"Taxes - Part of the Solution?"

Sydney M. Williams

Thought of the Day

“Taxes – Part of the Solution?”

July 19, 2011

Democrats are fond of blaming the Bush tax cuts for all the ills visited on the country over the past three years. “Millionaires and billionaires are not paying their fair share,” the President rails. It is certainly true that a few very wealthy people have benefitted through the help they receive navigating the complexity of our perverted tax code, as have their counterparts in the corporate sector, the most notorious example being General Electric. But that is an argument for reforming the tax code by simplifying it, not for raising nominal rates.

However, it is also true that revenues (or lack thereof) have been a problem during the current cycle, unlike what was the case during the recessions in the 1970s and early 1980s. The question is why? By 2007, after the Bush tax cuts of 2001 and 2003 had been in effect for a few years, the amount paid by the top one percent of all income tax payers amounted to 40.42% of all federal personal income tax paid. In 1999, with tax rates higher, the comparable percentage was 36.18%. In 2007, the top five percent paid 60.63%; in 1999, the amount was 55.45%. Over the same period, the amount paid by the lowest fifty percent of income earned declined from 4% in 1999 to 2.89% in 2007.

In terms of receipts as a percent of GDP, the same story holds. In 2007 receipts, as a percent of GDP, amounted to 18.5%. (In 2003, before the cuts went into effect, receipts amounted to 16.2% of revenues.) They were not back to the level they had been during the 1990s when the economy was percolating, but they were above the fifty-year average of 18.2%. The current tax system may or may not be fair, but the Bush tax cuts were not the cause of our deficits. The reasons have been spending and the effects of a slow economy.

Over the postwar years, federal outlays and receipts, as a percent of GDP, have been remarkably constant, despite recessions. During those years, the marginal tax rate declined from 90% to the current level of 35%. Yet receipts were barely impacted. The fact that highest earning Americans today pay the largest share of taxes, at a time when marginal rates are at their lowest, is a manifestation that behavior is indeed affected by changes in the tax code.

The current downturn has seen a dramatic shift in the habits of fiscal Washington, both in terms of spending (up) and in terms of tax collections (down). Spending has been up. Measured as a percent of GDP, government expenditures rose 29% between 200l and 2011 – from 19.6% to 25.3%. A more important question: Why are receipts running at 14.5% of GDP, four hundred basis points below where they were in 2007? The most obvious answer is the slow economy, with its attendant high unemployment. But other factors are at work, not the least of which is the complexity of the U.S. tax code, now estimated at over 70,000 pages with over 500 separate IRS tax forms. One hundred and fifteen thousand employees work for the IRS, and there are 1.2 million paid tax preparers in the U.S.

Warren Buffett may complain, in his sanctimonious way, that he pays a lower tax rate than does his secretary, but he has never explained why he has chosen not to pay the IRS a little extra each April. Most of his income is derived from long term capital gains, investments that had been made with dollars that had already been taxed. But, more relevant to Mr. Buffett’s case is that the very complexity of the code works to his benefit, as he can afford legions of lawyers and tax accountants to uncover the Code’s hidden opportunities, and to lobby Congress when it is in his self interest. While I cannot prove it, I suspect that a fundamental explanation for the shrinkage in receipts is due to special loopholes granted to individuals and corporations. (“Me first” is a common and accepted attitude. One has only to look at the number of Obamacare supporters who have since been granted waivers to its demands to understand the principal.) High marginal tax rates cause people to alter their behavior. They lobby for exemptions and credits; they move assets offshore and set up trusts; they hide or defer income.

The very existence of an income tax permitted the government to encourage behavior. It has worked. With mortgage interest deductible, but not rental payments, home ownership was promoted versus rentals. Consumption was encouraged (no national savings tax,) while investments have been discouraged (dividend and capital gains taxes.) Excise taxes have served to discourage driving (not by much, given my experiences on Route 95,) smoking and drinking.

Corporate tax revenues account for 12% of tax revenues. (In 2008, individual income taxes accounted for 45%, payroll taxes 36%, excise taxes 3% and ‘other’, 4 %.) However, their share of taxes relative to GDP has declined from 4% to 2%. Part of that decline is due to rates that are lower today than existed thirty and fifty years ago. But the bulk of that decline is due to credits that favor certain industries, generally the nation’s largest businesses – not the ones who do the bulk of the hiring. Again, a simplification of the code should reap big rewards.

August 2 looms. Thus far the President is seen as winning the PR battle over the debt ceiling crisis. However, that should come as no surprise. Mr. Obama has talked in terms of a “Big Plan,” while providing no hard details. He has used the current crisis to come across as the only grownup in the room. He has played Falstaff to the Republican’s Prince Hal. (Though we know how that relationship ended!) The mainstream press has played along with this charade, ignoring his role in precipitating the crisis. The President’s silence in terms of specifics has left Republicans little choice other than to offer their own plans. No one likes the bearer of bad news, and budget reductions, no matter where they fall, mean lost jobs. The Republican leadership also suffers from the intransigence of some of their more recently elected members, who seem unaware of the concept that success in politics is performing the art of the possible.

Revenues will have to be part of any solution. The best way to increase revenues is to restore confidence in the private sector, a process, for all his protests to the contrary, the President seems determined to avoid. The next step would be to reform and simplify the tax code, something that appears to go against Congressional dependency on special interests. An increase in nominal rates may be necessary, because the consequences of default or even the threat of one could be dire. To borrow a word from our firm’s Jeremy Pinchot, the country appears caught in a zugzwang – a situation in which no matter what move is made, the President’s giving in to intractable Republican demands or Republicans agreeing to a nonsensical increase in nominal tax rates, there are no victors and the losers appear to be the American people – the very ones those bloviating politicians purport to represent.