Why the Tax Code is a Mess

I have a friend who I will call Dr. X, or DX for short.  He is a friend of mine who is involved in some but not all things that I am involved in.  We talked recently about taxes, and this is my stylized version of the discussion, because I did not tape it.

Me: So, DX, how did you make out this tax season?

DX: What do you think my federal tax rate was?

Me: Uh, 25%.  You’re a successful guy.

DX: Try again. Lower.

Me: 15%?

DX: Lower.

Me: 10%?

DX: I said LOWER.

Me: Uh, yeah… 3%?

DX: It’s lower.

Me: 1%?

DX: I’m sorry, LO-wer.

Me: O%, you paid nothing?

DX: I’m SORRY, lower.

Me: Wait, the government paid you?

DX: That’s one way to put it.

Me: Then I am clueless.  I have no idea what to do with someone like you who earns a lot, but pays no taxes.

DX: Negative 3%.

Me: How does that happen?  Why aren’t you caught by the AMT?

DX: Many deductions, and many children, with some in college, like you my friend.  Aside from that there is the swiss-cheese post-AMT that wipes out taxes.

Me: Wow.  Why would the government allow this to happen?

DX: Beats me, but I am happy to be wealthy and pay no federal taxes.  That’s been largely true for the prior two years as well.  It genuinely helps if most of your income is coming from sources of investments, and businesses that benefit from certain tax credits.

Me: This is ridiculous.  Why should you get off paying no taxes when our government is running huge deficits?

DX: That’s the fault of the government favoring certain actions.  As long as the tax code is a policy tool, there will be some that take advantage of it.  As for me, I made few active actions to take advantage of it, but also, the way that I do things paid off because I have a certain configuration of income that is presently favored, and a family structure and deductions that are favored.  It may not always be that way — look at the code from the Depression through the 70s; it would be the opposite for me.

Something in-between the two would probably be optimal, including taxing all income at the same rate, and limiting deductions severely.  Stop the games, and fairness becomes a  possibility.  Otherwise, you will have some well-off that pay virtually nothing, like me for the past three years.

Me: Indeed, DX.  You are the man, and have triumphed over the federal government. But what are the common men supposed to do?

DX: Do what I do, or, pay taxes.

Dr. X is a bit of a “piece of work,” but he’s no Leona Helmsley.  (“We don’t pay taxes. Only the little people pay taxes.”)  Much of the reason for his low taxes stems from charitable giving, including donating appreciated stock.

But this helps to point out my point for what I call “true tax reform,” which I don’t think either side in DC would favor today.  Here’s the simple version of it:

• Flatten out the tax rates, and apply the rates uniformly to all income.
• Eliminate all tax preferences, and eliminate the estate tax.  Get people focused on growing the economy rather than employing clever people to eliminate taxation.
• Tax all income, including capital gains/losses, whether realized or not.  For illiquid investments, where there are no prices, assume a 12% return on equity for taxation purposes, and true it up when the investment is sold.  In other words, tax everyone as if they were traders, and develop fair market value accounting to do this.
• Tax corporations on GAAP income, which solves the problem on overseas subsidiaries.  If they act like private equity firms, then disallow the deduction for interest, or assume a 12% return on equity for taxation purposes.
• Eliminate all ability to defer taxation.  No more IRAs, or anything like them.  Tax the pension earnings inside corporations, etc.

My main point here is that the discussion on taxation should shift from rates to the definition of income.  You can tax wealthy people as much as you like, but if the definition of income is loose, you can bet that the wealthy will take advantage of it in ways that those less well-off can’t.

My proposal will make the clever wealthy pay.  It will make the poor pay.  We all will pay.  And that is fair.  Even Dr. X would agree with that.  And it will lead to a growing economy, because we will release many clever people who spent time trying to reduce taxes into trying to be productive.

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