Debunking Krugman (Again): On The Shift From Net To Gross Income Tax Basis

It seems anywhere one looks there days, one reads a refutation of Paul Krugman's tortured "economist" logic. Lately, the NYTer has fallen into the crosshairs of many due to his contention that currently taxes, based on some chart which the Nobelist probably mislabeled again, are at 20th century lows. Of course, cherrypicking data that fits the theory is precisely what economists do. Which is why Krugman may be excused for missing out on a trend so subversive that we have seen it only mentioned by tax attorneys at Weil Gotshal: namely the gradual transition in the definition of taxable income from a "net" to a "gross" tax basis. As Weil's Kimberly Blanchard explains: "Many observers — most prominently Paul Krugman — write in terms of tax rates being at an all-time low and compare today’s rates favorably with those that existed early in the 20th century. Their implication is that tax burdens are lower today and, therefore, there must be room for tax hikes. But we know that taxes are not lower today. How could they possibly be when government revenues are so much larger, even as adjusted for inflation? The increasing size of the national deficit cannot explain the gap, which was already in evidence during the Clinton years. The average individual taxpayer is frustrated and confused because she hears that tax rates are down but somehow she believes (correctly) that her taxes keep going up. What has occurred is that the base has expanded dramatically, leading to taxes far higher than those paid by individuals historically." Expect to hear much more of this in the next two years.

Kimberly Blanchard
Weil, Gotshal & Manges LLP

New York

The most significant change was a gradual one that took place incrementally and is proceeding apace: The shift in the definition of income for purposes of the income tax on individuals, from a net to a gross tax base. When I first began practice in 1981, the individual tax was still largely a tax on net income, with few exceptions. The only items of expense or loss that were not deductible, other than capital items, were truly personal items (that is, expenses that did not relate to the production of gross income). That is not the case today. This shift has included, in no particular order:

  • phaseout of the personal exemption and the cutback on itemized deductions (even more severely in New York state);
  • expansion of the alternative minimum tax, which functions as a disallowance of the deduction for state income taxes;
  • virtual elimination of the deductions for section 212 expenses and medical expenses;
  • the cap on the mortgage interest deduction;
  • numerous caps on tax-deferred retirement savings;
  • other rules limiting the use of losses, interest deductions, etc. (including the failure to index the $3,000 cap on capital losses of individuals);
  • removal of the cap on the 2.9 percent Medicare tax;
  • the repeal of the General Utilities doctrine and reinforcement of double taxation on corporate prof ts;
  • enactment of the passive loss rules, which for the first time put a class of income on a separate schedule to eliminate base stripping; and
  • enactment of the passive foreign investment company rules.

There are doubtless others that I have forgotten, but the trend is clear. Many of these changes — such as the last two — represented very sound tax policy. Others represented nothing more than a revenue grab. Whatever the motivation, the cumulative effect has been to build a fairly bulletproof tax on gross income.

The shift has been so incremental that virtually no tax policy academic or economist appears to realize what has happened. Many observers — most prominently Paul Krugman — write in terms of tax rates being at an all-time low and compare today’s rates favorably with those that existed early in the 20th century. Their implication is that tax burdens are lower today and, therefore, there must be room for tax hikes. But we know that taxes are not lower today. How could they possibly be when government revenues are so much larger, even as adjusted for inflation? The increasing size of the national deficit cannot explain the gap, which was already in evidence during the Clinton years. The average individual taxpayer is frustrated and confused because she hears that tax rates are down but somehow she believes (correctly) that her taxes keep going up. What has occurred is that the base has expanded dramatically, leading to taxes far higher than those paid by individuals historically. And we will see more of this. In modern tax policy parlance, any exception from a tax on gross income is labeled a subsidy or tax expenditure.

So we have the average taxpayer looking in one direction, and the average policy wonk looking in the opposite direction. The failure on both sides to honestly assess where we are, and how we got here, is creating the most tax-related public acrimony that I have witnessed since I started practicing.