Friday, November 26, 2004

The Rich are Different....

The Millionaire
Tax Cheat
Next Door

Our last post ended with a cliffhanger question: Are rich folks just a bunch of tax cheats? Time for some academic research. What does the evidence say?

The answer is probably not what you expect. First, tho, let's think about definitions, because in political economy the way a question is framed generally shapes the answer. When we say "rich", what images or stereotypes are we bringing to mind? Are we describing the top 20% of the population? The top 1%? The Forbes 400 richest Americans? Are we looking at people with high incomes or high net worth? Is our data pool composed of individuals, of families, or of tax return filing units? It makes a difference. Similarly, we need to start thinking clearly about what it means to "cheat" -- since the term can cover a range of behavior, from sloppy arithmetic errors to technically legal "creative compliance" to cold-blooded criminal evasion. We don't want to be like those loud anti-tax troglodytes who attack all the works of government as "waste, fraud and abuse" and whose gargantuan "fraudulent spending" numbers simply add up the cost of all programs they don't personally like or support.

Because the word "rich" is both hopelessly vague and loaded with emotion, let's use more neutral terms, like "tax return filers with incomes in the top 1%". To translate that into dollars, look at the most recent IRS Statistics of Income data for returns filed during year 2003 that reported income and tax for 2002. (Time lags are inevitable with tax statistics.) In order to make it into the top 1% that year, one would have to show income over $285,000 (technically, "Adjusted Gross Income = "income after subtracting the cost of getting it"). Already there are at least three potential distortions in the data: (1) a tax filing unit may be one person or may be husband and wife combining two incomes onto one return: (2) the denominator is inflated by the many returns filed for children and other dependents with minor amounts of income that does not reflect their real family economic circumstances -- about half of the 24 million returns reporting income under $10,000 are in this category, and (3) the statistics describe income as reported by taxpayers, but we are trying to learn about unreported income and similar dishonesty. Because the truly successful cheat is an undetected cheat, we will always be somewhat limited in understanding the extent of our ignorance.

It's not nice to accuse folks of cheating, whether it's true or not, so let's use more neutral terms like "noncompliance". Think of it as "difference between income/tax as originally shown on return and income/tax proposed by experienced revenue agent after thorough examination". This is the so-called "tax gap" that the IRS probed with its "Taxpayer Compliance Measurement Program" (a/k/a the "Audits from Hell") back in the 1980's. (This was before the Republicans gained control of Congress in the 1994 elections and told the IRS to stop annoying the voters.) Again, some potential sources of distortion need to be mentioned -- it seems as tho under close examination the tax noncompliance data keeps jittering around, like quantum particles under Heisenberg's microprobe. For example, 12% of the total amount of proposed increases in income tax liability that resulted from these intense line-by-line audits was later dropped as the result of taxpayer appeals or court proceedings. And it is really, really hard to detect all unreported income, so the IRS uses a fudge factor -- on the basis of an old (1976) study, the Service assumes that for every dollar detected there is another $3.28 that has flown below the revenue radar and has missed hitting the books.

The next posts in this series will try to organize the evidence about hi-income noncompliance and explain what it means. As teasers, tho, here are some tentative conclusions:

The Rich cheat on their taxes, but not as much as they should.golden

[According to the economists, that is].

The Rich cheat on their taxes, but it's not their fault.

[Say the white-collar crime sociologists].

Thursday, November 11, 2004

The Shark Is

Not A Shark

President Bush Says He Will Seek Tax Simplification

It's a long way from Weimar Berlin to today's Washington DC, but some things never change. The Dreigroschenoper ("Three Penny Opera") portrays the struggle between MacHeath (a robber with the morals of a businessman) and Peachum (a businessman with the morals of a robber). From the opening bars of Mack the Knife (a cheerful tune about a serial killer -- here's the fingernails on chalkboard original) to the obligatory happy ending, the message is clear: the rich are all criminals, and only criminals get rich.

This is probably not what President Bush believes, nor is it a belief that Americans generally share. When the founding Pilgrims climbed off their ancestral boats, they brought with them a peculiarly Calvinist attitude towards wealth -- that it is a mark of God's favor, a sign that the holder is one of the lucky souls pre-selected by the Lord who will avoid the fire and torments of eternal damnnation. That propensity to view the rich as morally superior has endured to this day. In the last few years this subtext has dominated income tax policy, leading to cuts in capital gains taxes in 1997, tax rate reductions and the gradual elimination of the estate tax in 2001, followed by a 60% reduction in taxes on corporate dividends and an additional capital gains rate cut just two years later. Those who object are accused of fomenting "class warfare".

Now the President, fresh from his election victory, has announced that tax simplification will be high on his agenda. Here's the press conference text, together with a first cut at deconstruction:

The President Says

Which Means

"The - first of all, a principle would be revenue-neutral. If I'm going to - you know, if there was a need to raise taxes, I'd say, let's have a tax bill that raises taxes as opposed to let's simplify the tax code and sneak a tax increase on the people. It's just not my style. I don't believe we need to raise taxes. I've said that to the American people. And so the simplification would be the goal.

{"We'll just happy-face the $ 400 billion hole in the Federal budget and refuse to believe anyone who says it's a problem. Look how far Kerry got with his plan to take away the tax cuts I gave to rich folks."}

"Now, secondly, that - obviously that it rewards risk and doesn't have unnecessary penalties in it.

{"Rewards risk" = tax breaks for business startups, venture capital and stock speculators."}

"But the main thing is that it would be viewed as fair, that it would be a fair system, that it wouldn't be complicated, that there's a, you know, kind of - that loopholes wouldn't be there for special interests, that the code itself be viewed and deemed as a very fair way to - to encourage people to invest and save and achieve certain fiscal objectives in our country as well.

{"Invest and save" = tax consumption, not income = don't tax increases in wealth}

"You know, one of the interesting debates will be, of course, in the course of simplification: will there be incentives in the code? Charitable giving, of course, and mortgage deductions are very important. As governor of Texas, when I - at some time I think I was asked about simplification, I always noted how important it was for certain incentives to be built in the tax code. And that'll be an interesting part of the debate....

{"Incentives - Oil depletion deductions, intangible drilling allowances" ...}

"And so the groundwork has been laid for some legislation that I've been talking about. On an issue like tax reform, it's going to - tax simplification - it's going to take a lot of legwork to get something ready for a legislative package. I fully understand that."

{Which leaves all political options very, very open.}

So what are we to make of all this? Especially that "revenue neutral" opening line?

"Revenue-Neutral" - was the mantra for successful tax reform back in 1986. It meant two things: that the reformed system would raise the same amount of revenue as the old system, and that the distribution of the tax burden by income class would stay roughly constant. That is, within each income range some folks would pay more and some would pay less, but the total for each income range would remain roughly the same. These are very tight constraints.

In practice, the 1986 Act blended reform with a considerable quantity of deceit. "Revenue raising neutrality" was tested by projecting receipts over a five year "window". This tempted the taxwriters to use temporary gimmicks and one-shot transition revenue to pay for supposedly permanent rate cuts. Of course, this meant revenue shortfalls and a ballooning deficit once the "window" period was over. In a happy bit of irony, Richard Darman, who as Reagan's Assistant Treasury Secretary was the leading deceitful reformer, reappeared as Budget Director under President Bush the Elder. Darman's 1991 need to fill the hole he had carved in the revenues five years earlier forced his boss to recant on his pledge of "no new taxes", and may have cost Bush Senior the 1992 election.

The 1986 Tax Act also introduced a variety of clever gimmicks that were invented to arrive at a "revenue neutral" result despite a reduction in stated tax rates. After all, if tax rates get cut in half, but a sneaky calculation trick doubles "taxable income" at the same time, government revenue will stay the same. Do the math: Revenue = rate * tax base = rate/2 * (tax base * 2). The algebra-challenged public celebrate their tax cut, while wily legislators take secret pride in their ability to tax and be loved at the same time. These gimmicks include the Alternative Minimum Tax, the phasing-out of deductions as income rises, and the various traps and carryforwards that limit losses. Since 1986 they have grown into monsters of complexity. The tax policy reformers of 1986 have good reason to be ashamed of their bastard children.

"Revenue neutral" is even trickier today, because legislators have made a fine art of manipulating the "window" periods that score how tax law changes affect the public treasury. The current revenue projection baseline assumes, for example, that the Alternative Minimum Tax will devour 29.2 million taxpayers by 2010 -- the current temporary partial patch expires at the end of 2005, and extending the fix will cut revenues by @ $30 billion plus per year. Many other provisions "sunset" over the next few years, that is, they vanish unless re-enacted, because an easy way to hold down the apparent cost of tax cuts is to pretend that they are only temporary, and that any offsetting revenue increases are permanent. As the law reads now, the increased tax credits and lower rates that have been legislated during the Bush administration will vanish, like Cinderella's coach, on January 1, 2011. That bugaboo of the rich, the hated estate tax, is repealed for year 2010, but rises up again in 2011, as loophole ridden and confiscatory as ever. Just try fitting "revenue neutral" into that pumpkin.

"But hey, Professor Tax", you say. "What about that nasty shark with the hat back there in the introduction? What about the Protestant Ethic? Are rich folks vile or are they virtuous? Do you really think that they are a bunch of cheats? What does the evidence say?"

Professor Tax will answer in his next posting, and hopes from now on to update on a more regular schedule -- perhaps every other Tuesday (assuming there is anything to say...) Til then, let us meditate on the final cryptic verses of Mack the Knife.

“Und die Fische, sie verschwinden,
Doch zum Kummer des Gerichts
Man zitiert am End den Haifisch,
Doch der Haifisch weiß von nichts

Und er kann sich nicht erinnern
Und man kann nicht an ihn ran,
Den nein Haifisch is kein Haifisch
Wenn man nicht beweisen kann."

"Little fishies, all gone missing,
And it’s trouble for the Law
When they try to haul the Shark in.
There’s a problem. No one saw.

He'll just say: 'I don’t remember.'
And they cannot make him sing.
And the Shark is not a shark, dear
If you cannot prove a thing.”

"There are some who don’t remember
There are some who just won't sing.
For a shark is not a shark, dear
When you cannot prove a thing."

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