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The Tax Rate Fallacy

madhedgefundtrader's picture




 

When anyone starts lecturing you that the US has the highest tax rate in the industrialized world, just turn around, walk away, and pretend you never heard of them. This person is either ignorant about this country’s taxation system, or is deliberately trying to deceive or mislead you.

According to a report released by the Internal Revenue Service, America’s tax collection agency, the top 400 individual tax returns filed in 2009 reported an average gross income of $358 million each. The average amount of tax paid by these individuals came to under 17%, less than half the maximum Federal rate of 35%, which kicks in on annual income over $372,950 (click here for the 2009 tax tables at http://www.irs.gov/pub/irs-pdf/i1040tt.pdf ). This explains why Warren Buffet pays a much lower tax rate than his secretary. It really is true that in America, only the poor people pay taxes.

Look at any international comparison of taxes to GDP, and one can always find the United States at the bottom of the table. Low American taxes is one of the main reasons why I moved my company here from England 15 years ago. Take a look at the Fortune 500, where one third of the largest companies pay no tax at all, and many that dominate the top of the list, like the oil majors, pay only token amounts. However, if any politician wants to pander to voters during election time on a tax cutting platform he will only bluster on about “tax rates”, not actual taxes paid.

What the US has that other countries lack is the 100,000 pages of the Internal Revenue Code. It is a 97 year accumulation of deductions, accelerated depreciation rates, tax credits, and other tax breaks that are the end product of intensive lobbying efforts and bribes by special interest groups, corporations, unions, and even religious groups. Take a look at the oil industry again. The oil depletion allowance permits drillers to deduct a substantial portion of the cost of a new well in the first year (click here for its fascinating history at http://www.spartacus.schoolnet.co.uk/JFKoildepletion.htm ). When I first got into the oil and gas business a decade ago, after reading the relevant sections of the tax code, I couldn’t understand why everyone wasn’t drilling for Texas tea.

I have a very simple solution to the country’s budget deficit problem. Hit the reset button. Eliminate the Internal Revenue Code. Just set it on fire. Keep the existing progressive, hockey stick tax rates on income, but eliminate all deductions. And I mean everything; deductions for dependents, home mortgage interest, medical expenses, the works. There are no sacred cows. My revised Form 1040 would have only three lines on it:

Income
Tax Rate
Tax Due

The budget deficit would disappear overnight. Government spending would shrink dramatically, because you could ditch most of the 100,000 who work for the IRS. Some 1.3 million auditors and CPA’s would have to hit the road in search of new work too. The amount of money that is wasted on tax collection in this country is truly staggering. This is not some pie in the sky concept. This is how taxation already works in most countries, and they seem to get along just fine.

In fact, the whole scheme might even pay for itself.

To see the data, charts, and graphs that support this research piece, as well as more iconoclastic and out-of-consensus analysis, please visit me at www.madhedgefundtrader.com . There, you will find the conventional wisdom mercilessly flailed and tortured daily, and my last two years of research reports available for free. You can also listen to me on Hedge Fund Radio by clicking on “This Week on Hedge Fund Radio” in the upper right corner of my home page.

 

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Tue, 12/07/2010 - 00:49 | 784683 dizzyfingers
dizzyfingers's picture

Decades-old joke...

Simplified IRS form

1. What did you earn?

2. What did you spend?

3. What do you have left?

Send it.

Mon, 12/06/2010 - 13:05 | 782339 Quantum Nucleonics
Quantum Nucleonics's picture

You've made a few salient points wafting up from a big pile of crap.

Buffett pays a lower rate than his secretary?  Please, his secretary doesn't pay taxes at all.   For 2008 (most recent year for which data has been released), the top 5% of income earners made 39% of all income, but paid 58% of all taxes.  The bottom 50% pay essentially no federal income taxes at all.  The average tax rate paid by someone in the top 1% is 23%, so kudos to Warren on 17%. (Remember he's reducing his tax bill via his philanthropy, and most of his "income" is unrealized capital gains anyway)

US corporate taxes are high, the seemingly low effective rates are an illusion.  One of the reasons that US corporate effective tax rates appear so low is that US corporations keep much of their overseas income stranded there, running it through Ireland and the Caribbean.  Favored industries, like oil and gas, drive down effective rates with deductions and credits.  If US corporations were all forced to recognize their foreign income on their US returns, you'd see a spike in effective rates.

Yes, deductions reduce effective rates, but marginal rates ARE important... investment decisions, especially by small business where most job creation occurs, is made based on marginal rates. (And not every industry gets free handouts from Uncle Sam like the oil industry)

Yes, scrap the tax code!  You're correct that the cost of compliance imposes a huge burden on our economy.  Though, don't tell me that tax compliance in Germany, France, Greece, or say, Argentina is a breeze.  We could easily construct a vastly more simple tax system that generates the same or more revenue at lower marginal rates, with a fraction of the compliance costs.

Mon, 12/06/2010 - 13:02 | 782322 cdskiller
cdskiller's picture

I completely agree, with one sticky little problem: what are the rates? Until we agree on that, the plan is unworkable and won't change a thing about the wealth gap that has exploded in the last 30 years. That problem is exponentially more important than simplifying the tax code.

Here's my suggestion-

Income                           Tax Rate

over $500,000                     90%

$250,000 to  $500,000         65%

$100,000 to $250,000          50%

$75,000 to $100,000            28%

$50,000 to $75,000              23%

below $50,000                     0%

Mon, 12/06/2010 - 13:24 | 782449 flacorps
flacorps's picture

Why shouldn't taxes be regressive rather than progressive, as you've shown. Can you think of any good or service where you are forced to buy more of it as you make more money? Do you have to buy and store cartons of toothpaste? Cover the wall of an arena-sized mansion with flat-screen TVs? Get a haircut and a manicure every day?

Isn't government in the business of providing you with goods (roads, schools, etc.) and services (security and dispute resolution)?

Shouldn't there be a point where we tell people we won't be taking any more? Otherwise, government sounds more like a mafia we answer to than a servant that answers to us.

Mon, 12/06/2010 - 13:18 | 782388 Quantum Nucleonics
Quantum Nucleonics's picture

LOL, you may want to acquaint yourself with the concept of elasticity of taxable income, and redo your chart to something that won't collapse the tax base and economy.

Mon, 12/06/2010 - 12:00 | 782066 whisperin
whisperin's picture

MHFT, you're missing the point of your argument!! Follow the wisdom of the Constitution, to wit: "taxes shall be uniform". Why is this important? When 51% who pay little to no taxes decide that the other 49% are going to pay for them or their programs it's game over. If everyone pays the same flat rate with no deductions then each time someone proposes some "new" program they will understand that doing so will raise their taxes not just someone elses.

Mon, 12/06/2010 - 11:50 | 782027 chunkylover42
chunkylover42's picture

MHFT-

Agree with you on simplifying the tax code and removing deductions.  The current system is an orgy of special favors, breaks, and bribes.  You rightly point this out.  However, your tax rates are much too high to do that, and doing so without lowering the brackets (even if you want to keep 5 brackets and highly progressive) results in a major tax increase for everyone.  It's not clear what the full impact of that would be in terms of economic activity and tax revenues.

However, your point about "only the poor pay taxes in this country" is incorrect when it comes to income tax.  Roughly 50% of the population pays a negative effective rate through the use of EITC and other credits.  The poor are hit especially hard on things like sales tax, real estate tax, gas tax, and other regressive levies, but many do not pay income tax at all. 

Also the argument that "this is why Warren Buffett's tax rate is lower than his secretary's" is wrong as well.  Warren takes a modest salary, but most of his "income" comes from capital gains, which is at 15%.  However, capital gains taxes are levied on after-tax dollars, so they are taxed twice.  Even your own argument domestrates that it's mathematically impossible for a person in a higher marginal bracket to pay a lower effective rate than someone in a lower marginal bracket. 

Mon, 12/06/2010 - 13:20 | 782425 flacorps
flacorps's picture

The earned income tax credit does amount to a negative income tax, but it is also widely neglected. According to Wikipedia, Research by the Government Accountability Office (GAO) and Internal Revenue Service indicates that between 15% and 25% of households who are entitled to the EITC do not claim their credit, or between 3.5 million and 7 million households.

Capital gains taxes are not levied on after-tax dollars, they are levied however on dollars that have some exposure to inflation.

Corporate dividends ARE taxed "twice" (by no means double), however, the corporate recipient of dividends may take a "dividends received" deduction, reducing the amount owed so as to avoid the sting of so-called "triple taxation."

Mon, 12/06/2010 - 11:44 | 782005 MarkCaplan
MarkCaplan's picture

Would you grandfather families like the Duggars (20 kids and counting)? How are they going to get by without their 22 personal exemptions and child tax credits? It isn't fair to change the rules in the middle of the game.

Mon, 12/06/2010 - 11:36 | 781931 MachoMan
MachoMan's picture

The budget deficit would disappear overnight. Government spending would shrink dramatically, because you could ditch most of the 100,000 who work for the IRS. Some 1.3 million auditors and CPA’s would have to hit the road in search of new work too. The amount of money that is wasted on tax collection in this country is truly staggering. This is not some pie in the sky concept. This is how taxation already works in most countries, and they seem to get along just fine.

In fact, the whole scheme might even pay for itself.

Rule #1 of fund accounting, spend everything this year or else you might not get as much next year.

Rule #2, if you find yourself having trouble meeting your spending goals or you just want to make your job easier and not have to find as many new ways to piss away money, then increase your fixed costs and infrastructure, thus holding a gun to your benefactors' heads.

Rule #3, once #2 has been successfully enacted, you'll need additional funding each year to pay for variable costs and pay increases, thus, you'll need to run in the red each year, as far as you can reasonably get away with.

Rule #4, hide your transgressions and if you cannot hide them, attempt to confuse the affected parties.

Needless to say, you've missed the damn boat if you think this will dramatically decrease government spending.  All you can say is that it would dramatically decrease government spending on tax preparation/enforcement...  the money would promptly be funnelled into another department.

Mon, 12/06/2010 - 11:01 | 781874 snowball777
snowball777's picture

Nuke the abomination of a tax code from space and replace it with this simple progressive tax rate formula:

rate = ln(income) * 5

income will include hedge compensation and cap gains. that is all.

Mon, 12/06/2010 - 10:45 | 781846 Nels
Nels's picture

So, after talking about how the super rich cut their taxes below the 35% max rate (tax-free munis? carried interest? capital gains?), you comes up with the idea to hammer the lower to middle income levels by cutting personal exemptions and medical deductions.

Home mortgage deductions are also a much higher percent of the middle/lower income deductions.  They probably should be removed, as their primary benefit is to more to create a huge market for loans for the banks, rather than any real benefit to the homeowner.  But doing so all at once would really hammer folks, some with a rise in tax paid, others with a fall in home equity.

The mention of corporations having no taxes usually means they show no income, or all income is shown to be in foreign lands.  How is that supposed inequity going to get fixed by eliminating deductions on medical and mortgage expense?

If you like a progressive tax, taxing folks differently based on their situation, why are a few deductions (taxing folks less based on their situation) sticking in your craw?  And why not go after the things the rich use to lower their taxes, rather than those things that are the primary things used by the less than rich?

Mon, 12/06/2010 - 10:46 | 781839 ALPO
ALPO's picture

What I would like to see this country pass is a prohibition on income tax, a prohibition on sales tax, a prohibition on property tax, and replace them all with a single flat tax.

To be clear;  a flat tax is *not* a flat-rate tax.  A flat tax is a fixed number of dollars per person, also known as a per-capita tax.

This is the only possible fair system of taxation I can conceive of.  One where each adult pays an equal share of the burden of having a government.

 

 

Wed, 12/08/2010 - 01:22 | 788124 MurderNeverWasLove
MurderNeverWasLove's picture

Per-capita smacks of eugenics.  Just saying.

user fee, should be flat.  every tax gone.  every USD transaction has initiation fee of .49%

No reporting.  private.  anonymous.  consent-based.

 

Mon, 12/06/2010 - 10:39 | 781818 jakeman
jakeman's picture

Am I the only one who is suspicious of any comment Buffett makes on the tax code, given his investments in H&R Block (which profits enormously from complexity)?

Mon, 12/06/2010 - 10:44 | 781841 Bicycle Repairman
Bicycle Repairman's picture

I am suspicious of anything that is attributed to Buffett by anyone.

Mon, 12/06/2010 - 10:34 | 781799 Bicycle Repairman
Bicycle Repairman's picture

Is the tax code a revenue producing mechanism or a control mechanism?

Wed, 12/08/2010 - 00:45 | 788081 MurderNeverWasLove
MurderNeverWasLove's picture

Yes.

Mon, 12/06/2010 - 10:31 | 781791 cheapy
cheapy's picture

That proposal would be hopelessly dead on arrival because without a standard deduction, and leaving the same rates, you will dramatically raise taxes on the working poor.  

 

I think the BEST answer is to eliminate income taxes entirely, and replace them completely with a non-regressive alternative consumption based tax like the Fair Tax.

 

The 2nd best would be a tax structure similar to what you proposed, but leaving a per person exemptions to keep it from getting too regressive, and outlawing all other credits, deductions and excemptions.

Mon, 12/06/2010 - 10:40 | 781824 Bicycle Repairman
Bicycle Repairman's picture

Having already paid income tax while accumulating some of my savings, I object to being taxed twice through "a non-regressive alternative consumption based tax like the Fair Tax".  Moreover I object to you labeling it a "Fair Tax".  The label is disingenuous on at least a couple of levels.

Mon, 12/06/2010 - 11:50 | 782026 cheapy
cheapy's picture

Yes, I agree it has that side effect, but at the same time, to continue this disaster of budget and trade deficits, encouraging borrowing, waste, and imports, and discouraging savings, investment and work, is the height of idiocrasy, regardless of whether we each need to suffer a bit to turn things around.

 

Otherwise, all those dollars you and I have saved will become worthless.

Mon, 12/06/2010 - 11:56 | 782047 MachoMan
MachoMan's picture

Just a word of advice...  and I'm not in any way prodding you to make a decision one way or the other...  but, if you're worried about those dollars becoming worthless, you might want to convert them into alternative means of wealth storage.  First to blink wins.

Mon, 12/06/2010 - 10:23 | 781767 LowProfile
LowProfile's picture

Finally... MHFT writes something that makes sense.

I have a very simple solution to the country’s budget deficit problem. Hit the reset button. Eliminate the Internal Revenue Code. Just set it on fire. Keep the existing progressive, hockey stick tax rates on income, but eliminate all deductions. And I mean everything; deductions for dependents, home mortgage interest, medical expenses, the works. There are no sacred cows. My revised Form 1040 would have only three lines on it:

Income
Tax Rate
Tax Due

The budget deficit would disappear overnight.

 

Love it.   Unfortunately

 

Government spending would shrink dramatically, because you could ditch most of the 100,000 who work for the IRS. Some 1.3 million auditors and CPA’s would have to hit the road in search of new work too.

That won't happen.

The amount of money that is wasted on tax collection in this country is truly staggering. This is not some pie in the sky concept. This is how taxation already works in most countries, and they seem to get along just fine.

And that is just one of several structural problems with the American empire that will insure it's demise.

Mon, 12/06/2010 - 10:11 | 781739 Mark Medinnus
Mark Medinnus's picture

Wabbit season.

Mon, 12/06/2010 - 10:09 | 781732 cbaba
cbaba's picture

Sir,

With all my due respect, you must be Dreaming.

This is America, the rich steels and the poor pays it all.

In order to do that there must be  revolution in this country. We are not there yet. It may take 10-20 yrs.

First the dollar should crash, then  the Fed should be abolished. then we can hope for this change.

 

Mon, 12/06/2010 - 10:28 | 781776 Prejudice in Fa...
Prejudice in Fancy Dress's picture

You must be the dreamer if you think rasing taxes won't destroy jobs... I'm against the fed too but i don't think you have understanding of what the dollar represents... medium for trade, a crash would only hinder trade which creates weath

Mon, 12/06/2010 - 10:59 | 781871 ella
ella's picture

So where are the jobs?  Oh, there they are off shore where the Bush tax code induces employment with lower taxes.  Bush 43rd had one of the worse job creations on record in spite of his tax cuts.  Funny how that worked out almost as if they planned to destroy American jobs with off shoring.  Eliminate all of the Bush 43rd tax cuts! 

Mon, 12/06/2010 - 11:54 | 782042 MachoMan
MachoMan's picture

So additional taxes on the only people capable of bringing the jobs back is your solution to offshoring?  It's called a race to the bottom in tax structures...  a race we can nary afford given our debt.  This is what's called a recipe for default.

Also, as stated above, correlation is not causation...  aside from, jobs were running away prior to bush, and the revisionist history your comment presumes.

Mon, 12/06/2010 - 10:07 | 781722 Prejudice in Fa...
Prejudice in Fancy Dress's picture

Tax the weathly and most productive people and give it to an unproducive, inefficient and broke government!  Be careful who you want to screw with taxes or you'll lose your job producers...

Mon, 12/06/2010 - 10:53 | 781854 ella
ella's picture

One of the most productive eras in this country was in the 50's when the tax rates on the uber elites were the highest. Yeah, sure they are the most productive.  And the middle class, the creators of demand are what???  Supply side is a dismal failure.

Mon, 12/06/2010 - 11:11 | 781896 MachoMan
MachoMan's picture

repeat after me, correlation is not causation

Mon, 12/06/2010 - 10:03 | 781708 Rogerwilco
Rogerwilco's picture

Of course "wealthy" people are stationary targets. They will submit willingly to any and all violations from the IRS, maybe even beg for more. Perhaps we can even station IRS employees in their homes and businesses on a permanent basis, like members of their extended family.

Tell the truth MHFT, Leo wrote this column for you, didn't he?

Mon, 12/06/2010 - 09:46 | 781683 MurderNeverWasLove
MurderNeverWasLove's picture

To hell with tax returns.  0.49% fee every time money moves.  Until debt paid.  Then .1%.  No IRS.  No reporting.  No exemptions.  No exceptions.  A funding mechanism that is constitutional, for a change.  All the other taxes have to go.

.49% * $4Q = $20T = debt go bye-bye = goldback me.

Mon, 12/06/2010 - 12:33 | 782182 Astute Investor
Mon, 12/13/2010 - 16:10 | 802402 Mentaliusanything
Mentaliusanything's picture

It would end HFT in a day. 

it would remove the curtain

one must obfuscate to steal from the punters

 - it will never be allowed

Mon, 12/06/2010 - 09:25 | 781657 harveywalbinger
harveywalbinger's picture

Damon Vrabel explains the US caste system. 

http://www.csper.org/intro-video.html

No chance for tax reform the way I see it. Our owners have us exactly where they want us.

Mon, 12/06/2010 - 09:19 | 781649 nontaxpayer
nontaxpayer's picture

"This is not some pie in the sky concept. This is how taxation already works in most countries, and they seem to get along just fine. "

Name a few.

Mon, 12/06/2010 - 09:44 | 781639 Mercury
Mercury's picture

What the top 400 earners pay in taxes isn't nearly as important as what earners 401- 4,000,000 pay.  And if you fire 100,000 IRS employees, even at $100k each that's only $10B in a $3.5T budget.  That's not "dramatic" thats Peanuts.

Besides, I'm not sure I want to solve the deficit by ferreting out more tax revenue. If it comes down to letting the government go broke or paupering myself to prevent that guess which outcome I'm pushing for?

Obama is way ahead of you anyway. He has a revised 1040 in mind too and it  consists of only two lines:

1. What did you earn last year?

2. Mail it in!

Mon, 12/06/2010 - 09:10 | 781628 tom
tom's picture

Sounds like you don't know what you're comparing. Federal income tax rates are a small part of the tax picture. You need to compare total taxes (federal or national plus all kinds of local). If you're an employer comparing the US to a country with socialized medicine, you need to factor in US health insurance costs. The US comes out neither worst nor best among developed countries. It is overall a very expensive place to manufacture for export, in part because the low taxes relative to public spending are covered largely by foreign borrowing, which inflates the value of the dollar and thus defeats the advantage.

Mon, 12/06/2010 - 08:47 | 781607 primefool
primefool's picture

The parasites - the 50% of the population that take more than they give to the public coffers and the political class that is fully bought and paid for - these parasites are not smart parasites . Smart parasites dont kill off the host organism.

Mon, 12/06/2010 - 10:57 | 781867 snowball777
snowball777's picture

And the people using those 50% for financial gain, as long as we're talking about smart parasites.

Mon, 12/06/2010 - 10:48 | 781849 ella
ella's picture

You of course would be referring to those who live in the red states and receive far more in federal dollars than they pay in.  Not to mention Alaska where the state has a huge surplus but still receives mucho federal tax $.   And of course all of those wealthy elites who get bailed out by the FED and the Treasury, have huge tax advantages and still whine. 

Mon, 12/06/2010 - 09:50 | 781689 mark mchugh
mark mchugh's picture

What you said!!!!

 

(all of it)

Mon, 12/06/2010 - 08:44 | 781604 primefool
primefool's picture

I would bet that changing the tax code in this manner would have the single biggest impact on actual real economic growth than any other single policy change. So - why do I think it will never happen? Because I think the top is now too corrupt to care.

Mon, 12/06/2010 - 11:09 | 781890 MachoMan
MachoMan's picture

Depends on how the US ends up faring, relatively speaking, on the tax scale.  As the author noted, he moved his corporation to the united states to take advantage of our ridiculous tax system...  if this were to end, what would he do with his corporation?  What would others do?

Further, if you were to do away with all those hard lobbied happy endings, what does that do, psychologically speaking, to the elite?  In other words, would someone who has traditionally been able to buy his way into prosperity and barriers to entry be more or less likely to bail for greener pastures?

The biggest problem with tax schemes is that we have to be cognisant of our neighbors, who may be a better attraction for productivity...  In short, the actual real economic growth from the author's suggestion might just be negative...

Mon, 12/06/2010 - 12:08 | 782093 TDoS
TDoS's picture

Boo hoo, they don't like it, they can get the hell out.  

Mon, 12/06/2010 - 12:29 | 782156 MachoMan
MachoMan's picture

In other words, the solution to offshoring is to get the last of our productive to offshore themselves.  Got it. 

Fri, 12/17/2010 - 15:02 | 813550 TDoS
TDoS's picture

You and I define "productive" differently.  If the destroyers of the landbase want to go "offshore" themselves, my only hope is that they forget their boat.

Fri, 12/17/2010 - 18:00 | 814041 MachoMan
MachoMan's picture

The people you're talking about are multinational players...  for all intents and purposes, they're already offshored.  They only stick around because our fatass carcasses still have some meat on them.

The proposed changes by the author affect not only the multinational/world players who use the united states as a neat sandbox, but also the 2% to 19% ers that produce a shit ton.  Reducing dependent deductions, mortgage deductions, etc., affects strata lower than the multinational players...  In the end, all it takes is desire to move, not money.  And the desire may simply be created by a complete lack of consistency among regulations (constant change)...

 

Mon, 12/06/2010 - 12:56 | 782286 FDR
FDR's picture

Offshoring only really took off about 20 years ago (as did our current accounts deficit.)  And yet income tax rates on top earners are the lowest since the 1930's and have tended that way for the last 30 years.  The period of highest income tax rates was the middle part of the 20th century (30's-70's), during which there was - guess what - almost no outsourcing, low trade and fiscal deficits, and the highest real growth rates ever achieved by man. 

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