Understanding Taxes: A Primer for LiberalsOctober 20, 2004
SUMMARY: In a dynamic world, people respond to tax increases in logical and legal ways in an effort to minimize their taxes. The rich are readily able to accomplish this, while even middle class people can do much to avoid taxes. As a result, trying to raise revenue by soaking the rich is a strategy doomed to failure.
The liberal answer to raising revenue is to increase taxes on the rich. Of course, this sounds like the fair thing to do – the rich can always afford to pay a little more. Never mind that when the tax law actually gets written, "the rich" seem to include lots of middle class people making $50,000 per year. There's a more fundamental problem with raising taxes on the rich. It doesn't work.
The liberal static analysis assumes that taxpayers don't change their behavior when tax laws change, and if you raise their rates, taxpayers will just pay more. This sounds wonderful in a 15 second sound bite. But we live in a dynamic world in which people DO modify their behavior to minimize taxes, and the rich do it most of all. That's why raising tax rates may actually reduce tax revenues.
If you're not well off, and you need every cent of your income just to survive, or if you make an average living, but spend it all without ever saving a dime, you may not be able to take advantage of the tax code to minimize your taxes. But if you're middle class and don't spend all you make, there are lots of options for you. And the richer you are, the more options there are.
Here are some of the things average people do to minimize taxes:
- Invest in tax-exempt municipal bonds. If you buy bonds issued by your state or Puerto Rico, the interest is tax-free on your state income tax as well.
- Put off until the next year selling any stocks that have appreciated, or put it off until the year after that, or never sell the stock. When you die, your heirs get the stock with a stepped-up basis reflecting the price after your death.
- Invest in rentable real estate. Usually the mortgage interest, taxes, and other expenses of renting the property offset the rent you receive. Ultimately you will own the property free and clear while never having paid a cent in tax on the revenue that allowed you to pay it off. And if you never sell the property, or exchange it for a different property via a Starker exchange, your heirs also inherit it with the stepped-up basis.
- Keep a mortgage on your home and deduct the interest you pay on Schedule A if you itemize deductions.
- If you can negotiate your salary and benefits, take less salary and more non-taxable benefits, such as health insurance. Invest the maximum amount in pre-tax dollars in your pension plan or 401K. Contribute to a regular IRA if you can deduct the contribution from your taxes. If you aren't eligible to deduct the contribution, contribute to a Roth IRA on which you'll pay no taxes once you retire.
- Get any bonuses due you deferred until next year.
I mention these things not to offer you tax advice (which I'm not qualified to do), but to illustrate how easy it is for most people to minimize their taxes. If you're rich, you can hire very expensive accountants and tax lawyers to do it for you. Why do you think most professional athletes incorporate themselves?
Here's a contemporary example. Theresa Heinz Kerry is worth somewhere in the neighborhood of $1 billion. Her income in 2003 was a mere $5.07 million, or a less than a ½% return on her capital. Pretty pathetic, really, until you consider that she owns five (very expensive) houses which don't have a taxable return, although they allow her to live a quite comfortable life. And any Old Masters hanging on her wall can continue to appreciate untaxed. Same with any stocks she owns – until she sells them, there's no tax on the gain. Mrs. Kerry reported a total of $14,412 in capital gains in 2003. That's right, the profits she needed to take from selling assets was only $14 THOUSAND. I'm guessing that it came from mandatory bond redemptions by the issuers which she could not avoid.
Now, of that $5.07 million in reportable income, $2.78 million came in the form of tax-exempt interest from investments in "state, municipal and public entity bonds" according to the Kerry campaign. On the remaining taxable income of $2.29 million, she paid $627,150 in taxes, or an effective rate of 27.4% on that portion of the income or 12.4% of her whole income. I'll bet if you paid taxes at all, your rate was a lot more than that.
Now, I'm not saying that what Mrs. Kerry's accountants did was illegal or even immoral. Absolutely not. But it's a prime illustration of how the rich can avoid taking income and can avoid paying tax on the income they do take. And the richer you are, the less income you need, so the more flexible you can be. I think it's safe to say that if Mrs. Kerry (or Warren Buffet or Bill Gates) never took another dime of income, they could live out their lives in the style to which they've become accustomed. For people like these, paying any income tax at all is pretty much voluntary.
It's worth contrasting this with small business people. Depending on how their business is organized, it must either pay tax on its profits as a corporation and pay the owner a salary (taxed at the individual rates), or it must flow through all its profits to the owner who is then taxed at the individual rate. It's much harder to shelter income as a small business person – and small business people are the ones who are the engine of growth for our economy in terms of job creation.
So, when you start talking about soaking the rich, remember that the rich are pretty hard to soak. As a consequence, either the revenue-raising changes in tax law fail to raise much revenue (or even lose revenue), or else you have to define the rich as the everyday people who can't hire expensive tax attorneys to shelter their income.
As an addendum, it's worth noting that the rich (and the retired) can even more easily avoid state and local taxes — by moving. It's easy to shop the various localities according to their tax policies. Raise state income taxes, local real estate taxes, or sales and gas taxes to the point of pain and the rich will move, while the retired will settle elsewhere. It's not rocket science. See my article on state and local taxes.
Copyright Doug Boulter, 2004