Red Ink Page 9

  • The bottom 40 percent of Americans, whose gross incomes were below $33,500, got 12 percent of the income in 2011 and paid 3 percent of all federal taxes.

  • The middle class, the 40 percent of Americans with incomes between $33,500 and $103,000, got 33 percent of the income and paid 27 percent of the taxes

  • The best-off 20 percent, whose incomes range upward from $103,000, got 55 percent of the income and paid 70 percent of the taxes.

  That last group includes some really well-off people, of course. Zooming in on them, the Tax Policy Center estimates:

  • Those famously branded “the 1%” by the Occupy Wall Street protesters, the ones with incomes above $533,000 in 2011, got 17 percent of the income and paid 26 percent of the taxes.

  • The top-top tier, the 0.1%, the 120,000 taxpayers with incomes above $2.2 million—think Goldman Sachs partners, Microsoft’s Bill Gates, the megastars of sports and music—got 8 percent of all the income in 2011 (which, by the way, is four times the size of the slice the top 0.1% got thirty years earlier). They paid 13 percent of all federal taxes.

  And then there are the Fortunate Four Hundred. For years, Congress has required the IRS to report each year on the income taxes paid by the four hundred taxpayers with the highest incomes without identifying them. The snapshot for 2008, the latest available, is illuminating. To make the list, one had to have income in that one year of $110 million; the average for the group was above $270 million, down from the boom year of 2007 but more than comfortable. The ranks of the Fortunate Four Hundred aren’t stable: people move in and out; about one hundred of them have made the list more than once in the seventeen years for which the IRS reports the data.

  As a group, these four hundred taxpayers paid 18.1 percent of their gross income in taxes. “The very rich not only made lots more money, they made it in a very different way,” Roberton Williams of the Tax Policy Center observed. Nearly 60 percent of their gross income in 2008 came from capital gains, nearly all of it taxed at a 15 percent rate. Only 8 percent of their income came from wages taxed at a marginal rate of 35 percent. In contrast, the rest of the population got only 5 percent of its income from capital gains and 72 percent from wages.

  Over the years, under both Republican and Democratic presidents, the tax burden on those at the bottom of the pyramid has been steadily lightened. One big reason is the earned income tax credit, created by Senator Russell Long, the Louisiana Democrat who, in 1975, was seeking an alternative to spending more on welfare. The EITC is a bonus the government pays the working poor, reducing the taxes they would otherwise owe or, depending on their circumstances, giving them cash. After food stamps, the EITC is now the federal government’s biggest antipoverty program, worth nearly $60 billion in 2011 to 27 million households, more than one in every five households.

  “SPENDING THROUGH THE TAX CODE”

  For ordinary Americans, there’s the money you take in and the money you spend. The federal budget doesn’t work that way. No discussion of taxes can avoid the money that the government doesn’t collect because of some provision of the tax code, a deduction or a credit or an exclusion or an exemption. In response to years of calls to control “spending” and “smaller government,” Congress and presidents have discovered something simple: giving people a tax break—a credit, a loophole, a deduction—makes them happy without increasing government “spending” and can accomplish the same objective. Practically and economically, there’s no difference between getting $1,000 in cash from the government and getting a $1,000 voucher that you can use to reduce your taxes. Either results in a federal budget deficit that’s $1,000 bigger than it would have been had the tax break not been created. But the first is called “spending” (boos, hisses) and the second is called “a tax cut” (applause, cheers). The first is formally recorded on the budget books as an outflow of money. The second doesn’t show up in the outflow and inflow accounting. It is revenue that wasn’t collected. By the same logic, the Earned Income Tax Credit is a way for the government to spend money—in this case, giving money to low-wage workers—without counting it as spending.

  The late tax economist David Bradford once joked that Congress could wipe out the defense budget and replace it with a Weapons Supply Tax Credit. Arms makers, he said, would be allowed to save enough money on taxes to cover whatever the government would have paid them. Then the government would announce that through “targeted tax relief,” taxes had been slashed without jeopardizing national security or increasing the deficit. But nothing would have changed: the same labor, energy, and materials would have been taken by the government to make the weapons.

  It’s no longer a joke.

  These “tax expenditures,” as they’re called in Washington patois, add up to a lot of money. There’s a credit for adopting a child, another for investing in biomass generation of electricity, and the popular deduction for home-mortgage interest. More than 60 percent of all federal subsidies for energy are routed through the tax system rather than through direct spending. Put all these together, and they added up to $1.1 trillion in forgone revenue in 2011, the Treasury calculates. That’s enormous, given that the total revenues of the U.S. government that year were $2.3 trillion.

  Erskine Bowles calls them “backdoor spending through the tax code.” He told (yet another) congressional deficit-reduction committee last year, “It is just spending by another name. It’s somebody’s social policy.” The deficit-reduction commission he cochaired recommended doing away with most of them, and using the money to lower tax rates and reduce the deficit.

  The Tax Reform Act of 1986 stripped away many barnacles from the tax code, wiping out tax shelters, raising taxes on businesses, and using the money to lower individual income tax rates. The barnacles grew back, though. Today, about 10 percent of the spending through tax-code savings goes to businesses and 90 percent to individuals, notably the provisions that allow workers to get health insurance from employers without paying taxes on that as wages ($184.5 billion in 2012) and homeowners to deduct mortgage interest ($98.6 billion). If all the tax expenditures in the corporate tax code were wiped out, which will never happen, the tax rate on big companies could fall from 35 percent to 28 percent and raise the same amount of money.

  The saga of a tax break known as Section 1031 for its place in the tax code shows how entrenched these are. If you sell a share of Microsoft stock at a profit, you owe capital gains taxes even if you immediately put the proceeds into shares of Google. But if you swap one office building for another, and play by 1031 rules, that’s considered “a like-kind exchange,” and you can defer—or, if you’re clever, avoid—capital gains taxes. “All real estate, in particular, is considered ‘like-kind,’ allowing a retiring farmer from the Midwest to swap farm land for a Florida apartment building or a right to pump water tax-free,” the Congressional Research Service has said. The revenues lost through this one provision were about $2.5 billion in 2011. It’s relatively small, but illustrative.

  Like so many tax breaks, this one began long ago for reasons that have little to do with its current size. It popped up in 1921 when the income tax was in its youth, to allow investors to avoid taxes when swapping property without a “readily realizable market value.” In 1934, the tax-writing House Ways and Means Committee explained, “If all exchanges were to be made taxable, it would be necessary to evaluate the property received in exchange in thousands of horse trades.” Over the years, it has been tweaked and the definition of “like-kind” shrunk, stretched, and reinterpreted.

  Today, one can swap a dental office for a vacation property and avoid taxes, if you structure the deal the right way. One can trade horses, cattle, hogs, mules, donkeys, sheep, goats, and other animals owned for investment, breeding, or sporting, advises Andy Gustafson, a 1031 broker, but not chickens, turkeys, pigeons, fish, frogs, or reptiles. But you can’t trade a bull for a milk cow and avoid taxes: “Livestock of different sexes,” the IRS cautions, “are not like-kind properties.”


  In 1935, the federal Board of Tax Appeals, a precursor of the federal Tax Court, approved the use of middlemen in the transactions, which made like-kind exchanges far more practical. Then in a court case that reverberated for decades, T. J. Starker and his son and daughter-in-law traded 1,843 acres of Oregon timberland to Crown Zellerbach Corp. in 1967 for a promise to get property (or cash) of equal value five years later.

  It was, the Starkers argued, a like-kind exchange with lag, so they said they didn’t owe capital gains taxes on the deal in 1967. The Internal Revenue Service disagreed, arguing that waiting five years to make the exchange broke the law. The matter went to court. Twelve years later, a federal appeals court sided with the Starkers, establishing that an exchange didn’t have to be simultaneous to qualify for the tax break. Congress later narrowed the window to 180 days.

  The result is an industry of middlemen devoted to helping people find property to buy and sell, and matching the transactions in ways that the IRS considers like-kind. One twelve-year-old outfit, Accruit LLC of Denver, secured a patent in 2008 on its method of matching buyers and sellers to assure that their exchanges comply with the tax rules. (In September 2011, Congress said no more patents could be issued for “any strategy for reducing, avoiding or deferring tax liability.”) There are even “reverse exchanges” where—as one 1031 broker describes it on its website—“you can make a new purchase prior to selling the current asset, allowing you to continue generating revenue from your original asset.”

  Real estate, cable television, and other industries argue that if investors had to pay capital gains taxes, they wouldn’t swap one property for another even when the trade made sense, such as for consolidating adjacent cable franchises. Perhaps. But consider this example Accruit posted on its website: Joe and Marilynn Croydon (not their real names) collected and restored vintage cars. A buyer was interested in several of their Formula 1 race cars to the tune of $2.5 million. “After going through countless part orders, mechanic expenses and original purchase prices,” the couple figured they would turn a $1.97 million profit—which at the current capital gains tax rate on collectibles meant a tax bill of $552,440. Their accountant recommended a 1031 exchange, and the couple began looking for other cars to buy with the proceeds of the sale.

  Eventually they found four of them—a 2008 Lamborghini Reventon ($1.2 million), a 1969 Yenko Camaro ($180,000), a 1981 BMW M1 ($133,500), and a 1933 Duesenberg Model J ($1 million). That more than covered the $2.5 million proceeds. They didn’t have to pay the $542,400 in capital gains taxes immediately. And with smart accountants and careful planning, a tax deferred can become a tax never paid. Accruit said in its account that the gains might escape taxation altogether if the cars were bequeathed to the Croydon children.

  The tax code has few defenders these days. It’s criticized for being too complicated and too onerous, for pushing companies overseas and rewarding them for going abroad, for discouraging saving and restraining growth. In concept, tax reform is popular. But ultimately reforming the tax code turns on some big, contentious issues. Will Congress actually force anyone to surrender a cherished provision of the tax code? Will it raise anyone’s taxes, even if only to come up with the money to lower taxes for everyone else? Can Republicans and Democrats resolve their standoff over whether the tax code should bring more money to the Treasury in the future than the unreformed tax code would?

  CHAPTER 5

  WHY THIS CAN’T GO ON FOREVER

  Although it is said that the most important things in life cannot be measured, American presidents are judged in real time by numbers, particularly when it comes to the economy. There’s the unemployment rate, the one economic statistic everyone instantly understands. And the price of gasoline, the largest price tag on anything sold in the entire country. And the stock market, an instant barometer of the mood of the business and investing class.

  Then there’s the budget, the national credit card bill. By that metric, where did the United States stand in the fourth year of Barack Obama’s presidency? Four years older, and deeper in debt. “We’re driving seventy miles an hour toward a cliff,” says Bob Reischauer, the former CBO director. “And when we reach that cliff will be determined by events over which we have very little control. The path we’re on can’t go on for fifteen years. Whether it can go on for two, three, four years, I have no idea.”

  In Washington, where no one seems to agree on anything these days, substantial agreement actually exists on this assertion. Problem is, there’s next to no agreement on what to do about it and when.

  The debate over how to steer the budget has produced a multiact Washington drama for the past couple of years. Act One was the rush to rescue a collapsing economy in 2009 with fiscal stimulus, and the bitterness over bank bailouts. Act Two featured tension among Obama’s brainy, big-ego economic advisers about whether to pump more money into the economy and when to shift to worrying about deficits. In Act Three, a procession of bipartisan blue-ribbon groups assembled to seek compromise, none of which forged a consensus broad enough to produce action. Act Four involved a confidence-shaking showdown in August 2011 between the White House and congressional Republicans over raising the ceiling on federal borrowing. And then came Act Five, the legislation that emerged from the showdown that threatens deep, across-the-board spending cuts at the beginning of 2013 unless some deficit-reducing alternative passes before then. In classical tragedy, this is known as the denouement. In Washington, it could be just farce.

  Each episode had political consequences, ripples that almost surely will influence the outcome of the 2012 presidential and congressional elections. But in the midst of the political jockeying and brinkmanship, the relevant economic consequences of the past four years can be summed up in two fiscal facts. Everything else is pretty much detail.

  The first fiscal fact is this:

  Obama inherited a collapsing economy. He used substantial fiscal muscle that, with a significant assist from the Federal Reserve, helped arrest that collapse.

  A running argument among Obama advisers early in the administration—one that has continued in the after-action books—involves whether the Obama fiscal stimulus should or, given political realities, could have been bigger than the $787 billion initially approved by Congress in February 2009. There were unending debates about whether the mix of spending increases and tax cuts in that package was optimal: Too much in tax cuts or too little? Too much spending that went instantly into consumers’ hands or too much on “shovel-ready” construction projects that took years to launch? The 2012 presidential campaign has homed in on whether the fiscal stimulus did any good at all. Barack Obama said it helped save the United States from repeating the Great Depression. Mitt Romney called it a failure that amounted to “throwing $800 billion out the window.”

  The fiscal response was big by the standards of history, but then so was the recession. The first shots were fired by what are known in budgetspeak as “automatic stabilizers,” the built-in features of the budget that resulted in more spending (because more people were unemployed or eligible for food stamps, for instance) and lower tax receipts (because few people had income on which to pay taxes). These added up to well over $300 billion a year for 2009, 2010, and 2011, CBO estimated. Then came the Obama fiscal stimulus—or, as he prefers, “the Recovery Act.” CBO’s latest price tag on that: $831 billion over a few years, more than initially estimated because the economy was worse, so more were eligible for aid. And then, with the economy still languishing, came the $100-billion-a-year payroll tax holiday for 2011 and 2012, temporarily reducing the payroll taxes workers pay by 2 percentage points.

  The argument that such massive spending had no impact on the economy at all hasn’t much merit. It isn’t possible to throw that much money out of the window without someone getting a job and someone spending more than he or she otherwise would. Even Obama critic Douglas Holtz-Eakin, a former McCain adviser who now heads his own center-right think tank, allows, “No one would argue that
the stimulus has done nothing.” (Never mind that Republican candidates routinely argue just that.)

  Yet it’s easy to understand why many ordinary citizens see the stimulus as a failure, given how poorly the economy did after the money began to flow. Gauging the impact, measuring the bang for the billions of bucks, requires an exercise with which economists are comfortable and the public isn’t—comparing today’s economic conditions to what they would have been without the spending increases and tax cuts. “Suppose a patient has been in a terrible accident and has massive internal bleeding,” Christina Romer of the University of California at Berkeley told a League of Women Voters audience in August 2011, a year after leaving her post as chair of Obama’s White House Council of Economic Advisers. “After life-saving surgery to stop the bleeding, the patient is likely to still feel pretty awful.… But that doesn’t mean the surgery didn’t work.… Without the surgery the patient would have died. Well, the same is true of the economy back in 2008 and 2009.”

  Economists like Romer who believe that fiscal stimulus is a potent weapon against unusually severe recessions use economic models and rules of thumb that kick out big beneficial impacts. Witness Harvard’s Larry Summers, adviser to Clinton and Obama: “Do you really believe if we had done nothing in response to the crisis in 2008, it would have been a good idea?” But other economists have less faith in fiscal potency, and they produce models that reveal smaller impacts—or even none at all. Witness Stanford’s John Taylor, adviser to both Bushes: “They [tax cuts and spending increases of stimulus] wither and they don’t give you a lasting recovery,” he said. “It goes away and we are even weaker than before.”

  Though the debate over the efficacy of fiscal stimulus will go on, the consensus among economists is that the spending and tax cuts did more than a little good. A February 2012 survey of forty of the biggest names in academic economics (“the world’s best economics department,” the organizers at the University of Chicago Booth School of Business call it), for instance, found near-unanimity on one point: 90 percent said that unemployment was lower in 2010 than it would have been had there been no stimulus.