Friday, December 2, 2011
Today, friends, we are going to have a little different "My View", one that will address an issue that is going to impact all of us in the near future. That issue is one of the two certainties in life. Yes, we are going to talk about...
(cue the ominous background music)
So buckle up and hang on for the ride.
With the recent failure of the Congressional Super Committee fresh in our minds, it is a good time to talk about taxes. The Super Committee bogged down as Republicans held the line on tax increases and the Democrats demanded more tax increases. It is very easy to slip into a partisan mindset about taxes and point fingers at the other side, but it is critical that we in the public really understand the fundamentals about what is going on regarding taxes so that we can make reasoned decisions and provide valid input to our elected representatives.
So I think it is important for us to understand what is happens in a progressive tax system like ours, and why our system is not working efficiently.
We all talk about taxes and the tax rate, the rate at which a person or a business is taxed, but we really need to explore and understand what we are talking about. Here are some important definitions:
Nominal Rate- This is the stated tax bracket. This is also called the statutory rate. When someone says,"I am in the 28% bracket", they are referring to their nominal tax rate.
Marginal Rate- the tax on the last dollar earnings. This is important as one's income rises. For instance, one could earn a bonus in a calendar year that moves them from a 28% bracket to a 31% bracket for tax purposes. Individuals and business make marginal tax considerations an important part of their decision process if they are going to pay more in taxes to earn another dollar of income.
Effective Rate- This is the tax rate that an individual or business pays AFTER all government offsets or deductions are applied.
It is very important to have these concepts in mind, because understanding them will help us understand part of the financial dilemma that we are facing in our country.
Did you know that the United States has one of the highest corporate tax rates in the world? The current corporate tax rate is 35%. Do you think most corporations pay taxes at the 35% rate?
That would be a big UH-UH.
The effective corporate tax rate in the U.S. last year was 22%, significantly lower than the nominal corporate rate of 35%. Many companies did not pay taxes. One of the most frequently cited examples of companies not paying taxes is General Electric, which in 2010 had income of $14 billion and yet paid no taxes. How did that happen? They used legal deductions and offsets to pare down their tax liability to nothing.
And GE is no different than you or me. I deduct mortgage interest, charitable contributions, and claim the maximum exemptions allowed all in an effort to do what GE did, and that is to minimize my tax burden.
Do you see the problem starting to emerge? Congress can raise nominal rates to 50% in this country, but the EFFECTIVE rate will still be lower.
Why is this?
For several reasons. Washington views the world in a static way, which means their belief is that if taxes are raised, collections by the government will rise in a straight line to a certain amount. The reality is that the world does not work that way. You and I will legally avoid paying the maximum amount of taxes in any way possible. We may defer income; we may make more charitable contributions; or we just may not work as much and engage in more leisure activities to avoid generating higher income and higher marginal taxes (see where all those definitions start to mean something?).
Also, having a complicated tax code with numerous deductions, exemptions, and special credits gives Congress an enormous amount of power to bestow said deductions, exemptions, and credits on favored groups or industries. Think Congress wants to give up this power? Neither do I, but in so doing, could actually move the effective rates higher. We will talk about that in a minute.
So the real problem for leadership in Washington is to raise the effective rate, not the nominal rate. The discussion about nominal rates- "raising taxes"- is sound and fury with little net effect.
I want to stop right here. Those of you that have read these Friday blogs know that I disdain the inordinately high tax rates in this country and the subsequent wasteful spending that it engenders at all levels of government. So what I am about to talk about- improving tax collections- doesn't mean that I have gone to the dark side of the liberal left. You will see why.
The salient question for all of us is how do we improve tax collections- increase the effective rate- without decimating the economy?
I'm glad you asked.
There are several ways.
First, close the loopholes and eliminate all deductions except mortgage interest and charitable contributions. Congress should not be in the business of deciding to favor certain industries or interest groups with exemptions. This step alone takes away one of the primary tools used by Congress for legislative overreach and is a gigantic first step in reining in the power of Washington legislators.
Why keep mortgage interest and charitable contribution deductions? Without the mortgage interest deduction, housing prices will fall even lower than their current levels, and since for many in this country, their house is the major component of their assets, this is essential to maintaining their wealth. As for charitable contributions, the elimination of that deduction would obviously impact the flow of dollars to these ventures and limit their outreach.
The second thing that MUST occur concurrent with the closing of the loopholes is that the tax rate at all brackets should be lowered. We currently collect taxes on individuals at an effective rate of 14%. If that effective rate doubled to 28%, can you imagine the profligate spending that would come out of Washington? Think if Washington flattened the tax code to two rates, say 10% below a certain income level and 20% above a certain income level. Do you think the effective rate would go up? Especially if the loopholes are closed? Simplify the tax code and impart certainty to the taxpayer, and the results would be astounding.
And here is why. Remember those marginal tax rates we talked about? Under our current system, an individual that makes $83,600 is in a 25% tax bracket. They owe a base tax of $4,750 PLUS 25% on the earnings over $34,500. However, say that individual closes one last sale in December and earns $85,000. Their situation changes significantly. Their base tax is now $17,025 and 28% of all income over $83,600. In effect, that last sale cost them some significant money by pushing them into a higher tax bracket.
This is the effect of rising marginal rates. At a certain level, they create a disincentive to earn.
Now go to the flattened rate that I mentioned above. Rather than rising marginal rates- meaning the government is going to take a progressively larger amount out of each additional dollar that you earn- the rate stays the same and the worker is not penalized for earning more money. Do you think this would lead to more economic activity and growth?
Obviously, both sides of the flat tax, or flatter taxes, can be argued, but here are two things to keep in mind. Washington vehemently opposes a simpler tax system, whether a flat tax system or some other. Why? Check the list of campaign contributions given to our elected officials and compare that to the tax breaks or credits that some of those groups have received. Remember what I have told you- ALWAYS follow the money. The current tax code is one of the biggest sources of power for those in Washington and consequently one of the biggest tools used to gather campaign funds. This has to stop.
The other thing to keep in mind is that the current system is not working effectively. All of us are avoiding taxes through any legal method available, and this behavior will continue. We all act in our economic self interest, and that includes legally keeping as much of our hard earned income as possible. Washington has to understand that this current system is broken and will not provide the vehicle to effectively collect revenue nor does it provide a framework the economy to grow.
Hopefully, this discussion will shed some light on what is happening with the debate on taxes and provide some understanding of how it will impact us as taxpayers.
And it will impact us.
Our engagement in this process will be essential to shaping the direction of our tax policy. Get involved and contact your elected representatives and let them know your feelings on this matter.
The federal government views your income as "theirs".
And remember, "theirs" can be also be "THE IRS".
And that, my friends, is my view