Tuesday, April 10, 2012

Tax Policy Based on the 0.001%

Nothing gets us fired up more than blatantly misleading tweets from @White House.
In the absence of any real substantive ideas or accomplishments to communicate to the masses, the White House has once again resorted to its tried and tested “fair share” (sorry, #fairshare) arguments for raising taxes.  Today's tweet mentions that 1,470 taxpayers “made more than $1 million in 2009 [and] paid $0 in federal income tax” in an attempt to again try and illustrate the "fairness" problem.     
The "fairness" issue was first personified through the evil 1% and how it’s unfair that they only fund 37% of all tax revenues and as a group have an effective tax rate of 24%.  An effective tax rate of 24% is unfair because it is only 46% higher than the rate paid by the top 1-5%, 192% higher than the rate paid by the top 10-25%, and 1,199% higher than the Bottom 50%. 
Apologies if you don't recognize these figures, we like to use actual aggregated data from the IRS, not the White House “data” which seems to consist solely of the effective tax rates of Warren Buffet (17%), his secretary (36%), and 1,470 unique taxpayers with at least $1 million in income (0%).  We don't believe it makes sense to set tax policy affecting millions of Americans based on the unique tax situations of 1,472 tax returns (0.001% of all tax returns).  Is the data on the remaining 99.999%, or 137,980,731 tax returns irrelevant?  Perhaps just inconvenient.  Who needs statistically significant data and information when assumptions based on headline-grabbing outliers polls so much better?
We’ve already debunked the theory that taxes on the “rich” can solve our problems (hint: you could tax 100% of that income, and still be left with a huge annual deficit).  We’ve already debunked the idea that the marginal tax rate is the bellweather of fairness
In this piece we highlight the complete set of facts that debunks use of 1,470 taxpayers who “made more than $1 million in 2009 [and] paid $0 in federal income tax” to promote "fairness."  
Even ABC News can get its facts straight when discussing this population of 1,470 taxpayers.  After presenting the click-provoking headline that some millionaires paid zero income tax, the story actually does a good job of explaining how or why this phenomenon happens.  Again, this is 0.001% of total tax returns, so not exactly a common occurrence. 
It turns out that it’s not because these individuals are sneaky or even have good accountants, it’s just that they have unique income. 
Three main tax positions can lead to large reported income, but zero federal tax. 
1.       Tax free interest income
2.       Charitable donations
3.       Foreign Source Income and Foreign Taxes Paid. 
Tax Free Interest Income
To incentivize investing in municipal bonds, Congress has legislated that interest income on municipal bonds is not subject to federal income tax.  Therefore, someone living off the interest of $20,000,000 in municipal bonds earning 5% (remember our "unique" claim above), will report $1 million in income, but will pay zero federal income tax.
Before you scream “NOT FAIR” remember that the market has already priced in this tax exemption into the interest rate on the bonds, meaning that the interest earned on these bonds is reduced by the tax benefit received.  Despite the administrations hints to the contrary, there are no free lunches. 
Therefore, investors are effectively taxed on the income through lower returns – with the municipalities benefiting from lower interest expenses instead of the federal government benefiting from income tax revenue.  Quick example.  Grandpa wins MegaMillions and deposits his after-tax winnings of $20,000,000 in a brokerage account.  His broker gives him two high quality investment options:
  • Corporate Bond A - AAA- rated with interest rate of 7%
  • Municipal Bond B - AAA-rated with interest rate of 5%. 
At this level of income, let’s assume Grandpa has an effective tax rate of approximately 30% and no other income or deductions.  What is Grandpa’s after-tax income for each investment?  The same - $1 million. 
  • Corporate Bond A will earn $1.4 million in annual income and Grandpa will pay approx $400,000 in federal income tax on that income.  
  • Municipal Bond B will earn $1 million in annual income and Grandpa will pay zero in federal income tax.
Therefore, Grandpa’s economic results are identical regardless of whether he paid federal income taxes or not.  Not coincidentally, the difference in interest rates on these instruments exactly matches the difference in tax treatment.  It's amazing how pricing is so efficient in a free market.    
Therefore, the only substantive effect of implementing the Buffett Rule on Grandpa is that he will sell the Municipal Bonds and buy the Corporate Bonds.  Without the tax benefit, the Municipal Bonds are a bad investment at their stated interest rate.  The net effect will be that the federal government will end up with more cash, the already cash-strapped municipalities will end up will less cash and a less liquid market in which to issue bonds.  We presume the politicians would run around claiming they’ve restored fairness to country, even though Grandpa still earns $1 million after tax.  We concede his effective tax rate will be higher (yea, fairness!), but it's meaningless as his after-tax income will not change, and municipalities get crushed in the process.     
Charitable donations
Charitable donations are tax-deductible - for every $1 you give to charity, you can deduct $1 from your taxable income.  For example, if Grandpa bought the Corporate Bond above, but also donated $1.4 million to charity, he would have zero federal tax liability as his donations offset his taxable income. 
The impact of the Buffett Rule in this scenario is that Grandpa would give $400,000 less to charity, and instead give it to the IRS.  If your idea of fairness is funneling money away from worthy charities and into the government coffers, the Buffett Rule is for you! 
Foreign Income and Taxes
This one is near and dear to our hearts as former ex-patriots.  The IRS requires you to report your total income, both foreign and domestic in your tax return.  However, the IRS then lets you deduct some foreign source income from that total, and then also provides for a tax credit for taxes paid in most foreign jurisdictions. 
For example, a US citizen is living and working in London and is fortunate enough to earn £600,000, which converts roughly to $1,000,000.  By virtue of living and working in London, this executive is taxed by the Inland Revenue, the UK’s version of the IRS, at an effective rate appraoching 50% (isn’t socialism great!).  The US and the UK have an agreement in place where neither country will double tax its citizens – meaning that the US executive living and working in London does not need to pay UK taxes and US taxes on the same income.   
Therefore, in his US tax return, the US expat will show roughly $1 million in income, but zero federal tax payments as the IRS allows the £300,000 he paid in taxes to the UK to be applied to his US tax liability.

The impact of the Buffett Rule in this scenario is that every expat living abroad would be on the first flight back to the US.  If your idea of fairness is limiting US citizens ability to work abroad, then the Buffett Rule is for you!!
President Obama and his administration must think voters are only capable of reading headlines.  If voters took the time to actually understand the complete set of facts around effective tax rates, they might come to a different conclusion on what is “fair.”


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