The Most Controversial Tax Codes

By | October 21, 2008

If there’s one thing we can all agree on, it’s that there’s nothing we can all agree on, and nowhere is this as true as when we talk about taxes.

Are tax cuts good? Bad? Should we make it easier for cash-strapped folks to buy houses, or harder for them to spend money they don’t have?

The following controversial tax codes, most real, one proposed, show why conversations around taxes can quickly spiral out of control.

Flat tax

Steve Forbes proposed one of the most controversial tax codes during his 1996 election when he proposed we use a Flat tax system. The idea is that you throw away the telephone-book sized tome of regulations and treat everybody more or less the same. Say whatever you want, but this tax form would have been a lot easier to fill out.

Even so, most people still seem to think that a flat tax is a bad idea. Even other flat-taxers can’t agree on the exact stipulations.

I guess it’s not easy to figure out a system whereby Bill Gates and my grandma pay the same rate. Without someone getting lynched.

AMT

Regardless of what system we use, it seems the rich always find a way to get around paying as much taxes as they probably should. So how do you keep the rich from shoveling their mounds of cash underneath the mattress where Uncle Sam can’t find it?

The Alternate Minimum Tax, of course!

The idea was that if you had a certain income, and your taxes were too low, you had to pay at least the AMT. The problem is that it was never indexed for inflation, so even ‘normal’ people wind up getting beat over the head with it. As William Gale at The Brookings Institute says:

This monster was created to ensure that all wealthy people pay taxes, but the AMT increasingly threatens to gobble up more of the hard-earned income of middle-class Americans and doesn’t stop the wealthy from using generous tax shelters.
Sounds like whack-a-mole to me, except that in this game the mole always gets away.

The Bush Tax Cuts

Apparently you can’t please anybody.

The most recent Bush tax cuts were designed to put money in pockets and thereby stimulate the economy.

The problem is that these cuts, usually labeled the “tax cuts to the rich” by their critics, are either ineffective, or else unfair to the poor. Or wait, maybe they’re unfair to the rich? Well, they’re unfair to somebody, at any rate.

Interest deductions I: mortgage interest

A crucial component of The American Dream has always been home-ownership. A fundamental tool in realizing this dream has been a chunk of the tax code that allows a homeowner to deduct interest on his mortgage payments.

Anyone who’s bought a house has saved thousands of dollars in just this way.

The verdict: a great idea, except for when it isn’t.

Like most really great ideas, this bit of tax magic came with heavy baggage in the form of unintended consequences. In The Mansion: A Subprime Parable Michael Lewis describes the implications of how this tax code has affected the culture:

But the real moral is that when a middle-class couple buys a house they can’t afford, defaults on their mortgage, and then sits down to explain it to a reporter from the New York Times, they can be confident that he will overlook the reason for their financial distress: the peculiar willingness of Americans to risk it all for a house above their station. People who buy something they cannot afford usually hear a little voice warning them away or prodding them to feel guilty. But when the item in question is a house, all the signals in American life conspire to drown out the little voice. The tax code tells people like the Garcias that while their interest payments are now gargantuan relative to their income, they’re deductible.

What? We have to pay for these things? Seems downright un-American.

Interest deductions II: mortgage debt interest

In December of last year President Bush, trying to balm the early wounds of the subprime meltdown, proposed to exclude cancelled mortgage debt from taxable income along with increasing the limit on writing off equipment for small businesses.

For instance, if a homeowner is forced to sell his house for $200k, but has $300k on his mortgage, that $100k difference counts to reduce the homeowner’s taxable income. Bush’s proposal was a seemingly obvious response to the crisis: if you have to sell your home in a fire-sale, at least they could spare you the further indignity of a tax liability on a property you don’t even hold.

Who could argue with that? Well, nobody. Except people who take the trouble to think it through, like J.D. Foster:

The Administration’s desire to help these families is well intentioned, but the proposed solution is off base. If done on a permanent basis, eliminating the tax on cancelled mortgage debt would provide an unwarranted and distortionary tax loophole under certain economic outcomes. The value of the cancelled mortgage is a beneficial gain to the former borrower which, under income tax principles, should be subject to tax. Eliminating the tax altogether would be, in effect, a tax-based mini-bailout for former borrowers who, it must be remembered, are in their current straights largely as a result of their own poor decisions.

A mini-bailout? How timely. Do we let people sleep in the beds they’ve made, or save them from the consequences of their own foolishness? Multiply that by three-quarters of a trillion dollars and you’ve got today’s headlines.

Taxes in the 2008 Presidential Election

If there’s one message guaranteed to be popular with voters, it’s the promise to lower our taxes.

So it should come as no surprise that both candidates are running on tax-cutting platforms, though they differ on where exactly these cuts will come from, and how the cuts will help: McCain wants to lower everybody’s taxes in the hopes that this will indirectly bestow economic benefits, whereas Obama wants to raise the taxes of the wealthy in order to make up for tax cuts elsewhere.

Since most of us are not wealthy, and since the gap between rich and poor is so large, it can be tempting to suggest that we make up shortfalls by taxing the hell out of the rich. Why not? Well, the Heritage Foundation has one reason:

[Y]ou can’t just indiscriminately tax the wealthy. The consequences of this policy would be a return to the bad old days of tax avoidance, with taxpayers disguising personal income as business income or capital gains and the migration of capital from the United States to abroad.

In other words: rich people are crafty, and if you try to take too much of their cash they’ll find ways around it so you actually wind up getting less than if you hadn’t shaken them down in the first place. But fear of the rich ducking through loopholes is not the only reason to question the “tax the rich” strategy. According to John Tamny, in the excellent Good, Bad of Obama’s Tax Plan, people who buy into this philosophy misunderstand the origin of middle-class comfort. In short, a 10% rate cut on income of $250,000 and up frees up far more capital than a tax cut on income of $50,000.

The idea is that if you let rich people keep more of their money, they’ll do stuff with it that helps everybody else, like start companies, or buy stuff that cause companies that already exist to hire more people, etc.

Sound familiar? Trickledown economics. It’s still with us after all this time and still as controversial as ever.

While everyone claims to want a healthy middle-class, figuring out the best way to put money in the pockets of middle-class families is not so obvious as it may first appear. Both candidates will cut your taxes, unless you’re rich. If you’re rich (> $250000) then only McCain will cut your taxes. And regardless of which candidate wins, national tax revenue is going down.

Which makes you wonder how we’re going to catch up with that zillion dollar deficit, doesn’t it?

Summary

The common thread through these points is TANSTAAFL (There Ain’t No Such Thing As A Free Lunch). Taxes are complex creatures with complex consequences in a complex world.

Anybody who tells you different probably doesn’t know what he’s talking about.

Except for Steve Forbes, of course. He was on Saturday Night Live.

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