ProfessorBainbridge.com

Tax Reform: Reduce the Corporate Income Tax Rate and More

My friend and UCLAW colleague Eric Zolt has posted a new paper on tax reform:

The U.S. corporate income tax rate is too high. In an increasing global economy, we are the odd man out. Any corporate rate reduction, however, will have ripple effects throughout the tax system, some intended and some not. This article highlights the possibility of using the potential reduction in corporate income tax rates as a catalyst for fundamental changes in the tax regime for business income and the relative contributions of tax revenue from different types of taxes.

Hopefully, somebody in Washington will take note.

Cite: Zolt, Eric M., Tax Reform: Reduce the Corporate Income Tax Rate and More (August 30, 2011). Tax Notes, p. 923, August 2011; UCLA School of Law, Law-Econ Research Paper No. 11-13. Available at SSRN: http://ssrn.com/abstract=1919683

Buffet's BofA buy explains a lot about his tax proposals

Jonathan Macey explains the logic of Warren Buffet's investment in Bank of America:

The lead news story across America on Friday was Warren Buffett’s $5-billion investment in Bank of America.... Buffett’s investment surprised many market watchers because Bank of America — like many other giant U.S. banks — is in no better shape now than during the financial crisis of 2007 and 2008....

Certainly the Obama administration wants to assert that Buffett’s investment means that giant financial institutions — like Bank of America and Citigroup — have finally turned the corner. This interpretation would bode well for the economy....

Unfortunately, while Buffett’s $5 billion likely was a savvy investment from the billionaire’s point of view, it doesn’t tell us much, if anything, about the financial health of the nation’s biggest banks. In fact, on closer analysis, what little it does tell us is discouraging.

Buffett’s investment likely signals not that he is confident that Bank of America is a good bet, but rather that he is confident that the government will again step in and bailout the bank if his bet turns out to be a bad one.

To understand why, it’s important to know that Berkshire Hathaway is not buying the regular, so-called “common” stock available to ordinary investors. Instead Bank of America is to issue Buffett 50,000 preferred shares, for which Berkshire Hathaway is paying $100,000 each.

Unlike the paltry returns available to most other investors these days, Bank of America is promising to pay Buffett’s investment a whopping annual dividend of 6 percent to be paid out quarterly. ...

This translates into Bank of American making cash dividend payments to Berkshire Hathaway of $300 million a year. And, of course, these payments come out of the pocket of the company’s lowly common stockholders.

Many of whose taxes Buffet recently called for raising, by the way. But back to Macey:

In addition, Bank of America has sweetened the pot by giving Berkshire Hathaway securities, called warrants, that give him the right to buy an additional 700 million shares of BofA over the next 10 years, for around $7.14 per share. When Buffett made this deal Bank of America’s shares were trading at around $8.15. This valuation translates into an immediate profit to Berkshire Hathaway of approximately $1 billion profit — assuming that Buffett exercised his warrants immediately....

His warrants give him a huge upside – because, if things go well for Bank of America, his right to buy stock at this low price will be worth many more billions than it already is.

Yet if things continue to go poorly, Buffett is sure that the U.S. taxpayer will again come to Bank of America’s rescue — providing a nice cushion for the billionaire on the downside.

And so we once again learn some valuable lessons about Saint Warren. The supposedly savvy stock picker these days often makes most of his money by cutting sweetheart deals that no other investor could get. He's also investing in firms that are too big to fail--like Goldman Sachs and GE, and now BofA--fully confident that "the government will do whatever it takes to prevent mega-firms like Bank of America from failing," which means he faces no downside.

From this perspective, it's not really surprising that Buffet favors higher taxes on the rich. He wants to make sure that the government has plenty of money available to bail him out if his big investments go south. Of course, as Tim Carney pointed out, that's not Buffet's only reason:

Buffett regularly lobbies for higher estate taxes. He also has repeatedly bought up family businesses forced to sell because the heirs’ death-tax bill exceeded the business’s liquid assets. He owns life insurance companies that rely on the death tax in order to sell their estate-planning businesses.

So the next time you hear Buffet complaining about how his taxes are too low, remember that (a) he's lying, at least in part, and (b) he's got personal financial interests in a high tax system.

 

Misleading class rhetoric on the payroll tax

Harold Meyerson is worked up about GOP reluctance to extend the payroll tax cut that was passed as a temporary stimulus measure last year, opining:

America’s presumably anti-tax party wants to raise your taxes. Come January, the Republicans plan to raise the taxes of anyone who earns $50,000 a year by $1,000, and anyone who makes $100,000 by $2,000.

Their tax hike doesn’t apply to income from investments. It doesn’t apply to any wage income in excess of $106,800 a year. It’s the payroll tax that they want to raise — to 6.2 percent from 4.2 percent of your paycheck, a level established for one year in December’s budget deal at Democrats’ insistence. Unlike the capital gains tax, or the low tax rates for the rich included in the Bush tax cuts, or the carried interest tax for hedge fund operators (which is just 15 percent), the payroll tax chiefly hits the middle class and the working poor.

What Meyerson would like you to think is that the payroll tax only hits people who earn less than about $100K per year. In fact, even a Hollywood limousine liberal studio executive who makes a million dollars a year pays the payroll tax. It applies to up to the first $106,800 of wage income for all taxpayers. So everybody takes a hit.

As for the merits of extending the payroll tax cut, at a time of massive deficits in which the tax base is steadily shrinking to encompass fewer and fewer citizens, everybody needs to help pull the wagon. Plus, look around, we aren't getting very much stimulus out of the cut are we? Maybe it's time to put all this stimulus crap on the shelf.

Golub responds to Buffet

Henry Golub's response to Warren Buffet's call for higher taxes on the "rich" deserves to be read in full. So please go do so.

The problem with soak the rich solutions to the deficit

Proposals to close the deficit by taxing the rich are unlikely to prove effective even if they manage to squeeze past the DC GOP. Why? Because it results in a narrow tax base whose taxable income tends to be highly volatile.

Barbara Hollingsworth, for example, notes that:

Newsalert has posted a chart from a Wall Street Journal blog titled “Recession and the Rich.” The chart, based on 2009 IRS figures, shows that the number of taxpayers reporting annual income over $1 million fell 39 percent between 2007 and 2009; the number of super-wealthy individuals making over $10 million annually plunged 55 percent.

The carnage wasn’t confined to millionaires. The number of taxpayers earning over $200,000 per year also decreased by 612,000 – or 13 percent. ...The chart also shows how the loss of these top income earners adversely affected the federal government’s bottom line.

In 2007, those making above $200,000 (but less than $1 million) paid $610 billion in federal income taxes. In 2009, it was only $434 billion – leading to a 29 percent decrease in government revenue.

In other words, the more dependent the government becomes on income and capital gains taxes on the rich, the greater the volatility in government income.

State governments--including those in my home state of California--are now once again rediscovering this basic proposition:

The volatile stock market highlighted a growing problem for budget planners. In recent decades, states from California to New York have become increasingly reliant on taxes generated from their residents' investment income. Now, they have found themselves more vulnerable than ever to the market's gyrations—with serious consequences for state-funded schools, courthouses and other institutions. ...

California is among the states most dependent on the wealthy and their investments, along with such states as New York, New Jersey, Connecticut and Massachusetts, according to the Rockefeller Institute.

In California, the top fifth of taxpayers accounted for 89% of personal state income tax revenue in 2007, up from 81% in 1993, as wealthy Californians profited from the dot-com and real-estate booms, according to state data. The contributions from all other income groups declined in that period.

Then came the recession, which sent the contribution of the top fifth of taxpayers slipping to 85% in 2009. That helped lead to a crippling budget crisis for the state, which resorted to IOUs to pay its bills that year.

As the state's economy continued to suffer, state forecasters were puzzled this May when they saw that income-tax collections for 2010 had come in much higher than economic data had led them to predict.

That bolstered their confidence that a recovery was under way. That belief, along with pressure to close an enormous budget gap without added taxes, persuaded Gov. Jerry Brown to boost his earlier revenue assumption by $8.4 billion by the time he signed the budget for the fiscal year starting July 1. That increase denotes the apples-to-apples rise after adjusting for other changes to the budget, said a finance-department official.

A key source of the hoped-for boost: a rise in wages and capital gains for wealthy Californians, according to the finance-department official. That means the market downturn of recent weeks will "tend to make additional revenue less likely," the official said, "but we don't know what's going to happen in the coming weeks and months."

The California Department of Finance will update its forecast in December. If it seems then that revenue will fall short of expectations, the budget calls for up to $2.5 billion in midyear cuts to schools, higher education, public safety and other areas depending on the size of the shortfall. That's on top of $15 billion in cuts and other spending-reduction maneuvers already approved this year.

The solution is to broaden the tax base, as Harvey Golub suggested in today's WSJ:

Today, top earners—the 250,000 people who earn $1 million or more—pay 20% of all income taxes, and the 3% who earn more than $200,000 pay almost half. Almost half of all filers pay no income taxes at all. Clearly they earn less and should pay less. But they should pay something and have a stake in our government spending their money too.

 

In addition, the extraordinarily complex tax code is replete with favors to various interest groups and industries, favors granted by politicians seeking to retain power. Mortgage interest deductions support the private housing industry at the expense of renters. Generous fringe benefits are not taxed at all, in order to support union and government workers at the expense of people who buy their own insurance with after-tax dollars. Gifts to charities are deductible but gifts to grandchildren are not. That's just a short list, and all of it is unfair.

Flatter (but still progressive) tax rates applicable to a much broader swath of the populace with many fewer special interest exemptions strikes this observer as a system that would be both fairer and much more stable in application. Proposals to move the tax system in the opposite direction will thus make the system less fair and more volatile, neither of which seems like a good idea.

The Biden's tax return and the case for tax simplification

Hank Adler:

The 2010 Federal income tax returns of the Vice President and his wife demonstrate a great deal about the Bidens. More importantly, the Biden tax returns demonstrate that today, a fairly uncomplicated personal financial situation requires an eighteen page federal tax return. This is crazy.

One key to a responsible tax system is to reduce complexity for most, yet leave significant complexity for those with the resources and knowledge to invest their assets in a manner that will result in reduced taxes (tax shelters). The Bidens’ return offers the opportunity to demonstrate how fairly straight-forward and simple changes to the Internal Revenue Code and the rate tables could reduce tax preparation complexity without creating tax planning opportunities.

He proceeds with examples.

So why are my scholarly book royalties reported on Schedule C?

Paul Caron links to a new tax case, Shpilrain v. Commissioner, T.C. Summ. Op. 2010-133 (Sept. 9, 2010), in which the "Tax Court on Thursday denied a CUNY tenured math professor's $15,397 deduction for expenses related to his research and writing activities (including $2,108 for a Sony Vaio notebook computer)."

The interesting passage in this opinion reads as follows:

Petitioner has, potentially, two trades or businesses. He is employed as a professor of mathematics, and he is engaged in research and writing on mathematical issues. He “wears two hats” but the “hats” are so similar in appearance that it is difficult to tell the difference between them. Because of this circumstance, it is particularly important that petitioner distinguish his research and writing activity from his activity as college professor as well as from his personal activities.
If a particular expense is related to his employment, it might be deductible as an employee business expense on Schedule A, Itemized Deductions. Petitioner would have to show, however, that the expense was not subject to reimbursement from his employer, CUNY. An expense is not deductible as ordinary and necessary to the extent that it was subject to reimbursement by the employer. Podems v. Commissioner, 24 T.C. 21, 22-23 (1955).
For an expense to be deductible as a trade or business expense on Schedule C petitioner must show that the expense is not a personal expense and that the expense is that of a trade or business other than that of his services as an employee.

Flip the issue around from expenses to income. As a professor at a research university, I am required to engage in scholarly research. The UCLA Call has several relevant provisions:

1. "Basic appointment normally must be at 100% of full time (subject to temporary reduction and to changes reflecting combined service in administrative and/or research capacities)." In other words, being a professor is a full time job.
   
2. Among the criteria for appointment, promotion, and periodic merit salary raises is a requirement that the candidate engage in "research and other creative work."
3. Another requirement is that of "high quality teaching."
4. Text books, treatises, and the like can count as either teaching or research: "Textbooks, reports, circulars, and similar publications normally are considered evidence of teaching ability or public service. However, contributions by faculty members to the professional literature or to the advancement of professional practice or professional education including contributions to the advancement of equitable access and diversity in education, should be judged as creative work when they present new ideas or original scholarly research"

Here's the question: Since writing treatises and case books thus is part of my "services as an employee," why does my tax preparer insist on reporting the royalties from those items on Schedule C? I would argue that I can't distinguish my "research and writing activity from [my] activity as college professor." Ergo, it's not a separate trade, and I shouldn't have to report the royalties on Schedule C.

The IRS wants to get us academic types coming and going. They want us to report our writing royalties on C but deny us deductions in connection therewith. Unfair and uncool.

The Estate Tax

I see that President Obama wants to bring back the estate tax. The GOP wants to make repeal permanent. I'm more or less in the middle.

The politics and economics of taxing death are very subtle, as Bruce Bartlett once explained:

A man-bites-dog story occurred on February 18, when a group of rich people signed an ad in the New York Times opposing elimination of the estate tax. Since the estate tax only affects those with net assets greater than $675,000, it is per se a tax only on the "rich." Thus, when those upon whom the tax is levied protest its abolition, it is news. But in reality, it is not at all surprising that some rich people support the estate tax, because they benefit from it in many ways.

Tax Law is Crazy

The Tax Court has decided in O’Donnabhain v. Commissioner that a MTF transsexual can deduct her hormone therapy and sex reassignment surgery as a medical expense, but cannot deduct her breast augmentation surgery. (HT: Tony Infanti) That's slicing the baloney pretty thin. So to speak.

Update: Paul Caron breaks down the legal logic, but leaves me still thinking that our tax laws are way too complicated if we're making this fine of a distinction. It's no wonder that even the IRS Commissioner can't do his own taxes.

Tax Semantics

The AP press report on Obama's budget is headlined "Obama Budget Would Impose Host of Tax Increases" When we drill down deeper into the story, however, we learn that the bulk of the "increase" comes from allowing the Bush tax cuts to expire as the original adopting legislation provided.

So is allowing a temporary tax cut to expire fairly called a tax increase?

Either way, I'm against it, of course, but we are a stickler for semantic fairness here at PB.com (at least when the mood strikes us).

Obama tax relief for employees who use the boss' cell phone

Via Paul Caron, we learn that:

 President Barack Obama will urge Congress to repeal a law requiring workers to pay taxes when they use employer-provided cell phones and similar equipment for personal reasons, a Treasury Department official said.

The reprieve, to be included in Obama's budget outline Feb. 1, is a victory for companies such as Little Rock, Arkansas- based Alltel Corp., Dallas-based AT&T Inc., Overland Park, Kansas-based Sprint Nextel Corp., and New York-based Verizon Communications Inc., which have complained the 20-year-old requirement was outdated.

The budget proposal would end the need for employers to keep detailed records when company-owned cell phones, BlackBerrys or similar telecommunications equipment are used for both business reasons and the personal convenience of employees, the official said. Current law, which is rarely enforced, requires employees to pay income tax on the value of any personal use.

Highly commendable. My dear friend and UCLA law colleague/tax professor Bill Klein is always telling me that there are three criteria for a "good" tax law: fairness; simplicity; ease of administration. Current law would seem to violate at least the last latter two principles, since it's costly for businesses and employees to compute and difficult to enforce. Plus, it would seem to encourage evasion, which promotes a sort of scofflaw attitude that undermines the largely voluntary system of taxation. 

Credit where credit is due. Good move by Obama.

Oregon Voters Discover the Tipping Point

Deficit hawks and other fiscal conservatives worry about what The Economist called "a 'tax tipping-point,' when a majority of Americans pay little or no taxes and discover that they can vote themselves goodies paid for by others."

Oregon voters may just have reached that point. The Oregonian reports that:

Oregon voters bucked decades of anti-tax and anti-Salem sentiment Tuesday, raising taxes on corporations and the wealthy to prevent further erosion of public schools and other state services. The tax measures passed easily, with late returns showing a 54 percent to 46 percent ratio. Measure 66 raises taxes on households with taxable income above $250,000, and Measure 67 sets higher minimum taxes on corporations and increases the tax rate on upper-level profits.

Indeed, proponents of the tax hikes specifically played on the tipping point phenomenon by suggesting that ordinary Oregonians would be unaffected, a message that appears to have resonated with the masses:

Tuesday's strong support also validated a strategy by Democratic lawmakers to single out the rich and corporations for targeted tax increases. Campaign ads by supporters highlighted banks and credit card companies and showed images of well-dressed people stepping off private jets. They also hammered on the $10 minimum tax that most corporations have paid since its inception in 1931.

Those messages helped counter warnings by opponents that the taxes would lead to job losses, worsening the state's 11 percent unemployment rate, and prompt wealthy residents to move elsewhere.

Liberal Mother Jones blogger Kevin Drum blithely dismisses those warnings:

I await the immediate immolation of Oregon's economy. That's what happened to America after Clinton raised taxes on the rich, after all.

Kevin is being far too glib, of course. The costs of exiting a nation are far higher than the costs of exiting a state. In his classic work, Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States, economist Albert O. Hirschman wrote that:

Even after the closing of the frontier, the very vastness of the country combined with easy transportation make it far more possible for Americans than for most other people to think about solving their problems through "physical flight" than either through resignation or through ameliorating and fighting in situ the particular conditions into which one has been "thrown."

In contrast, Hirschman observes that at the national level:

... the United States long been the "country of last resort." To most of its citizens — with the important exception of those whose forefathers came as slaves — exit from the country has long been peculiarly unthinkable.

The possibility of exit at the state level was a reality for California in the 1990s, when it saw a net outward migration, with many of those departing going to states -- such as Nevada -- perceived as having a friendly economic climate:

Many of the inmigrants to Nevada, Arizona and other fast-growing states were came California, which had a net outmigration of 755,000 people to other states between 1995 and 2000 second only to New York, which had a net outmigration of 874,000.

Indeed, even today, Nevada still recruits California residents and business on grounds that, as one Nevada law firm puts it:

Nevada’s employment laws are generally more favorable to employers than California’s. By moving their operations to the Silver State companies may be able to realize monetary savings and other benefits.

To be clear, I am not predicting the "immediate immolation of Oregon's economy." I am simply saying that (a) Kevin's analogy is inapt and (b) we may be about to witness a great social experiment testing the consequences that follow when voters who "pay little or no taxes ... discover that they can vote themselves goodies paid for by others."

Update: Apropos my disagreement with kevin, Megan McArdle observes that:

• The fact that Clinton raised taxes, and then the economy recovered, is not proof that raising taxes has no effect on the economy. Most people thing that there is at least some dampening effect, which is especially problematic in a downturn.
• Realistically, income tax response gets more elastic as the tax region gets smaller. Oregon borders two states with attractive migration possibilities. California's taxes are no bargain--but Oregon's relatively lower tax rates may have attracted wealthy individuals and businesses that will now find it not so attractive....
• Trying to close the gap with only taxes on high income makes state revenues very dependent on a very small group of people. Ask New York and California how that's going.

But Megan goes on to note that:

• The Tax Foundation says that pre-tax, [Oregon] was on the top ten list for business tax climate. That suggests that it has relatively more room to increase taxes than other states.

Update: Geoffrey Manne rants:

Oregonians, my fellow residents of the Beaver State (and, by the way, the only state in the Union with a different image on each side of its flag), voted yesterday to increase top marginal income tax rates and corporate tax rates, including minimum corporate tax rates and the addition of a tax on gross receipts.  I’m still waiting for Paul Krugman to decry the anti-stimulus measure, but I doubt it will happen (he’s a partisan hack, you know).  But there is a “bright” side: Capital (human and otherwise) flight from Oregon to its neighbors (including income-tax-free Washington to the North and foundering behemoth California to the South) will help those states with their economic troubles!  <sarcasm>And fewer people and less economic activity in Oregon will be good for spotted owl habitat, after all</sarcasm>.  I just hope the local beer industry survives.  I don’t know what I’d do without the ability to drown my sorrows in a few bottles of Terminal Gravity IPA.