What You Didn’t Know About our Federal Income Tax

Posted in: Tax and Economics

Congress and the president are considering tax reform, in an effort to simplify taxes and increase economic growth rates. Let us look at some of the proposals and the amount of tax revenue each reform would affect.

One of the proposals includes eliminating the preferential treatment for homeownership. For example, in general, individuals cannot deduct nonbusiness interest expenses, but they can deduct interest on home mortgages. Such tax benefits are often called “tax expenditures” because they resemble federal spending in that they provide financial assistance in the form of lower taxes targeted to cover specific people, entities, or activities.

This proposal to eliminate the mortgage interest deduction has many realtors and homebuilders in a tizzy. The typical complaint is that eliminating or limiting the home mortgage deduction will hurt poor people who are trying to buy their first house. However, the nonpartisan Congressional Budget Office studied this claim in 2013 and discovered that the top 20% of people who file income tax returns account for 75% of the mortgage interest deduction. In fact, the top 20% of filers get the benefit of 50% of all “tax expenditures.” It is not an exaggeration to say that to this extent, the poor (the bottom quintile) are subsidizing the rich (the top quintile).

Still others justify mortgage interest deductions on the grounds that these “tax expenditures” encourage more people to buy houses and that is good for the stability of the country. The empirical evidence does not bear out that claim. Canada, Australia, and Great Britain offer no mortgage interest deduction, but they have rates of home ownership similar to those in the United States.

Another problem with the present tax code is that it discourages U.S. companies from investing in the United States the profits that they earned abroad. Representative Paul Ryan (Rep. Wis.) is floating the idea of a “border adjustment” tax to compensate for that problem. The border adjustment tax is a complicated tax with the end result somewhat like a value added tax. The value added tax is somewhat similar to a sales tax. When you live in a country with a value added tax, you can deduct that tax (the VAT) when you export the item subject to the tax. That deduction helps exports.

One problem with the border adjustment tax is that it is complicated. Complications create new demand for tax lawyers. While that is good news for lawyers (and for law professors who need students to teach), it will not improve our rate of growth. A simpler alternative is to reduce or eliminate the tax on corporations when they transfer their money from abroad to the United States.

The United States already has the highest corporate tax rates in the developed world (39%). In addition, the stockholders pay tax, yet again, on the dividends that the corporations distribute. Those high tax rates are built into the products we buy that are made at home, by U.S. corporations paying the high rates.

When Canada lowered its corporate rate from 43% to 26%, it increased the amount of taxes it received from corporations. Yes, lower taxes can increase tax revenues. When Canadian corporate taxes were higher (1988 to 2000), tax revenues averaged 2.9% of Canadian GDP. From 2000 to the present (when the tax rates were 17 percentage-points lower), Canadian corporate tax revenues increased to 3.3% of GDP—a higher percentage of a higher GDP. Corporations paid less, and Canada collected more. It’s almost like the miracle of the loaves and fishes.

However, the tax problem goes beyond that. The United States also imposes taxes on its companies for all profits earned anywhere in the world. Countries that compete with us typically only tax their corporations on the income earned in their territory. We tax income worldwide, no matter where it is earned, once our domestic corporation imports that money held abroad into the United States.

Once our corporations bring their profits into the U.S., they have a new tax bill, even though they have already paid foreign taxes where they earned their profits. Corporations use various methods to reduce this tax, such as merging with a foreign company and moving their headquarters abroad. Our country does not benefit when our tax laws encourage corporations to move their headquarters abroad.

Right now, experts estimate that U.S. corporations have about $2.5 trillion in profits, sitting overseas. General Electric and Microsoft each have over $100 billion held abroad. Apple Corporation now has over a quarter of a trillion dollars in profits sitting overseas. The $256 billion in cash that Apple has is more than the combined foreign currency reserves of the United Kingdom and Canada.

One of the proposals for tax reform will allow corporations to repatriate that money, move it back to the United States, and pay a one-time low rate of 8.75% (the House proposal) to 10% (President Trump’s proposal), followed by a slightly higher rate (15%) for money repatriated later.

Whatever the tax rate, importing such huge amounts into the United States will give the economy a real goose. Apple and other companies would do something with the money—invest in the business, hire more people, increase dividends. Any of those things will improve our economy. Having that money rest comfortably abroad does nothing to help us.

Another proposal is to repeal the federal deduction for state and local property taxes. Richer people get the benefit of that deduction. Remember, about 70% of tax returns do not itemize and, instead, take the standard deduction. Only richer people, the upper 30%, can take advantage of the property tax deduction because they are the ones who take deductions. Second, even these people do not have the advantage if they live in a low-tax state. One wonders by the taxi driver living in low tax New Mexico should be subsidizing the Hollywood mogul in California. How much of a subsidy? The property tax deduction will cost the U.S. Treasure more than $1 trillion in the coming decade.

Then there is the tax advantage for “carried interest.” Carried Interest is the—

share of the profits of an investment paid to the investment manager in excess of the amount that the manager contributes to the partnership, specifically in alternative investments (private equity and hedge funds). It is a performance fee, rewarding the manager for enhancing performance.

If the investment manager is offering financial advice, and that advice is profitable, the manager receives money for enhancing the performance of the fund. Who cares, one might ask. What difference does it make what you call it? The difference relates to the marginal tax rate.

When the managers are making more money because they are using their brains, we normally think of that as ordinary income. That is certainly true of doctors, lawyers, accountants, and others who use their brains to make money. However, the present tax law now treats this income (the carried interest) as capital gains income. Hence, the top rate is 23.8% (long-term gains) instead of ordinary income (39.6%).

In other words, the recipient of the carried interest tax advantage would have to pay over 66% more in income taxes if the tax code were to treat carried interest like ordinary income. Reince Priebus, the White House Chief of Staff, said a few weeks ago, “That balloon [the carried interest favorable tax treatment] is going to get popped pretty quickly. The president wants to get rid of carried interest, so that balloon is not going to stay inflated very long, I can assure you of that.” If that happens, it will fulfill one of President Trump’s campaign pledges.

Removing these loop holes or (in the language of the I.R.S.) “tax expenditures,” will create a more simplified code, allow the government to reduce the tax rates, and, in the view of many people, reduce the unfairness of the Code treating similar income dissimilarly. The issue of carried interest is one where both Sen. Elizabeth Warren (Mass., Dem.) and President Trump can agree.

Posted in: Tax and Economics

Tags: Legal

3 responses to “What You Didn’t Know About our Federal Income Tax”

  1. Like the simple way Ronald explains these ideas. All sounds good but what else is there, use to seeing bad with good? Need to wait and see what develops, like Trump ideas but always watching for down side I guess.

  2. tamoroso says:

    So my question is “How many companies based in the US actually pay that corporate tax rate”? And while the question is prompted by the usual news reports of corporations who have, through various strategems now legal, paid no taxes at all to the US, I feel it’s a reasonable question regardless. The point of any change in the tax code for corporations ought to be to require them to actually pay taxes. The perception is that few (at least, few really large ones who can afford herds of lawyers) actually do. If the changes you propose make it harder to dodge taxation, while at the same time reasonably lowering the tax rate, then I will have to swallow my intense distaste for the now-current president and say he’s had a good idea (assuming he executes it in line with that principle).

    Fact is, though, that I don’t trust him to do that. I will suspect him of trying to figure out a way for US corporations to pay even less taxes than they currently do, especially at the highest levels of size and wealth. I’d love to be wrong, but here’s a place where Reagan had it right: Trust, but verify.

  3. TZ says:

    GE did not pay any income taxes in the recent past because the “shifted” profits overseas and maximized deductions in the US. If they are allowed to bring those profits back at a discount, what is to prevent them from doing the same in the future?