Wednesday, April 18, 2007

Class Warfare Taxation Hurts Middle Class Pawns

I once had a career as a federal tax professional. I was initially hired for a project that refigured taxes for people that had failed to take known deductions. It felt good to be generating refunds for people.

Eventually I worked up the ladder and went to tax auditor school. I learned to read the Internal Revenue Code, which is the compilation of actual tax laws that Congress has passed and the President has signed. If you pop open your handy-dandy IRC for some light reading, you will quickly realize that few legislators could possibly have actually read through the arcane language they put into place.

Not surprisingly, tax professionals (and even judges) can’t read it very well either. And ingenious taxpayers are forever coming up with ways to apply the code that nobody ever thought of before. So the Department of the Treasury issues Treasury Regulations, which include advisories from the IRS, rulings by the Commissioner of Internal Revenue, rulings by lesser authorities, and rulings by tax courts. While the IRC itself comprises thousands of pages, the Regs are roughly four times as thick.

Again, it should surprise no one that even the addition of this multi-tome set fails to adequately clarify matters. Often it serves to murkify. But thankfully the private sector has come to the aid of both taxpayers and tax officials swimming in a seemingly boundless sea of laws and regulations by offering a variety of guides aimed at the professional level. These voluminous guides dissect each minute subsection of the code, cross reference pertinent Regs and court cases, and gingerly explain how issues are applied in real life. I supply no link to these because they are available only by spending considerable money.

During my tenure as a tax professional, our federal politicians succeeded in “simplifying” the tax code so much that it doubled its required shelf space. The regs and guides, of course, did the same. That is why I’m always skeptical when I hear a politician talking about tax simplification.

Utah Policy’s LaVarr Webb is fond of saying that Congress is only capable of two things: nothing and overreacting. Nowhere is this better exemplified than in the tax code. It is a collection of 94 years of overreactions and failure to act where action should have been undertaken.

Politicians regularly gripe about the complexity of filing a tax return. Some give lip service to the idea that taxes should be simplified to the point that they could be filed on a postcard. But they cannot bring themselves to go this route. Why not? For two reasons, which are actually two variations of the same reason: 1) Tax law is frequently used to pay political favors, and 2) tax law is often employed as a tool of social engineering.

Let’s look at an example of the latter, which is also an excellent case study of Congress’ two default behaviors of both overreacting and doing nothing — just at different times. It started in 1969 when Congress overreacted to the news that 21 tycoons had escaped paying taxes by applying legal loopholes. In its fury, the Democratically controlled Congress imposed the Alternative Minimum Tax, which was designed to make sure that rich people that get out of paying regular income tax will still pay some taxes. President Nixon signed it as part of that year’s tax act.

Over minority objections, the AMT was not indexed for inflation. So over the years, the tax began to apply to increasing numbers of taxpayers. In 1993, Congress exacerbated the problem by raising the AMT rate from 24% to a combined 26%/28% rate. The upshot is that for the 2006 tax year, 3 million taxpayers had to pay AMT. But this number was only that small because of temporary measures included in the Bush tax cuts that are set to expire. In this case, Congress didn’t do nothing, but it failed to go far enough to reign in this unruly tax. While Congress now sits around doing nothing about the problem, the tax is set to impact 23 million taxpayers in the 2007 tax year.

So a tax that was meant to apply only to a small handful of Warren Buffett types will soon apply to 20% of the taxpaying public. If you’re sitting there thinking that at least you’re out of the woods, consider the fact that some people earning only $75,000 will be paying this tax when they file their taxes next year. You might find yourself among that number. Oddly enough, some of the tycoons for whom this tax was custom built have managed to find legal ways to avoid paying it. Go figure.

Why is Congress doing nothing about this? The simple answer is that they are addicted to spending. It is estimated that scrapping the tax would “cost” the government billions next year and $1 trillion over a decade. (Never mind what it will cost taxpayers if the tax isn’t scrapped.) These numbers ignore the revenue increases that would occur via regular income tax if the AMT were not collected, because Congress mandates that it live in a universe that ignores reality.

Why is Congress likely to at least make some attempt to do something about the AMT? Many of the taxpayers that will be paying the AMT for the first time come from states with the highest state tax rates. You see, state taxes that are deductible for regular income taxes are not deductible for purposes of the AMT. And unsurprisingly, congressional delegations from states with the highest tax rates consist overwhelmingly of Democrats, some of them quite powerful. Think California, New York, New Jersey, and Michigan, among others.

The Wall Street Journal editors note in this editorial that the “easiest exit from this box canyon would be for Democrats to cut the AMT rate back to its pre-Clinton levels….” But the most common schemes being floated around ply the old class warfare waters of sticking it to the rich. Um, you might note that sticking it to the rich was the entire goal of the AMT, and that this didn’t work out so well over the long haul. It’s a bad idea to try to fix the problem simply by creating another similar one.

The other night I spent half an hour running through Form 6251 to figure my retired (decidedly not rich) parents’ AMT. It only took half an hour because, as a former tax professional, I know how to do these things quickly. Fortunately they didn’t owe any AMT — for 2006. I don’t know what will happen to them in 2007. I wouldn’t be surprised if this 1969 get-the-rich scheme ends up getting my faltering parents in their twilight years instead.


Jesse said...

One word thwarts all tax reform efforts: deductions. I'm not talking things like equipment depreciation or buying heavy equipment either. Middle-class America is addicted to mortgage interest deductions, charitable donation deductions, child tax credits and dozens of other deductions. We can't agree on which ones should be the ones to hit the chopping block either.

Washington played it smart by making sure that their deductions for buddies benefit a bunch of the rest of us too. As a 1099 employee, I was able to deduct all kinds of things including my cable modem, cell phone, vehicle mileage, a laptop purchase and so forth. The laws may have been written to benefit Sen. Whathisface's friend Jimmy, but I got a windfall too to ensure that it stays on the books.

With computer software, you occasionally need to make a new version entirely from scratch to clean things up and purge some bloat. Our tax code could use it. Too bad we're addicted to the bells and whistles.

Reach Upward said...

Good point. No real tax reform happens at the federal level because nobody really pushes for it. They don't push for it because they have been co-opted by the politicians as well, in a fashion reminiscent of a racoon trap where the animal could be free if it would only let go of the worthless shiny object in it's paw.

I have often counseled with people that thought it was good to have a mortgage simply because the interest on it was deductible. Some of these people have been educated, erudite folks. The fact is, if you're a Utahn in a 15% tax bracket, you can get back about $0.22 for every dollar you spend on interest (15% fed + 7% state). You still end up spending $0.78 in unrecouped interest.

But it's not just the political payoffs that keep this system alive. Some politicians revel in the sense of power they feel when they find that they can get people to behave in a certain way simply by changing the tax law. And many, seeing the power of the tax law to change behavior, openly support using it to push certain social agendas.

Democracy Lover said...

Turns out the Democrats agree with you. "Democratic leaders this week vowed to make the alternative minimum tax a centerpiece of next year's budget debate, saying the levy threatens to unfairly increase tax bills for millions of middle-class families by the end of the decade."

Furthermore Congressman Charles "Rangel's aides, meanwhile, have been marshaling evidence that Bush tax cuts have exacerbated the effects of the AMT by reducing regular taxes for many families but not their AMT rates, forcing them to pay the higher amounts. And families thrown into the AMT don't benefit from many of the deductions, rate cuts and credits that comprise the Bush tax cuts..."

Reach Upward said...

I must agree with WSJ editors that Rangel's logic is Orwellian. They say, "The Orwellian logic of this argument is that the 2001 and 2003 tax cuts lowered the bill for almost everyone who pays taxes, but it didn't lower their bill as figured by the AMT (except temporarily). So by lowering taxpayers' "normal" taxes, President Bush is said to have made the AMT a bigger problem. However, you pay the AMT because of the Bush tax cuts only if those tax cuts lowered your bill in the first place--you're still paying less than you would have."

The AMT was bad policy to begin with. However, it would have remained completely unknown to all but a tiny number of Americans had it been indexed for inflation. It is this willful lack of foresight, rather than cutting people’s taxes, that has caused the problem we face today.

Democracy Lover said...

Frankly I would repeal it altogether. It's just another complexity in our Rube Goldberg tax system. If we didn't have such a plethora of deductions and credits and exclusions and differing treatments of income, we could just do a simple progressive income tax that would exempt the lower income workers and insure that high income folks paid commensurate with the benefits they receive from being Americans.

Reach Upward said...

Simpler = better. I can agree with that. But apparently our politicians can't.

Anonymous said...

Heh. "Class Warfare" is a bit melodramtic, don't you think? If you voted republican, you voted for this tax structure. Google it.

Reach Upward said...

Did I say I voted Republican?

When I wrote, "Class Warfare," I was referring specifically to the Alternative Minimum Tax. It was passed in 1969 specifically on a class warfare footing. You ought to go back and read the Congressional Report on it.

I have quite an intimate understanding of our current tax structure. It is made up of literally tens of thousands of bills that have been passed since 1913. During that time various parties have controlled the two houses of the legislature and the executive office. All of them -- ALL OF THEM are complicit.

As I noted in my post, the AMT was passed by a Democratic Congress and signed by a Republican President. No one succeeded in dismantling it. A Democratic Congress and President extended it in 1993. A Republican Congress failed to get rid of it during President Clinton's second term. A Republican Congress and President failed to get rid of it during President Bush's first term and a half.

But now the problem is set to reach critical mass. A Democratic Congress and Republican President will be forced to deal with it. I'm just not confident that the outcome will be much better than what we have today.

Democracy Lover said...

If you call AMT "class warfare" then you must also call the Bush taxcuts for the wealthiest Americans "class warfare". If indeed we have class warfare in America, it is patently obvious which class is winning it.

Reach Upward said...

In any system, cutting taxes in any meaningful way means cutting more for those that pay more. I harbor no resentment for the wealthy that have benefitted more from tax cuts than me.

However, I benefit from a Bush-sponsored class warfare tax arrangment. I receive handsome tax credits for each of my children under 17. Those without children under 17 subsidize this. That is an example of using tax law for social engineering purposes.