The issue of scoring could lead to a comedy of hypocrisy. Since the elimination of the charitable deduction and the levy on the privilege of operating through a limited liability corporation will affect many organizations that currently have advocacy operations. Watching them change their position regarding which is the most realistic approach will be interesting. Some of those organizations have argued for static scoring on tax cuts such as the reduction in the corporate profits tax. Yet, they will be quick to argue that eliminating the deduction and adding the levy has dynamic consequences that will have detrimental impacts on them because it will reduce the amount of revenue they raise. A little self-interest sometimes reveals truths that were previously hidden by ideological blinders.

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