The failed experiment

How misplaced faith in tax cuts and other economic myths are destroying the country

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When it comes to state and local taxes, the poor bear a heavier burden than the rich in every state but Vermont
ILLUSTRATION BY JUSTIN ROSE

news@sfbg.com

For three decades we have conducted a massive economic experiment, testing a theory known as supply-side economics. The theory goes like this: Lower tax rates will encourage more investment, which in turn will mean more jobs and greater prosperity — so much so that tax revenues will go up, despite lower rates.

The late Milton Friedman, the libertarian economist who wanted to shut down public parks because he considered them socialism, promoted this strategy. Ronald Reagan embraced Friedman's ideas and made them into policy when he was elected president in 1980.

For the past decade, we have doubled down on this theory of supply-side economics with the tax cuts sponsored by President George W. Bush in 2001 and 2003, which President Barack Obama has agreed to continue for two years.

You would think that whether this grand experiment worked would be settled after three decades. You would think the practitioners of the dismal science of economics would look at their demand curves and the data on incomes and taxes and pronounce a verdict, the way Galileo and Copernicus did when they showed that geocentrism was a fantasy because the Earth revolves around the sun (known as heliocentrism). But economics is not like that. It is not like physics with its laws and arithmetic with its absolute values.

Tax policy is something the framers of the Constitution left to politics. And in politics, the facts often matter less then who has the biggest bullhorn.

The Mad Men who once ran campaigns featuring doctors extolling the health benefits of smoking are now busy marketing the dogma that tax cuts mean broad prosperity, no matter what the facts show.

As millions of Americans prepare to file their annual taxes, they do so in an environment of media-perpetuated tax myths. Here are a few points about taxes and the economy that you may not know, to consider as you prepare to file your taxes. (All figures are inflation adjusted.)

1. Poor Americans do pay taxes.

Gretchen Carlson, the Fox News host, said last year "47 percent of Americans don't pay any taxes." John McCain and Sarah Palin both said similar things during the 2008 campaign about the bottom half of Americans.

Ari Fleischer, the former Bush White House spokesman, once said "50 percent of the country gets benefits without paying for them."

Actually, they pay lots of taxes — just not lots of federal income taxes.

Data from the Tax Foundation shows that in 2008, the average income for the bottom half of taxpayers was $15,300.

This year the first $9,350 of income is exempt from taxes for singles and $18,700 for married couples, just slightly more than in 2008. That means millions of the poor do not make enough to owe income taxes.

But they still pay plenty of other taxes, including federal payroll taxes. Between gas taxes, sales taxes, utility taxes and other taxes, no one lives tax free in America.

When it comes to state and local taxes, the poor bear a heavier burden than the rich in every state except Vermont, the Institute on Taxation and Economic Policy calculated from official data. In Alabama, for example, the burden on the poor is more than twice that of the top 1 percent. The one-fifth of Alabama families making less than $13,000 pay almost 11 percent of their income in state and local taxes, compared with less than 4 percent for those who make $229,000 or more.

2. The wealthiest Americans don't carry the burden.

This is one of those oft-used canards. Senator Rand Paul, the tea party favorite from Kentucky, told David Letterman recently that "the wealthy do pay most of the taxes in this country."

The Internet is awash with statements that the top 1 percent pays, depending on the year, 38 percent or more than 40 percent of taxes.

Comments

Simplify, Simplify Simplify

The US Tax system is horribly complex and the average tax burden as a percentage of income can be shown to be skewed unfairly towards the poor or the rich depending upon whichever set of statistics are used. The truth, however, is that tax rates can vary considerably between two taxpayers of equal income but disparate sources and/or deductions.

A tax system that rewards or punishes certain behaviors is prone to regular and recurring revisions that result in the current, convoluted system. A simple tax structure with three or four progressive brackets and no deductions would be fair and simple with which to comply. Eliminating capital gains tax breaks, mortage interest deductions, Earned Income Credit, etc. would go a long way towards increasing productivity and raising revenue. Of course, most every segment of the population would find something to dislike about this proposal so it will likely never be adopted.

As to corporate taxes, these too should be simplified AND lowered. Although one can argue about how GE or other large companies pay no US Income Tax, I assure you that many small businesses pay more than their fair share. As the former owner of a small business, I know first hand that there are significant incentives to draining the coffers each year rather than leaving money in the company to help build the business. The current tax structure seems designed to encourage borrowing and to discourage actually reinvesting in a business.

Finally, please don't trot out the old $2T in cash sitting in corporate balance sheets. It must be always remembered that much of that $2T in cash is offset by various corporate indebtedness in the form of bonds or other liabilites. It's just that in the last few years, the Fed's zero interest rate policy has encouraged companies to borrow for possible future expansion in the fear that future rates will be significantly higher.

Posted by Guest666 on Apr. 13, 2011 @ 3:51 pm

Why a simple tax structure for a very complicated economy?

How about a simpler economy first, one with fewer derivatives, less rent seeking and speculation, and THEN a simple tax structure?

-marc

Posted by marcos on Apr. 13, 2011 @ 5:43 pm

simple tax concepts cannot equitably pertain to an advanced economy. New Zealand is an advanced western nation and yet has a flat tax structure with hardly any deductions.

Much of the simplification needed is simply the removal of targeted tax deductions and subsidies for special interest groups like homeowners, businesses (er, Twitter?) and so on.

Taxes should not be used to modify behavior but solely to garner revenue from as wide a base as possible. And with that, lower rates become possible.

Posted by Minty on Apr. 13, 2011 @ 7:08 pm

Many of the complications in the economy come from the convoluted tax structure itself. The desire to reward or punish behaviors via the tax system is not a left or right issue. Both sides are expert at crafting various tax schemes to accomplish their goals.

Posted by Guest666 on Apr. 15, 2011 @ 11:13 am

I'm glad to see David Cay Johnson start to bring up the absudity of the depreciaton tax loophole. I hope he starts talking soon about the equal absurdity of the tax dodge for investment real estate interest write-offs, along with loopholes like tax-free property exchanges, increases in tax basis that can reduce tax gains forever, and very low capital gain rates if, or when, the asset is sold decades in the future.

His piece hits perfectly on one of the big-money tax games. When assets increase in value, I can take out loans against it, but don't have to pay any tax on the withdrawls. I can deduct the interest expense against other investment income, further reducing my tax liability. And if I really plan well, I'll never pay any tax on the investment gains when the property passes to my estate.

Using his example of a hedge manager who let's say "earns" $100 million from his services. Until he sells his "caried interest" share, no tax is due. But the hedge manager can borrow $40 million tax-free and spend it as he sees fit having a grand ole time in his remaining years. When his appreciated assets (including the "carried interest" of $100 million) pass to his heirs, there is no tax due ever on the $100 million because of a tax-free basis step-up. After the heirs cash in the $100 million investment and pay off the $40 million loan, they walk away with $60 million tax-free. Another expensive tax gift for the very wealthy.

If the "carried interest" was treated as ordinary earned income, which it should be, then the hedge fund manager would owe federal and state tax of approxilately $40 million in the year it was earned, not when it was sold. But thanks to Congress and state legislators, these billions of dollars in "carried interest" earnings may never be taxed.

These same tax dodges apply in California. And since all tax laws come from the legislature - which has been controlled in California by Democrats since almost forever - the Democrats give the same tax breaks to these very wealthy of the wealthy.

It's also good to see DC Johnson focusing on payroll taxes. He has had some great articles and at least one book clearing explaining complicated tax dodges in the business and investment world, but the bigger story is the massive amount of payroll taxes, sales taxes, excise taxes (eg, gasoline, cigs and alcohol), and even a fair amount of property taxes paid by lower and middle income people.

You know the economic and tax systems are rotten to the core when lower and middle income people pay approximately 50% of their earnings in combined federal, state and local taxes, and pay another 35-40% or so on rent/mortgage and utility costs.

Nice the government leaves us at least 10-15% of our measly wages since healthcare and food ain't so cheap either.

Posted by Robert on Apr. 13, 2011 @ 5:59 pm

It's an insurance policy. That is why both premia and benefits are capped.

If you don't even understand that, you're not qualified to opine on the topic.

Posted by Minty on Apr. 13, 2011 @ 7:10 pm

An insurance policy implies that I have some asset that I can access, either by selling it or by borrowing against it. I can do neither with my "expected" Social Security benefit.

If I'm under 62 and die tomorrow, as a single person without any children, I believe my estate gets a few thousand dollars from Social Security for burial expenses and that's about it. Whatever the amount is, it won't compared to the tens of thousands of dollars I've paid into Social Security, which may be as much as $150,000 - $250,000 including the employer matching amount over my 30 year work career.

Not many insurance policies perform that miserably where not even the money you've paid into the policy over the years is returned to the policy holder, not to mention at least some nominal earnings on those massive insurance payments I've been making.

Another reason Social Security isn't a true insurance system is that it has no "real assets" to cover it's trillion dollar liabilities. They have a bunch of paper scraps lying around with "IOU, signed Congress" printed on them for all the hundreds of billions Congress has raided from Social Secuity over the years. But since the cash going out of the fund will begin to quickly outpace the amount going into the fund as the baby boomers retire en masse, if the Fed inflates the economy to pay off this massive debt (maybe it will be QE Xll by then), I don't think my measly $850 is going to get me very far. I'm currently looking at Duluth MN as one of the few places where the rent is low enough that I can retire and not starve. (If helps that Duluth is essentially bankrupt and its economy is partly tanking because of the city's promised employee healthcare benefits. They have terrible politician managers there, apparently.)

If Social Secuity was a true insurance policy, the company (government) would have real assets they could sell to meet my expected insurance pay-out , and not have to rely on the goodwill of future taxpayers or Congress.

A couple of bigger points about FICA and Social Security. It shouldn't surprise anyone who reads The Guardian that poorer and middle income people pay a far higher percentage of their income for these payroll based taxes. The 15% tax on GROSS wage (combined employee and employer tax portion) phases out at a little over $100,000. Just 10 or 15 years ago, the phase out amouts were lower still - closer to $60 thousand.)

Poorer people, especially people of color or people with physical or mental disabilities, die at a much earlier age than the upper-income, wealthier taxpayers. Thus, the lower and middle-income people get the fewest Social Secutrity benefits just for the simple fact that they die a lot sooner than the affluent.

A bigger issue is there is no solid tax policy why we should fund Social Security from payoll taxes, other than this tax policy benefits the wealthy. (A common theme in our current federal, state and local tax systems.) A fairer, easier approach would be to collect a certain portion of real estate rents. After all, it's the surrounding community that creates the real estate value in the first place that allows landlords and real estate speculators to charge as much for rent as the local community can pay. We could start at a low 5-10% on gross rents and see how much we could lower payroll taxes by the same amount.

It's fair and reasonable tax policy to recycle some of the rental income value created by the community back into the community as a prime source of government tax revenue. This same approach should be occuring at the local, state and federal level - slashing taxes on labor, especially payroll and income taxes on lower and middle income workers - and increasing taxes on rent income and on high interest and dividend income earners (over 100K?).

Imagine an economy where lower and middle income earners received a large tax wage increase if payroll taxes were sharply reduced or eliminated. This would increase their purchasing power tremendously, increase business profits, lead to more hiring, lead to higher wages, and ultimately lead to more tax revenue. Economics isn't called "The Happy Science" without good reason!

The tiny segment of uber-wealthy that own and control a significant part of the world's valuable real estate would initally pay the new taxes, and maybe the net wealth of these few hundred thousand people goes from an average of $135 million to $115 million. But this is tiny price to pay - it likely won't even be noticed by 80% of them - and the significant increased economic activity will allow these landed elites to continue to earn their big incomes and build their wealth pile even higher.

Posted by Robert on Apr. 14, 2011 @ 8:46 am

structural weaknesses and defects in SSI, and especially if you are under 62, single, and unlucky enough to die early.

But it does carry disability insurance, a pension of up to about $2,000 a month and spousal benefits.

However, my main point is that it isn't officially a tax, although people often view it that way.

Posted by Minty on Apr. 14, 2011 @ 12:27 pm

A number of years ago the "foreign flip" was in vogue. The idea was to take a US company and turn it into a foreign company. Why? Because 100% of a US company's worldwide earnings are subject to US tax, but for most foreign companies, they are taxed only on their local earnings, not worldwide earnings.

So if a US company could magically turn into a Cayman or Dutch corporation, they would only pay tax on sales in the local country, but not on worldwide earnings. With a 30% or 40% tax rate, the savings are tremendous.

As is often the case, some new rules were adopted to make it more difficult for a US company to do a plain vanilla foreign-flip, but you may have noticed a recent trend of foreign companies buying large US companies, such as Im-Bev's recent purchase of Budweiser. This has a similar long-term effect as a foreign flip, although it may take a few years to rearrange operations to maximize the foreign ownership advantage and minimize the US taxes, but it will happen. Big time.

Newer companies may just start off as a foreign corporation or at least get as much of their valuable intellectual property to remain offshore. This helps avoid US tax except for the small part of the company's US sales. (I believe Mr. Johnson wrote about issue in past couple of months, but couldn't readily find it. The Bloomberg article below explains some of the main points as to why Google has a 2.5% tax rate instead of the standard 35-40% tax rate.)

http://www.bloomberg.com/news/2010-10-21/google-2-4-rate-shows-how-60-bi...

One of the companies that set this foreign model was a Palo Alto company that was (is?) one of the biggest makers of birth control bills, surprisingly enough. They developed the formula and processes outside the US and were headquartered in Panama as I recall. The US could only tax a small part of their millions in profits because of the foreign structure. I think their effective tax rate was close to 5%, whereas many big companies had effective tax rates closer to 35-40%. There is a lot of professional incest in Silicon Valley and Bay Area, so naturally the techniques spread to other companies, with "neat" improvements along the way.

Posted by Robert on Apr. 13, 2011 @ 8:03 pm

Tax evasion is illegal.

Tax avoidance - the structuring of your affairs to legally minimize your tax liability - is perfectly legal and in fact we all do it without guilt.

The US has a higher rate of corporate tax than most of our competitors, and so such tax breaks exist to offset the higher rate. It's a fairly common and well known practice.

And while a comany may pay no US tax on foreign operations, they will pay tax in that overseas location, in the same way as foreign companies operating here pay US tax.

The situation is more complex and reasonable than you are presenting it.

Posted by Minty on Apr. 14, 2011 @ 8:55 am

The rate issue is largely menaingless when a multi-billion US company like Google has an effective tax rate of 2.5%, (and I'm sure Facebook, Twitter, Zynga and all of the other new, uber-cool billion dollar companys will have a similar effective tax rate by the time the tax lawyers are done), whereas most other "mom and pop" main street businesses (let's focus on small businesses, say under $10 million of sales) will have an effective corporate tax rate closer to 35%-40%.

Now I'm not a fan of the current corproate tax whatsoever, if you've bene reading this blog or other SF related blogs. I've been banned from progressive pow-wows and Facebook groups because I don't think raising the corporate tax to 60% or 80% or 90% is the right answer. I think the gross receipts tax is much more elegant and effective: it's easy to calculate; it's easy to audit (we could get rid of probably at least 30% of the IRS saving the government some money afdminsitering the business tax system); it's easy to have smaller firms pay lower tax rates than the bigger firms, so if can accomodate a progressive tax rate structure; and a simple pass-through tax credit mechanism can be used to offset the cummulative tax issues that gets brought up whenever discussing gross receipts tax ystems.

As I'm sure you're aware, the best tax lawyers and accountants are paid 10-20 times more than their government counterparts so the govenment can't compete on talent. And as you admit, it's a terrribly complex system that is easy to evade (oh sorry, avoid) with new multi-million ollar corporate tax-saving plans being hatched everyday. Moreover, many of the best government tax people end up transferring as a partner at a law or accounting firm starting a couple million a year, using their valuable Treasury and Congress Joint Committee contacts to make the other law/accounting partners even more millions for themselves and multi-millions in tax saving for their clients.

But the basic concepts of corporate taxation are not nearly as complicated as you make them sound. The company has income. It gets to deduct a whole bunch of stuff from that income - including some "fictional" expenses. The company pays tax on the net income, less expenses.

Most of us can understand the way it works from a simple example using one of the better plans I've seen in action.

Let's say my US corporation owns a German "subsidiary" that i want to use for a long-term investment in Italy.

Using the German company I set up an Italian "branch" for an investment strategy that will pay big, but I have to wait ten years for it to pay-off. In the first year I spend $10 million on this investment strategy.

At the end of the year, my Italian "branch" tax return shows a loss of the $10 milllion that I spent in Italy. I get to use these losses in future years to offset income. (A loss carryforward (NOL), which is a very valuable asset becasue it can be used to offset current or future profits.

At the end of the same year, on my Genrman company tax return I also report a $10 million loss from the Italian expenses because the Italian "branch" is legally part of the German company - ie, it's not a separate "legal" corporation. So for Germany, I ALSO get to use the $10 million to offset future German profits (or even better, offset the profits of other profit-making operations in Germany.)

So I got two $10 million dollar deductions for the price of one. Not bad, huh?

Now for the best part. My German subsidiary is actually an "LLC" (foreign equivalent). For US tax purposes I have elected to treat the LLC as a partnership, which means the operations of the German company flow directly into my US financial statements. Thus, that SAME $10 million loss flows from the Italian branch, through the German partnership, and offsets ANOTHER $10 million of my US profits!

Is life beautiful, or what?

I'd love to hear feedback from anyone who is not that familiar with corporate tax and let us know if this subject is as "complex" and "opaque" and "only for the experts" as minty suggests.

Posted by Robert on Apr. 14, 2011 @ 10:09 am

The government should tax financial wizard salaries, Wall Street and tax lawyers, at 100% and use those proceeds to attract the same level of expertise that is the only way the public sector can compete with the private sector for enforcement of existing laws.

-marc

Posted by marcos on Apr. 14, 2011 @ 10:22 am

a tax rate were 0%.

Because nobody would work for no pay.

Anyone on Wall street can just as easily work in Bermuda, London, Zurich, Tokyo or Hong Kong. How are you going to get those nations to also impose a 100% tax rate?

Posted by Minty on Apr. 14, 2011 @ 12:31 pm

Minty you missed the sarcasm in his suggestion.

Posted by Guest on Apr. 26, 2011 @ 5:02 pm

I see nothing reasonable about the wealthy and corporations not paying as much as everyone else.

Actually, if it were you or I, and the deduction has no "economic substance" the IRS would disallow the deduction, theoretically.

http://www.nixonpeabody.com/publications_detail1.asp?ID=3278

Posted by Guest on Apr. 14, 2011 @ 9:55 am

That supply-side economics has been a disaster for the US as a whole.

But since the Laffer Curve was first written out on the back of a bar napkin it's entirely unsurprising that everything which flows from it is bunk.

Posted by Lucretia Snapples on Apr. 15, 2011 @ 1:00 pm

"For three decades we have conducted a massive economic experiment, testing a theory known as supply-side economics."

I wish I could have been a part of this experiment - for the past 30 years more than 50 cents of every dollar I have earned has gone toward one form or another of taxation -- Federal Income Tax, State Income Tax, Sales Taxes, business taxes being passed on to me and factored into the price of every single item I've purchased, etc. This is supply-side economics? Sounds a lot closer to Welfare State to me. Sometimes I wish I were one of the 47% who don't pay taxes

I have a feeling Mr. Johnson is one of those who believe his tax refund is actually a gift from the feds.

Posted by Kyle on Apr. 16, 2011 @ 4:42 pm

Supply side economics means shifting all costs onto the demand side so that the benefits all accrue to the supply side. That is why you pay the tax instead of having paying no tax and having all taxes on business passed on in the price of what you purchase.

This was done to "get guvmint off of people's backs," as Reagan used to say, but really makes average folks and small business cover the freight for the super rich and very large corporations.

Libertarian capitalism does not have broad support in the US, it is a fringe economic movement that is only visible in the media and thus the national consciousness because very wealthy individuals have an interest in it and have been financing lib cap as an economic discipline for the past 50 years or so.

Quit yer tax whining, when taxes were at historical highs, the economy hummed, wages increased and infrastructure investment paved the way for the golden era. You all remind me of the American Communist Party that claimed that Stalin got it all wrong, and that we just needed to try communism one more time, but to do it the right way this time! After Greenspan, the libertarian capitalists are not going to have as able and capable operative in such a position of power. Greenspan was your Stalin.

After 30 years of libertarian capitalist economic sharia government has been bought by and served the wealthiest elements of society. It thus uses the machinery of the state, military and Fed/Treasury to siphon public resources and entitlements back into the same pockets that bought the government. If that cycle of corruption were broken, taxes would fall and services would increase and improve.

-marc

Posted by marcos on Apr. 16, 2011 @ 5:15 pm

A flat tax with no (or few) deductions would widen the tax base, simplify the system, and avoid all the rhetoric about one group or another not paying their "fair share."

Other thoughts: this article doesn't address the fact that people in states like California, New York, and New Jersey pay a lot of state tax. When you layer that on top of federal tax rates, people are paying a lot of tax in California.

If we're going to stick with our overly complex system, there should be cost of living considerations. A guy living in San Francisco making $50,000 a year is in a much different boat than a guy living in Toledo, Ohio making $50,000.

Posted by The Commish on Apr. 16, 2011 @ 5:24 pm

Like the Laffer curve, supply side economics and the wonders of financialization of the economy on the manufacturing sector, the flat tax is a a right wing dream to further confine the effective tax rates down at the level of the "little people."

Just like the conservative Republicans and Democrats did supply side so that only mega corporations came out ahead, soaking working folks and small biz, the same will happen with a flat tax. And you all are stupid enough to buy the hype from the same shysters who fucked us all over so well for the past 30 years.

-marc

Posted by marcos on Apr. 17, 2011 @ 7:26 am
Posted by The Commish on Apr. 17, 2011 @ 8:21 am

Jerry Brown cuts old growth redwoods in a state park to widen US-101 so that WalMart supply trucks can save money on their way to Eureka.

Everyday low prices, everyday low redwoods. Does anyone look to Jerry Brown for principled leadership?

-marc

Posted by marcos on Apr. 17, 2011 @ 8:37 am

Thank you very much for the brilliant analysis of the tragedy of supply side economics. Finally we can get on with gettting the Republic going with hi taxes, and a huge expansion of government to create jobs. Keeping the illegals coming so we can have stuff done for pennies on the dollar and those of us who can't get on with the government have someone to wait on us.

Posted by Guest Steve on Apr. 16, 2011 @ 6:04 pm

The report by the Institute on Taxation and Economic Policy (http://www.itepnet.org/whopays3.pdf) contains a trick that is so dishonest it takes my breath away.

They count the federal tax deduction for state income tax as a negative, thus lowering the "state taxes" the "rich" pay. The actual state taxes paid do not include that negative. If they did this honestly, the "rich" would have paid a much higher tax rate -- which is, in fact, what they actually pay.

The key to why this is so dishonest is that this "deduction" would never be shown elsewhere as a positive. Any report on the federal taxes paid by the rich would show what they paid. It would be absurd to report what they WOULD HAVE paid without the state tax deduction.

So the subtraction used in the report is pure deception. They don't report the federal taxes paid yet they include the impact of the state tax deduction on federal taxes as a negative. This turn real taxes paid into a subtraction in their report.

Very clever!

Posted by Guest on Apr. 16, 2011 @ 6:50 pm

This article is just nonsense. No matter how much revenue you bring in, it avails naught if you spend more than you rake in. And all that spending merely infantilizes people so that they don't even WANT to take care of themselves and pull their own load. They never learn the satisfaction of actually taking care of themselves, needing help from no one.

Responsibility is learned by bumps on the head from the school of hard knocks. Take away those knowledge bumps and you have adults forever stuck in childhood. That's just what lib policies have wrought over the last 50 years. Letting responsible people keep more of their own money to invest, and thus create jobs, is an idea liberals simply don't get.

Robbin' Hood. That's liberal tax policy.

Posted by Jack Rail on Apr. 17, 2011 @ 6:07 pm

Nice of you to mention that the lower income folks do pay a variety of taxes - why didn't you also mention they receive the earned income tax credit to offset the social security taxes.

Great writing - too bad that you are only telling one side of the story, which causes me to ignore all you wrote.

Jim in California

Posted by Guest on Apr. 22, 2011 @ 11:16 am

This article doesn't match it's stated purpose. No wonder economists haven't declared 'supply side economics' dead if this is the case. There's no case. Just a bunch of non sequitors about evil greedy rich people. But notice what is missing: victims. Some dystopia.

Posted by Guest on Apr. 24, 2011 @ 10:08 am