Tuesday, November 20, 2012

Taxes 2013

Our government is debating what to do about future tax revenues. This is a big issue because there is a gaping hole or gap between what the government plans to spend and the money it will have to make those expenditures. When I was a teenager is was pretty cool to have a small hole in my Levis. But when the hole got big enough I had to buy a new pair of jeans. As you probably know if you live on the planet Earth the US government is spending more than a trillion dollars each year MORE than what they bring in. When governments have such gaps they have to go into debt. This means that each year they have to sell government bonds to the public of a trillion dollars or more. Selling bonds is usually pretty easy but at some point the public begins to wonder if the government will have the resources to pay the interest each year and then the principal balance when the bonds mature. We see this playing our daily with respect to the bonds of Greece, Ireland, Italy and several other places. The result is not pretty. Bloody street demonstrations are just one visible sign of how painful it becomes when people begin to worry that governments are in financial trouble.

In short, the US government is very preoccupied with reducing this fiscal gap. Both parties want to see this gap managed better. The fiscal cliff is just one aspect of this gap. A year ago policymakers said the fiscal gap was so worrisome that they agreed to enact a poison pill of sorts to put pressure on themselves to enact legislation to reduce the gap. This poison pill was an agreement to put in a very tough short-run solution to the gap – one that raised taxes and lowered both military and non-military spending. Most of us thought – wow – these legislators are really serious. Of course they won’t want to take such an awful pill. Of course, they will legislate something before the end of 2012. They had a whole year to get the job done. But alas, they didn’t. They talked and they accused and they argued and they spat and they even had an election. Yet still no agreement.

So as I write it is November 20 – two days before we Americans gorge ourselves with turkey and JD to celebrate Thanksgiving. We read and hear the news that Senator Reid will not even think about some solutions. Boehner has drawn the line or at least obfuscated the line with respect to other solutions. But one thing remains clear – to solve the problem of the fiscal gap means that two lines have to meet somewhere down the road. The gap will close only when the spending line meets the tax revenue line. This means that spending must grow more slowly in the future and it means that tax revenues must grow faster.

At least for the purpose of this blog – as the title indicates – I want to focus on tax revenues. So I am not going to get into spending this time. As I see it the problem with tax revenues has many dimensions but one really important one is definitional. Many people do not know what the term means.  It is a little like sport fans who want to talk about football. If it is a talk between two Hoosiers we probably are referring to American football and probably a game between lackluster teams like Indiana University and Purdue. Two Europeans would instead be talking about a game we Americans refer to as soccer. If an Aussie and a Kiwi are involved in a football discussion it would be a totally different game. So if we are sitting in the 3 Alley Pub in Itaewon – a place where a lot of foreigners congregate in Seoul – and someone says football – it could take a long time before the group can figure out what they are really going to talk about.

The same thing goes with taxes. In the same discussion you might hear all these terms bandied about – taxes, revenues, average tax rates, marginal tax rates, tax base, percent of income, value added, and more. If people are not familiar with the differences and distinctions of these terms, then it is hard to have a good conversation. So perhaps it is worthwhile to work on this language issue.

My above discussion of the gap concluded that tax revenues will have to not only grow but probably grow more quickly. Much of the tax discussion focuses on income tax. Income tax revenue equals the tax rate a person pays times the income they earn. So if Charles makes $100,000 this year and finds himself in the 28% tax bracket, he then pays $28,000 in income taxes, right? WRONG. Wrong for several reasons.

First, Charles may receive $100,000 this year from his wages, interest, and so on – but Charles has deductions. Whether or not he files a Schedule A, Charles will have some deductions so the income that is actually taxed will be lower than $100,000. Charles gave a lot of money last year to the Georgia Tech Foundation for the Advancement of Beer. Some might call this a tax loophole but Charles loves beer and the foundation appreciates the gift. Anyway, let’s say that his deductions come to $30,000. This means that Charles pays tax only on $70,000. A taxable income of $70,000 puts Charles in the 25% bracket so he will pay $17,500 in taxes. Right?  WRONG.

Charles might be in the 25%  bracket – or what we call the marginal tax rate – but the total amount of income taxes he pays depends on all the other marginal tax rates for incomes below $70,000. To break it down he pays:

  $870 = 10% on income up to $8700
  $3,390 = 15% on the income above $8700 up to $35,300
  $8,675 = 25% on the income above $35,300 up to the $70,000
= $12,935

If Charles pays $12,935 on a taxable income of $70,000 then his AVERAGE TAX RATE is 18.5%. Charles has a marginal tax rate of 25% and an average tax rate of 18.5%

Arrgghhh. Don’t you just love math! But without knowing the difference between income, taxable income, marginal tax rates, and average tax rates – you do not really understand the current debates.

For example, the goal is to raise tax revenue. Tax revenue is defined as taxable income times the average tax rate. This definition is not debatable. A bourbon whiskey has a definition. It is not debatable. What you do to increase your intake of bourbon is an interesting question. What we do to raise tax revenues is also an interesting question.

So the formula says you can raise tax revenue in only two ways – raise the average tax rate or raise the taxable income. That’s it. Those are the only two ways to increase income tax revenues. But here is where the fun begins.

How can you raise the average tax rate? How can you raise taxable income?

The government can increase the national average tax rate by legislating an increase in the marginal tax rate of any or all of the income tax brackets. Presently in the USA the marginal rates for individuals or couples are 10%, 15%, 25%, 28%, 33%, and 35%. By increasing the marginal rate for any of the income categories the average rate paid by the country will increase. Of course if you only raise the rate for the richest people paying 35% -- only the richest will pay a higher marginal and average tax rate. Everyone below will pay the same marginal and average rates as before. So you can see the political issue. You want to increase the nation’s average tax rate. But the question is whose ox gets gored? You can gore everyone or you can gore those only with higher incomes. Either way you can raise the average national tax rate.

You can raise taxable income in several ways. One way is through policies that increase economic growth that raises earned incomes. A second way is by what some people call widening the tax base. Widening the tax base means either having more people pay tax or by having fewer loopholes or deductions from earned income. We know many very poor people in US do not pay income taxes. Some of them could be added by reducing the earned income tax credit. A more popular remedy is to reduce deductions of people with higher incomes. We have more deductions in the US tax code than Apple has i-phones. Popular deductions are for mortgage interest paid on a primary residence. Charitable giving is another one. 

EVERY TAX LOOP-HOLE is in place for what someone at some time thought was a really good reason. I got a tax break one year because I bought a new furnace. This benefit was given to me because it was more fuel efficient that the old one, I was helping the country’s battle against air pollution. One year I got a tax deduction because I drank more than 100 bottles of JD. I forget why I got that deduction and I am sure that is not why the IRS has been calling me repeatedly lately.

So here is the political issue. Whether it is the average tax rate or the taxable income, there is much to debate with respect to who bears the burden of the new policy to remove the fiscal gap and how the new policy affects the country at large. Any policy that raises marginal tax rates often hits the wealthier people the most, but has ramifications for US economic growth. Any increase in marginal and average tax rates will impact consumer spending, national saving, business profitability, investment, innovation, stock market, and exchange rate. Any policy that increases the tax base will have impacts on charitable organizations, housing construction, and so on.

The fiscal gap has got to go. Tax revenue has to increase. Average tax rates, some marginal tax rates and/or loopholes have to be changed. Some groups will pay more than others. The nation’s economic growth and ability to increase income will be impacted negatively for a time. Democrats were born on Venus. Republicans came from Mars. We need a solution. Hopefully this little primer on tax revenues helps you to better understand the difficulties. 


  1. Hey Larry,
    It's been a while since I've posted. But I concur. I especially get irritated when those who want higher tax rates on the rich note (not incorrectly) that tax rates were higher under Reagan and even higher still in the decades preceding the Reagan presidency.

    While those statements are true, they are also irrelevant. What matters is what are the tax rates today and what will they be tomorrow. Marginal tax rates are what drives investment decisions, not the rates as written in the IRS tax tables.

    If marginal rates are going up, then investment will go down. Investment goes down, economic growth slows. Economic growth slows, more people unemployed for long periods of time. Fairly simple argument to make.

    We saw a very good example of how people respond to incentives on Nov 7: Obama wins reelection, therefore the probability of higher taxes in 2013 is significantly higher, investor calls his broker: "I'll pocket my investment profits now", DOW has biggest daily drop of 2012. So while a deal to turn away from the fiscal cliff will be an overall positive for the economy (hopefully), the degree to which the fiscal gap is closed with higher taxes will be the detail that is the more important market mover when it is announced. And while people probably pay way too much attention to the daily movements of the stock market (I know I do), I can't see any reason to be bullish about the stock market in the near-term. And even more so in the longer term once the heavy thumb of ObamaCare really begins distorting commercial activity later in 2013. Only after the cost of ObamaCare is fully assimiliated into the system will economic growth rebound. And that may take several years.

  2. Thanks John -- nothing certain but uncertainty! The next few weeks are definitely going to be interesting but as you say it is not easy to see a return to stronger economic growth right now...Happy Thanksgiving!

  3. I'm far from an expert on the subject......."expert" = a drip under pressure, or anybody 50 miles from home.......but if the Rs cave and agree to a marginal rate increase on those evil, filthy rich people like Davidson, we plunge into a deep recession. Somebody famous once said that you can't tax yourself into prosperity, and the statement has been proven many times.

    Happy Thanksgiving all! Go easy on the JD, Prof! Alcohol and L-tryptophan will put you into a coma.

    1. A coma doesn't sound so bad right now Fuzzy! Let's face it -- whatever choices they make to put a dent into the fiscal gap -- will have a drag on the economy. Like you I am not crazy about higher marginal rates for the rich since that will be self-defeating. But our politicians have basically backed us into a corner with few alternatives that don't require pain. It is very difficult for those people to vote for pain to gain a longer-term benefit.

  4. Dear LSD. Higher marginal rates or fewer deductions or both targeted to “those that need to pay their fair share” won’t matter if the economy doesn’t grow. Even tax apples to “small businesses” won’t stimulate wondrous behavior as the past handouts of Johnny Appleseeds to that constituency haven’t produced even a sprout. Interestingly, even the election, with its masking of obscure creeping socialism for those lusting for more govomit, hasn’t generated fresh air for the canary alongside the bell that opens Wall Street; the bell rings but the bird sucks for oxygen. November 7th kicked the air out of the bird and today Big Ben landed a gut punch. Pretty soon, as the Iron Lady said, socialism runs out of OPM and the bird runs out of O2.

    So, whether higher marginal rates or fewer deductions or both—or even flaccid reductions in the rate of govomit spending—fiat $$$ printed from thinning air won’t do. It’s elementary Mr. LSD, even the prospect of bigger, better govomit as the voters wanted can’t put Humpy Dumpy back together. It’s broken; it’s over; it’s the new normal; the air under the wings is too thin. Maybe, just maybe, if the govomit stops sucking all the wind out the bird can breathe and the econ can get some lift.

    1. Charles, Growth won't come until the long-term budget gap is seriously attended to. And that could take a while. As I said to Fuzzy, the short-run consequences of any approach to deal with the gap will slow growth for a while. While marginal tax rates and deductions offer partial remedies there is no way any program will work that doesn't put a major crimp in government spending. Given all the above it is hard to be very optimistic about our current bunch of politicians finding a solution. We continue to benefit from the same lack of progress in Europe. If they ever get their act together we will be in real trouble. The vigilantes will eat us!

  5. http://www.moneynews.com/StreetTalk/Feldstein-Cliff-Recession-Bernanke/2012/11/20/id/464926

    Interesting.....the "damned if we do, damned if we don't" philosophy.

    1. Fuzzy -- the fiscal cliff is a diversion. Go over it will surely create negative impacts on growth. But avoiding this one cliff does not mean you are home safe. As I said in previous posts -- there is still the debt crisis not to mention China, Europe, and our own housing and financial mess. Avoiding the cliff just means you live one more day to face the rest of a winding road!