Red Ink (12 page)

For a lot of Americans, the issue isn’t the size of their tax bill, but whether the tax code is—in their minds—“fair.” As Pew
puts it, “The focus of the public’s frustration is not how much they themselves pay, but rather the impression that wealthy people are not paying their fair share.” In the December 2011 Pew poll, 55 percent said the U.S. tax system isn’t fair.

This off-again, on-again “fairness” issue surfaced early in the 2012 Republican presidential primaries when Mitt Romney, reluctantly, released his 104-page tax return. “
Tax returns of the rich and famous have a way of highlighting important policy issues that often get ignored in public debate,” tax columnist Joseph J. Thorndike said at the time. Indeed.

Romney’s return revealed that he and his wife had income of $20.9 million in 2011 and paid $3.2 million in federal income and payroll taxes. In other words, they paid about 15 percent of their gross take (that is, before deductions) in federal income and payroll taxes, much less than the typical upper-income taxpayer. Romney’s income was largely from capital gains
(taxed at a lower rate than wages), and his taxes were reduced by big deductible charitable contributions, mainly to the Mormon Church.

The controversy over Romney’s taxes was nothing compared to the one that erupted over Richard Nixon’s during the Watergate scandal. On November 17, 1973, four hundred
newspaper editors gathered at Walt Disney World for a televised
question-and-answer session with the president. Nixon was tense. He had been reelected, but his presidency was on the rocks. He joked that if Air Force One went down, Congress “wouldn’t have to impeach.” The joke drew laughs, but the editors pressed him about the Watergate break-in and subsequent cover‑up as well as a less-remembered scandal: his taxes.

The
Wall Street Journal
had reported that the president’s handwritten tax returns (fewer than twenty pages each) revealed that he had paid just $5,100 in combined federal income taxes for 1970, 1971, and 1972 on income that totaled $795,000. His 1970 tax bill was only $792. It would have been zero if not for the alternative minimum tax enacted in 1969 over Nixon’s objections, to make sure no one got so many deductions and credits that he or she came close to avoiding taxes altogether. The new tax followed
testimony by the Treasury secretary that 155 households with incomes above $200,000 in 1967 (about $1.4 million in today’s dollars) hadn’t paid any income taxes. Tax historians speculate that Nixon’s $792 bill in 1970 may have been made him the
first AMT taxpayer.

It was during questioning about all this that Nixon uttered the famous words: “I’m not a crook. I’ve earned everything I’ve got.” That was true, but he had cheated on his taxes. He took a questionable $576,000 deduction for donating his vice presidential papers to the government, though the transfer documents were later found to have been backdated. He overdid the home-office deductions for his San Clemente, California, house, claiming it was his primary residence even though he
was living in the White House, and then, to top matters off, he didn’t pay state taxes in California despite alleging that he was living there. After audits by the IRS and, because the Nixon White House had so undermined the credibility of the IRS, audits by the staff of the congressional Joint Committee on Taxation, Nixon ultimately agreed to pay $465,000 in back taxes for those years. No surprise, every president since Nixon has released his tax returns voluntarily.
Nixon’s successor, Gerald Ford, reported paying more than $95,000 in federal income taxes in 1975 on gross income of $252,000, a 38 percent tax rate.

The flap over Nixon’s taxes, largely forgotten today, focused public attention at the time on the “fairness” of the tax code—who should be asked to pay how much—and the capacity of the best off to find ways to reduce their taxes. That debate has been revived lately for reasons beyond Romney’s tax returns: the gap between winners and losers in the U.S. economy has been widening substantially. Underlying the debate over how much to tax the rich is a fundamental disagreement about how hard the government should use the tax code to resist that tendency. Obama would raise taxes on those with incomes above $250,000: “
Those who have done well, including me, should pay our fair share in taxes to contribute to the nation that made our success possible,” he argued. Romney objected. His counterargument: “
You know, there was a time in this country that we didn’t celebrate attacking people based on their success and when we didn’t go after people because they were successful.”

It is important to understand the starting point. Today’s tax code does take more from the rich than from the middle class and the poor. The political issues are whether the rich, whose share of national income has been growing, should pay even more and whether making them do so would have undesirable side effects on the economy.
Here’s where things stand today, based on estimates covering all federal taxes—income, payroll, and corporate—produced by the Tax Policy Center:

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

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.

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.