FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
December 13, 2011

IN THIS ISSUE:

1.   Tax Rates, Inequality and the 1%

2.   Is the US Tax Code Progressive Enough?

3.   More on Capital Gains

4.   Tax Breaks for Everyone  

Introduction

As the presidential campaign goes into full swing, a few things have become crystal clear.  First, the Republicans are dead set on pummeling each other in endless debates, creating ever-more opportunities for gaffes that the Dems and the mainstream press can capitalize upon.  Why these candidates want to keep setting themselves up as the laughing stock of late-night TV I’ll never know.

Another sure-thing is that President Obama and some Democrats have chosen to hitch their wagons to the “Occupy Wall Street” movement and thereby make “haves” versus “have-nots” a central part of next year’s election.  Class warfare has always been a staple of the Democratic Party, and Obama has elevated it to a rallying cry for the progressive faithful.

The Dems may be onto something.  My August 23 E-Letter about Warren Buffett’s call for higher taxes on himself and other “coddled” billionaires hit a nerve with readers.  While some agreed that Warren and his billionaire buddies could cut an extra check to the government if they want, others agreed with Buffett that the rich should be taxed at a higher rate.

Nationwide polls now also indicate that Americans are in favor of taxing the rich at a higher rate.  A recent CNN poll found that 67% of all Americans support higher taxes for businesses and the wealthy.  Perhaps more important, 69% of Independents felt this way.  Since Independent voters are important in any election, this finding is very significant.

Republicans, on the other hand, argue that increasing taxes on high income individuals essentially targets many small business owners and therefore, jobs.  Paying more in taxes to the government leaves less money to expand and hire new workers.  Even so, an October Bloomberg/Washington Post poll supposedly found that 53% of self-identified Republicans actually supported higher taxes on households earning $250,000 or more per year.  Other polls, however, still show the majority of Republicans are firmly against these tax increases.

The stage seems to be set for an all-out brawl on taxation next year.  That being said, I think it is important to clarify some of the issues related to the “rich” who are so frequently mentioned in political speeches.  To get us started, I have reprinted an excellent article that addresses a recent CBO report on taxation that has garnered a great deal of attention in the press, but as usual, it has a lot of flaws. Here’s the article (emphasis mine):

QUOTE:
Tax Rates, Inequality and the 1%
By ALAN REYNOLDS

A recent report from the Congressional Budget Office (CB0) says, “The share of income received by the top 1% grew from about 8% in 1979 to over 17% in 2007.”

This news caused quite a stir, feeding the left’s obsession with inequality. Washington Post columnist Eugene Robinson, for example, said this “jaw-dropping report” shows “why the Occupy Wall Street protests have struck such a nerve.” The New York Times opined that the study is “likely to have a major impact on the debate in Congress over the fairness of federal tax and spending policies.”

But here’s a question: Why did the report stop at 2007? The CBO didn't say, although its report briefly acknowledged – in a footnote – that “high income taxpayers had especially large declines in adjusted gross income between 2007 and 2009.”

No kidding. Once these two years are brought into the picture, the share of after-tax income of the top 1% by my estimate fell to 11.3% in 2009 from the 17.3% that the CBO reported for 2007. 

   

The larger truth is that recessions always destroy wealth and small business incomes at the top.Perhaps those who obsess over income shares should welcome stock market crashes and deep recessions because such calamities invariably reduce “inequality.” Of course, the same recessions also increase poverty and unemployment.

The latest cyclical destruction of top incomes has been unusually deep and persistent, because fully 43.7% of top earners’ incomes in 2007 were from capital gains, dividends and interest, with another 17.1% from small business. Since 2007, capital gains on stocks and real estate have often turned to losses, dividends on financial stocks were slashed, interest income nearly disappeared, and many small businesses remain unprofitable.

The incomes that top earners report to the IRS have long been tightly linked to the ups and downs of capital gains. Changes in the tax law in 1986, for example, evoked a remarkable response – with capital gains accounting for an extraordinary 47.7% of top earners’ reported income as investors rushed to cash in gains before the capital gains tax rose to 28%.

That was obviously temporary, but the subsequent slowdown in realized gains lasted a decade. Taxable gains accounted for only 16.7% of the top earners' income between 1987 and 1996. And the paucity of realized capital gains kept the top earners’ share of income flat.

When the top capital gains tax fell to 20% in 1997 and remained there until 2002, realized capital gains rose to 25.4% of the top earners’ income, and it explained much of the surge of their income share to 15.5% in 2000. Stock gains were more modest from 2003 to 2007, yet the tax rate on profitable trades was down to 15%, so realized capital gains rose to 26.7% of income reported by the top 1%.

True enough, capital gains are not the whole story, and the CBO’s report, “Trends in the Distribution of Household Income Between 1979 and 2007,” notes that “business income was the fastest growing source of income for the top 1 percent.” But that too was a behavioral response to lower tax rates.

In 1988, business income jumped to 16.5% of the reported income of the top 1%, from 8.2% in 1986. Why? As the CBO explains, “many C corporations . . . were converted to S corporations which pass corporate income through to their shareholders where it is taxed under the individual income tax.”

The CBO estimates top incomes from individual tax returns. So it looked like a big spurt in top income in 1988 when thousands of businesses switched to reporting income on individual rather than corporate returns as the top individual tax rate dropped to 28% from 50%.

In reality, it was just a switching between tax forms to take advantage of the lower individual tax rate. Such tax-induced switching from corporate to individual tax forms in 1986-1988 makes it illegitimate to compare top income shares between 1979 and 2007. [I’ll bet that no one in the mainstream press bothered to tell this part of the story. GDH]

After the tax rate on dividends fell to 15% in 2003 from 35%, the share of income reported by top earners from dividends doubled to 8.4% in 2007 from 4.2% in 2002, according to similar tax-based estimates from economists Thomas Piketty and Emmanuel Saez. Top earners held more dividend-paying stocks in taxable accounts rather than in tax-exempt bonds, or they kept dividends in tax-free retirement accounts.

In short, what the Congressional Budget Office presents as increased inequality from 2003 to 2007 was actually evidence that the top 1% of earners report more taxable income when tax rates are reduced on dividends, capital gains and businesses filing under the individual tax code.

[And here’s the meat of this article, in one paragraph, GDH:]

If Congress raises top individual tax rates much above the corporate rate, many billions in business income would rapidly vanish from the individual tax returns the CBO uses to measure the income of the top 1%. Small businesses and professionals would revert to reporting most income on corporate tax returns as they did in 1979. If Congress raises top tax rates on capital gains and dividends, the highest income earners would report less income from capital gains and dividends and hold more tax-exempt bonds.

Such tax policies would reduce the share of reported income of the top earners almost as effectively as the recession the policies would likely provoke. The top 1% would then pay a much smaller portion of federal income taxes, just as they did in 1979. And the other 99% would pay more. As the CBO found, “the federal income tax was notably more progressive in 2007 than in 1979.”

END QUOTE

Mr. Reynolds is a senior fellow with the Cato Institute. This op-ed is adapted from a forthcoming Cato Institute working paper, “The Mismeasurement of Inequality.”

Is the Tax Code Progressive?

The US Tax Code is designed to be progressive, meaning that the more money you make, the higher your tax rate.  This is accomplished through tax brackets with increasing marginal tax rates applicable to income within that bracket.  Liberals, however, complain that the current Tax Code is not progressive enough and that the wealthy should pay more.

The Tax Foundation recently published tax statistics from 2009 that tend to take the wind out of the sails of the liberals.  The table is reproduced below, but here are just a few observations based on the data:

1. The top 1% account for 16.9% of adjusted gross income (AGI), but pay 36.7% of all income taxes;
    
2. The top 5% account for 31.7% of total AGI but also shoulder over 58% of all income taxes paid; and
    
3. The average tax rate on the top 1% is higher (24.01%) than any other group, despite lower capital gains and dividend tax rates.  The bottom 50% pays an average income tax rate of only 1.85%.

Here’s the table:

  

The results are clear – even with access to lower rates for dividends and long-term capital gains, the top 5% and top 1% pay taxes at a higher rate than any other demographic group.  What’s more, the top 50% of households pay almost 98% of all income taxes.  That sounds progressive to me.  Here’s what the Tax Foundation said about it:

“Although the 2001 and 2003 tax cuts were across the board (even though certain provisions within those cuts were targeted at various income ranges), the federal individual income tax remains highly progressive. The average tax rate in 2009 ranged from around 1.9 percent of income for the bottom half of tax returns to 24.0 percent for the top 1 percent. With the possible exception of the estate tax, the federal income tax is the most progressive tax in the United States, and these numbers show why.”

More on Capital Gains

As the above article notes, it’s very important to consider all of the various changes in tax laws before making any generalized comparisons.  Nowhere is this more important than in tax rules governing long-term capital gains.  With the revelation that billionaire Warren Buffett pays a lower rate of tax than his secretary, thanks to special rates on dividends and capital gains, these tax breaks have come under much more scrutiny.

Unfortunately, the only consistency of historical long-term capital gains tax rates is that they are inconsistent, changing every few years.  Obviously, all of this change makes it very difficult to draw meaningful conclusions when reviewing tax data.  Said another way, there’s little wonder that both sides of the capital gains tax debate can claim victory when reviewing the same data.  All you have to do is drop a couple of years like the CBO report described above did, or extend your analysis back into the 1950s when exclusion amounts were common.

The debate is as follows:  Democrats say that higher capital gains rates will raise additional tax revenue without harming the economy, while Republicans say that higher rates will not materially affect revenue but could hurt business investment and, in turn, jobs.  Who’s right?

When reviewing the tax receipts since the tax law change in 1986, it’s difficult to argue that higher rates produce greater revenues.  In fact, capital gains tax revenues tend to be higher when tax rates are lower, as a general rule.  It is also significant that realized capital gains as a percentage of GDP generally follow the same pattern – higher when tax rates are low and vice versa. 

So, while Mr. Buffett and his billionaire buddies presently pay a lower rate of tax on this income, they also tend to realize more long-term capital gains when rates are low, producing more revenue. Isn’t that the bottom line we’re looking for? When tax rates move higher, investors tend to hold onto appreciating assets rather than sell them, escaping the higher tax rate. So, based on actual tax receipts, the Republicans appear to be correct.

Those who argue against lower capital gains tax rates obviously can’t dispute the historical tax collections.  However, they say that the jumps in tax revenue before a capital gains tax rate increase or after a rate cut are only temporary phenomena.  Over the long haul, they argue, the lower rates will produce less revenue.

As proof, they trot out projections by the CBO and others which forecast that tax revenues will suffer over the long term if capital gains tax rates remain low.  Yes, the CBO, that bastion of accurate budgetary projections highlighted in the article above!  We all know the problem with CBO projections is the assumptions used.  In the computer world, they have a saying, “garbage in – garbage out.”  The same goes for the CBO.

Another argument used by those against lower capital gains tax rates is that most middle-income households do not benefit from tax breaks related to capital gains and dividends.  According to an article from the Center on Budget and Policy Priorities, the Tax Policy Center has estimated that the top 5% of households by income receive 83% of total capital gains income.

We’re now back full-circle to the liberals’ desire to wage class warfare.  Can you truthfully say that just because a tax break isn’t available to most middle-class taxpayers that it shouldn’t exist?  The special tax rates for dividends and capital gains are there for a purpose (see below).  If the purpose of the tax break is still valid, then that should dictate its value, not the demographic group that uses it the most.

As I have said before, the capital gains tax rates are designed to provide an incentive for investors to take risks necessary to invest in new and existing businesses.  The chief risk is that they may lose all of their investment, something not considered by the tax-the-rich crowd.

Given the long-term history of capital gains tax rates, perhaps the best way to say it is that realized capital gains tend to seek the lowest level of taxation.  Investors know that capital gains rates change with almost every administration, so they are likely going to be content to just hold onto their appreciated property during higher rates, awaiting lower rates that are sure to follow.

Tax Breaks for Everyone!

In all of the hoopla surrounding the tax-the-rich rhetoric, we sometimes forget that there are tax loopholes written into the law that benefit middle-class and even lower income taxpayers.  A recent Washington Post Special Report notes that there are 172 total tax breaks written into the tax code.  116 of these are reserved for individual taxpayers.  Here are a dozen of the more common tax breaks available to virtually anyone, along with their projected “cost” in terms of lost revenue for 2011:

1. Employer-provided health insurance & cafeteria plan exclusions:  $146.6 billion
2. Employer retirement plan contributions and earnings exclusion:  $105.8 billion
3. Home mortgage interest deduction:  $93.8 billion
4. Medicare benefit exclusion: $63.6 billion
5. Earned Income Tax Credit:  $52.4 billion
6. Charitable contribution deduction (including education and health):  $43.5 billion
7. Annuity and life insurance gains grow tax-deferred:  $25.7 billion
8. Real property tax deduction:  $22.8 billion
9. Educational tax breaks (various):  $17.5 billion
10. Individual Retirement Accounts:  $17.3 billion
11. Gain from sale of principal residence (within limits):  $16.5 billion
12. Medical expense deductions: $13.5 billion

(Source:  Joint Committee on Taxation, “Estimates of Federal Tax Expenditures for Fiscal Years 2010 – 2014”)

These 12 tax breaks were expected to cost the federal government a total of $619 billion in 2011, or roughly half of the estimated deficit of $1.3 trillion.  Now compare some of the individual totals above to the cost of capital gains and dividend taxation, which was projected to be $84.2 billion in 2011 in the Joint Committee’s estimate.  Even if you did away with all favorable tax treatment of long-term capital gains and dividends, it would amount to only a drop in the bucket when compared to the deficit and accumulated national debt.

That’s no-doubt why President Obama and others have already recommended chipping away at some of the tax breaks above for those with higher incomes.  However, it won’t be long until the government’s insatiable need for money will begin to push down the threshold of who is “rich,” until we see the burden hit the middle class.  Count on it!

Conclusions

In this week’s article, I have tried to make the point that, while the “tax-the-rich” mantra has a populist political appeal, it doesn’t always result in additional tax revenue.  Thus, if the Democrats are successful in raising tax rates on the wealthy, they could end-up winning the battle but losing the overall war of reducing budget deficits and federal debt.

Yet recent polls show that Americans now generally favor taxing the rich.  When you really get down to it, however, the issue isn’t necessarily taxing the rich, but rather “tax someone else other than me.”  Most people are not in the top 1% and do not make a million dollars per year and may not know anyone who does, so they think those paying higher taxes are others who can obviously afford it.

The problem is that due to the flexibility many wealthy individuals (especially the top 1%) have in regard to how and when they realize income, the actual tax revenue generated may fall far short of what is needed to significantly reduce deficits.  Where do you think they’ll look then?

One thing is for sure in this age of record large budget deficits: politicians will be looking for ways to raise taxes.  The Democrats are already targeting beneficial tax breaks like home mortgage interest, employer-provided health and retirement benefits, charitable giving, etc., etc.

Once they figure out that the reduction or elimination of these tax breaks don’t create enough revenue to make a significant dent in the deficits, where do you think they’ll look then?  Can you say, “tax increase on the middle class?” Case closed!

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

What is Rich and Poor in America?
http://www.realclearmarkets.com/articles/2011/12/13/what_is_rich_and_poor_in_america__99418.html

Why Unemployment is Worse Than You Think
http://american.com/archive/2011/december/why-unemployment-is-worse-than-you-think

Obama's math only works in bizzaro-econ world
http://cafehayek.com/2011/12/obamas-math-works-only-in-bizzaroecon-world.html

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