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Tax That Fellow Behind The Tree

Hi. I’m the fellow behind the tree. You may have heard of me in the old saying, “Don’t tax you, don’t tax me, tax that fellow behind the tree.”

I have no idea how I got here - behind the tree, I mean. In the beginning I was pretty ordinary. I worked for a pittance, griped about how the government took too much, and believed in a “progressive” tax system in which the burden would be based on one’s ability to pay. Next thing I know, I’m a duck in a shooting gallery.

Of course, nobody ought to cry for me. My children are educated and my retirement is secure. I am grateful to the system that made my success possible, and I am willing to shoulder a generous share of society’s load.

What burns my marshmallows is not so much the amount of taxes that I pay as the way the tax burden is figured. We do not have a “progressive” tax system; we have multiple systems in which the rules change as you go up the income and wealth scale.

If only a few people are in the top income brackets, only those few are likely to be offended if the rules are tilted against them. Legislators have every incentive to cater to the broad economic middle, where the votes are, regardless of whether this makes for a tax system that is just or efficient. Consider:

  • A married couple with adjusted gross income (AGI) of $100,000 has $20,000 of itemized deductions and receives tax benefit for the full $20,000. Another couple with AGI of $200,000 has the same $20,000 in expenses, but this couple must forfeit $2,202 of the deduction because itemized deductions are reduced by 3% of AGI exceeding $126,600 in 1999.
  • An elderly woman wants to convert her $1.25 million conventional IRA to a Roth IRA. Her Social Security and taxable investment income amount to only $40,000, but her required minimum distribution from the IRA – which is really just a transfer of her own money to a taxable account – pushes her above the $100,000 AGI cutoff for a Roth conversion.
  • An architect whose assistant earns $75,000 per year contributes 15% of the assistant’s annual compensation to a retirement plan. The architect, who earns $250,000, cannot do the same for herself, because contributions to qualified plans must be based on just the first $160,000 of income.
  • A construction worker buys U.S. Savings Bonds to finance a 3-year-old child’s college education. The child happens to enter college during a building boom that sends his father’s annual income above $90,000. The father cashes in the bonds as planned, but must pay federal taxes on 15 years’ accumulated interest because his temporarily higher income disqualifies him from tax-free “education bond” treatment.
  • A small business owner lives modestly, saves his money, and leaves $3 million to his children. His executor pays more than $1 million in estate taxes, on top of the lifetime of income taxes that the business owner paid. Another business owner earns the same amount during his career, but lives lavishly and leaves his children $650,000. His heirs pay no estate tax.

The tax code is littered with this type of deliberately unequal treatment, ostensibly intended to make the system more progressive – as if a series of graduated tax rates, with no limit on individual liability, is not progressive enough. The very idea that individual liability might have some logical upper limit is foreign to us. It would be the opposite of progressive. But would it be unfair?

A top executive cashing out a lucrative options package or earning a big bonus might make $30 million in a year and pay about $12 million in federal income tax. Does any one person “consume” enough national defense, economic management and other superpower stuff to warrant being stuck with a bill for $12 million in a single year? Our system presumes that an individual’s fair share of these costs rise with his or her income ad infinitum.

Maybe you have trouble feeling sorry for someone who takes down $30 million and gets to keep “only” $18 million. Then consider the opposite situation: A married couple with two children, who do not itemize deductions, could earn about $27,900 in 1999 and pay no federal income tax at all, after taking the Earned Income Credit into account. Of course this is not a lavish income, but it is more than double the federal minimum wage and is well above the poverty line. If the idea is to tax based on ability to pay, should not all but the truly poor in our society pay at least a little?

Well, what about capital gains taxes that are capped at only 20%, well below the rate that applies to even middle-income wages. Rich folks enjoy the great majority of the capital gains in this country. After nearly 20 years of rising markets for everything from stocks to statues, many would probably argue that the capital gains break evens things out very nicely for the well-to-do.

But keep in mind that the income of publicly traded corporations is taxed twice – once when the corporation earns it, and again when it is distributed to shareholders as dividends. Since the value of any stock represents the present value of future cash flows, and corporate cash flows are reduced by the taxes on corporate earnings, one could argue for a capital gains tax on stocks of zero. The “tax” already is reflected in the reduced value of the stock that results from the high taxes on corporate income. If you doubt this, ask yourself what would happen to stock prices if the corporate income tax is suddenly repealed.

Many other capital assets, such as houses and art work, typically generate taxable capital gains but no deductible capital losses, because such assets are not held for the production of income. Given this inequality, a reduced capital gains tax rate seems reasonable.

Democracy gives every person an equal vote. Unfortunately, only a small number of people earn large incomes. Those who do not make the large incomes will always out-vote those who do. This can lead to a system based on the ability to make someone else pay. The someone else, of course, being you-know-who, behind the you-know-what.