Half Sigma

Tax cheating is out of control

Back in June I asked why tax rates are so high. No one gave me an adequate answer.

Part of the answer is found in today's New York Times. Rich people are cheating to the tune of $70 billion/year. This amounts to 7 cents of every tax dollar collected. Massive tax cheating causes higher rates for honest taxpayers.

It really annoys me that economics bloggers like Greg Mankiw are obsessed over the minimum wage when rich people are cheating on their taxes by an amount greater than the aggregate additional salary that all 15 million low wage workers would realize from a $2 increase in the minimum wage. Isn't tax cheating a much bigger problem than a small increase in the minimum wage? Why don't right-wing economics professors care about real problems?

Tax cheating is a huge drag on our economy because the higher tax rates necessary to make up for the cheating discourages honest investment.

Why are tax rates so high?

The federal government spends approximately 20% of GDP annually. Therefore, a tax rate of 20% on all personal and corporate income ought to cover all of our government's expenses. In fact, because of double taxation as well as other miscellaneous federal taxes, 18% should cover it. So why are tax rates so much higher than 18%?

Some will say "because poor workers pay lower taxes which means that everyone else has to make it up." People who say this are severely understimating the taxes paid by poor workers. FICA taxes of 7.65% are paid by the worker and an additional 7.65% tax is paid by the employer, and of course this is really just a hidden tax on the worker whose real salary is 7.65% higher than what it says on his paycheck. The effective tax on the worker's full salary is 14.2%, and this is paid on the very first dollar earned.

An additional flat tax of 3.8% on all workers making less than $94,200, and an additional 15.2% marginal tax on income higher than $94.200, along with an 18% tax on all other income not subject to FICA taxes and an 18% corporate income tax rate should cover all of the government's revenue needs.

So why are taxe rates so high? Maybe I don't understand "GDP" because I was slacking off in my college macroeconomics class. Or maybe the tax code is so riddled with loopholes that rich people and corporations are able avoid paying tax on approximately half their income.

Why we should keep the estate tax

There's a movement, supported by Republicans, to abolish the estate tax. I disagree.

First of all, I'll start out by conceding that it's bad that our government spends so much money and that we need so many taxes to fund it. But unless we can reduce government spending to zero, we need taxes. So the issue here is whether the estate tax is somehow worse than other taxes.

The general rule is that whenever money is transferred from one party to another, there's a tax. If a hard working middle class person has a problem with his pipes, and he pays money to a hard working plumber to fix the pipes, the plumber has to pay income tax on the money he receives. So if a child of a rich person receives millions of dollars for doing absolutely nothing, why should he pay less tax than the plumber who actually did something useful?

When some working class schmuck wins the lottery, he has to pay taxes on his winnings. Inheriting millions of dollars seems like winning the lottery to me. Why should it be treated differently?

It seems to me that the problem with the estate tax is that too many people avoid paying it. Why are the first few million dollars of an estate exempt from tax? The plumber in the example above has to pay tax on his first dime of income, why should a rich person be exempt from paying tax on millions of dollars?

What are the arguments against the estate tax?

1. Not fair. Well no taxes are fair. Based on the examples above, I don't see why the estate tax is any less fair than other taxes.

2. Double taxation. Because every time money is transferred from one party to another there is usually a tax, multiple taxation is part of our tax system. Why should the working class plumber have to pay tax on the money paid by the homeowner who already paid tax, yet the rich person be exempt from this double taxation?

3. People should be allowed to do what they want with their money. The general rule of taxation is that you can't do what you want without paying tax. Every time you buy something there's a sales tax or a property transfer tax. You even have to pay a yearly tax just for owning property. Whenever you pay someone in exchange for services there's a tax. Once again, I'm in favor of lowering government spending in order to reduce overall taxes, but I don't see a logical reason why rich people should be given an exemption from paying estate taxes when everyone else has to pay taxes.

4. It's a "death tax" and we shouldn't tax death. This is a nonsense marketing word which was made up to make people think the tax is unfair. If the tax were instead called "the windfall without doing any work tax," then no one would be against it.

5. Discourages investment. How is this different than any other tax? It would be better to encourage investment by lowering the capital gains tax on short term gains to the long term capital gains rate. This way regular people could enjoy the tax benefits of investing instead of just super-rich people.

Will more rich people die in 2010?

The wise members of Congress have determined that the estate tax will be 45% in 2009, 0% in 2010, and then 55/60% in 2011 and years after. Clearly, the best year to die is 2010. By dying in 2010 a rich person essentially doubles the amount of money his heirs wil receive.

I predict that there will be a mysterious increase in deaths among the very wealthy in 2010. If it's December 2010, and your rich mom is in a hospital bed with not much longer to live, won't some people take action to hasten the death to make sure it happens in December and thereby more than double the amount of money inherited?

If it's mid December 2009, and your dad dies, maybe you can somehow get everyone to pretend that the body is still alive so that the official date of death is 2010? Didn't anyone see the movie Weekend at Bernie's? I think that in the last week of the December there will be a lot of dead bodies out there that people are pretending are still alive.

Suicides will surely increase in 2010. If you're filthy rich, there's no higher act of love for your children than to kill yourself in 2010.

And of course, there is outright foul play. 2010 is the best year to murder your rich relative. I went to law school with a guy who was involved in a murder for inheritence scheme. He almost got away with it too.

Stupidest tax cut ever?

So say The Club for Growth Blog, Professor Bainbridge and Jane Galt about the Republican plan to send a $100 check to most Americans because of high gasoline prices.

I agree. This is incredibly stupid. Yes, Americans pay too much tax, but unless Republicans actually do something about reducing government spending, mindlessly mailing out checks is only making things worse. And the Republicans need to reform the tax code instead of creating gimmicky tax cuts that only make everything more complicated and create additional administrative costs (like the costs of mailing out all those checks).

Are Americans really not saving any money?

According to the official government definition of the "savings rate," Americans aren't saving any money, leading journalists to write stuff like: "According to the U.S. Commerce Dept., consumer spending last December increased at a rate more than double the rate of income growth. This buying frenzy helped push the savings rate for the year down to the lowest level since the Great Depression."

How about this hypothetical example: suppose that between April 15 2005 and April 15 2006, through prudent management of my finances, I had socked away $10,000. But then I do my taxes and discover that I had $25,640 of realized short term capital gains because of my prudent investing activities. However, the combined federal and New York state tax rate on that is more than 39% (or something like that) so I owe $10,000 in capital gains taxes.

So how much money have I saved? According to the government I've saved nothing because capital gains are ignored as disposable income, but capital gains taxes are considered to reduce disposable income. However, the way I see it, I saved $10,000, which might be a pretty high percentage of my disposable income. A more aggressive way of looking at it is that I actually saved $25,640, because that's money I could have spent but chose not to.

It should therefore be no surprise that the soaring stock and real estate markets have resulted in a lower "savings rate."

FICA taxes screw the middle class

I previously wrote about about the marginal tax rate graph which showed that those on the borderline of middle class and upper middle class had higher marginal tax rates than the wealthy.

It turns out that I was incorrect in thinking that this had something to do with FICA taxes. There’s a followup post at Marginal Revolution with a link to the assumptions used. It seems that the bump in the marginal tax rate has to do with deductions for things like IRAs (as if anyone with a 401k plan would contribute that) and student loan interest being phased out.

It is a big mistake to ignore FICA taxes when considering tax reform. For people earning less than $90,000/year, the employee must pay a 7.65% FICA tax which he sees deducted from his paycheck, plus there’s a hidden 7.65% tax which the employer pays and the employee never even sees. Of course it’s merely a fiction that the employer pays this tax, because it represents money which otherwise would have been paid to the employee. FICA taxes are really like a 15.3% tax.

After $90,000, the FICA tax drops to 1.45% for both employer and employee (so it’s like a 2.9% tax).

So we see, once you reach $90,000 in income your marginal tax rate plummets by 12.4%.

A flat tax that ignores FICA taxes would screw the middle class because they would be burdened with higher tax rates than the rich. Unfortunately, almost all the flat tax proposals I hear about do ignore FICA taxes.

On the other hand, if FICA taxes and regular income taxes are merged into a single rate flat tax which kicks in once someone earns a threshold amount of income, the final result would be a tax system that’s fairer (assuming all the unfair deductions are removed) and more progressive than what we have now because lower income people would be paying no taxes at all. Under the current system, even the poorest workers still have to pay FICA taxes.

UPDATE 5/11/2005

TaxProf has the exact opposite take of this post. I'm complaining about how ignoring FICA taxes makes our tax system seem more progressive than it really is. But TaxProf complains that the NY Times modified the chart to make it seem more regressive.

Our regressive income tax

I've pointed out before (but at the moment I can't find where) that our tax system is actually regressive when FICA taxes are factored in.

The chart displayed at Marginal Revolution shows how people at what I consider the borderline area between middle class and upper middle class pay a higher marginal tax rate than those who are wealthier. (I think that it's FICA taxes influencing the shape of the chart, but there's no explanation.)

It's quite unfair in my opinion.

FOLLOWUP POST

FICA taxes screw the middle class

Defending Reaganomics

The Blithering Bunny, a blogger from the United Kingsom, defends Reaganomics, especially against the liberal assertion that Reagan's “tax cuts” caused the budget deficit to increase:

Tax revenues did increase under Reagan. That is, cutting tax meant more money came into the pot (I can even post the exact figures tomorrow). The deficit was caused by Reagan, like every other President of recent decades, spending like mad, and spending more than was coming in.

I have always wondered if Reagan really cut taxes at all. Under Reagan, we saw the top marginal income tax rate decrease from 70% to 28%. But under Reagan, many loopholes were closed (only people with very poor tax planning actually paid the full 70%) and corporate income taxes were increased (which is mostly a tax on the rich because most shares are owned by rich people).

I do give Reagan lots of credit for making our tax code better, and he deserves much credit for the economic boom of the 1990s.

The estate tax and the wealthiest 1%

Amy Sullivan at Washington Monthly complains that House Republicans voted to permanently repeal the estate tax.

Amy Sullivan is right to complain. While I think there’s a legitimate argument that the top rate of 47% is too high, lowering the rate to nothing is a giveaway to the richest Americans, those who least need a tax break.

It’s these types of laws being promoted by Republicans that has helped convince me that Republicans no longer care about regular Americans; they now exist to serve the wealthiest 1%.