Loopholes v Taxes

From my friend David Kotok to share

Loopholes, Subsidies, Incentives, and Taxes
January 31, 2012

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at http://www.cumber.com. He may be reached at Bob.Eisenbeis@cumber.com.

The political arena has been filled recently with rhetoric on both sides of the aisle concerning how much taxes various people pay. Mitt Romney’s tax return for 2010 showed that he paid an effective tax rate of 13.9%. And President Obama made it a point in his State of the Union Address earlier this week to highlight that it wasn’t right that Warren Buffet’s assistant had a higher tax rate than did Mr. Buffet. As we have argued in the previous commentary “What is Fair?,” one can’t look at effective tax rates or what various income groups pay or don’t pay and make a judgment from the numbers as to what is or isn’t fair, just, or “right.” For example, tables from the Tax Foundation for 2009 show that the top 1% of taxpayers’ share of total adjusted gross income (AGI) was 17% and they paid 37% of the taxes. These people earned over $343 thousand. The top 5 % earned 32% of AGI but paid 59% of the taxes. The cutoff income for the top 5% was $155 thousand. The average tax rate for the top 1% was 24% and for the top 5% it was 21%.

So the tax rates of 13.9% paid by candidate Romney and the alleged 15% paid by Warren Buffett are low, and they are low because of the sources of their income. Income from wages and salaries, for example, is taxed at a much higher rate than income from dividends or capital gains. The capital gains tax rate for individuals like Romney and Buffett is 15% and the rate on qualified dividends is also 15%.

But there is more. If income is from tax-free municipal securities, there is no federal tax liability. That provision in the tax law was put in for a purpose, to lower the cost of borrowing to state and local governments. Then there are allowable deductions and tax credits, which include energy efficiency investments, educational expenses, new car purchases, first-time home purchases, and of course charitable deductions, just to name a few. The objectives were promote energy conservation, spur consumption, and lower the cost of education. In the case of energy investments , tax credits are permitted for purchase of geothermal heat pumps, solar water heaters, solar panels (remember Solyndra?), small wind turbines, and fuel cells. Taxpayers who make such investments can lower their effective tax rates significantly, because a tax credit lowers taxes paid dollar for dollar, while a tax deduction only lowers the tax burden by an amount equal to the expenditure times the marginal tax rate.

Regardless, whether the payer is an individual or a corporation, taking advantage of tax credits and deductions lowers the effective tax rate paid. If you don’t like the fact that someone can reduce their effective tax rate through the use of tax credits and deductions, then you are apt to argue they are taking advantage of “tax loopholes” that should be eliminated. On the other hand, if you are a state or local municipality, then the favorable treatment of interest on municipal securities is a clear subsidy from the federal government to the taxpayers in the municipalities issuing the securities. Similarly, if you are for clean energy and saving the environment, or want to encourage firms to hire veterans and disabled people, or seek to spur investment in certain technologies like solar panels or geothermal heat pumps, then the tax break is viewed as a desirable “incentive” to get people or corporations to “do the right thing.”

In the case of capital gains and dividend income, the favorable tax treatment is viewed as a way to get people and corporations to invest in the long haul, to encourage the multiplier effect that includes job creation and stimulation of demand. The tax treatment of dividends is interesting in this respect. When a company is successful and earns a profit, it can do one of five things. It can accumulate cash, it can pay off debt, it can expand, it can make new investments, or it can pay dividends. In this respect, capital gains are simply the value of retained earnings and the capitalized value of investments. Paying off debt or making new investments are typically not taxed, since they are allowable expenses before profits or tax liabilities are determined. And, of course, a corporation pays taxes on its profits. Again, the tax rate varies between 15% to 35% while the effective tax rate depends upon allowable tax credits and deductions. Unlike other transfers, dividend payments are treated as income to the recipient and are taxed again. Hence, when one hears arguments for eliminating the taxation of corporations, it is because the owners are effectively taxed twice, once at the corporation level and again when dividends are paid or capital gains realized. So the true tax rate on corporate income can range from 25% to well over 40%, from the investor’s perspective.

The point that needs to be recognized is that one man’s tax loophole may be another man’s incentive, depending upon whether the goal is to increase revenue or incent behavior. Of course, from the recipient’s perspective, deductions and tax credits are effectively a price cut and thereby change relative prices of goods and services and affect purchasing behavior.

The politicians are arguing both sides of this issue at the moment. They talk about cutting tax rates. At the same time they urge elimination of tax credits and deductions, and these are nothing but tax increases in another form. Then they go on to offer up more tax “incentives” (read tax credits and deductions) to encourage energy conservation or to promote hiring or housing – pick your poison. Cut rates, eliminate loopholes, then start the process all over again by piling on more incentives. Come on, man, you can’t have it both ways!

Bob Eisenbeis, Chief Monetary Economist

Resources:
To sign-up for Market Commentaries from Cumberland Advisors: http://www.cumber.com/signup.aspx
For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: bob.eisenbeis@cumber.com

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