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Happy California Tax Freedom Day

The Tax Foundation has determined that today is California's Tax Freedom Day:

Tax Freedom Day is the day when [California] as a whole has earned enough money to pay its total tax bill for the year. ...

The Foundation also offers these California tax facts:

• In 2013, California taxpayers worked until April 24th (6th latest nationally) to pay their total tax bill.
• California ranks 48th in the Tax Foundation's State Business Tax Climate Index.
• California's personal income tax system consists of ten brackets and a top rate of 13.3%. That rate ranks highest among states levying an individual income tax. 

Happy Federal Tax Freedom Day

The Tax Foundation has determined that today is the Federal Tax Freedom Day:

Tax Freedom Day is the day when the nation as a whole has earned enough money to pay its total tax bill for the year. ...

Tax Freedom Day is five days later than last year, due mainly to the fiscal cliff deal that raised federal taxes on individual income and payroll. Additionally, the Affordable Care Act’s investment tax and excise tax went into effect. Finally, despite these tax increases, the economy is expected to continue its slow recovery, boosting profits, incomes, and tax revenues.

Globalize tax reform

My friend and colleague Steven bank has posted a very interesting paper entitled The Globalization of Corporate Tax Reform:

With the growth of multinational corporations and its effect on corporate tax revenues, it is not surprising that international tax reform is a major part of President Obama’s Framework for Business Tax Reform as he begins his second term. Noticeably missing from this and other discussions of the major structural reform proposals, however, is any mention of the influence and importance of international corporate tax reform efforts. Although the concern over corporate tax evasion is especially pronounced in the U.S., the "decentering" of multinational corporations and corporate tax revenues is by no means an exclusively American problem. Around the world, nations are under direct and indirect pressure to reform their corporate tax laws. Both the OECD and the European Commission have recently released descriptions of projects designed to address corporate tax evasion and profits shifting. Not only will this have an effect on U.S. tax laws and on the tax burdens of U.S. multinational corporations regardless of whether the U.S. actually reform its own laws, but it will have an effect on the success of any corporate tax reform initiated in the U.S. This essay, written for a symposium entitled "Tax Advice for the Second Obama Administration," argues that unilateralism is problematic. Any attempt to reform corporate taxation inevitably has to be undertaken in light of the already-existing global effort in this area, rather than proceeding purely as a domestic legislative matter.

Warren Buffett: Tax Evader

Warren Buffett is always bitching and moaning that the rich don't pay enough taxes. Greg Mankiw points out the numerous ways in which Buffett is avoiding massive amounts of taxes:

1. His company Berkshire Hathaway never pays a dividend but instead retains all earnings.  So the return on this investment is entirely in the form of capital gains.  By not paying dividends, he saves his investors (including himself) from having to immediately pay income tax on this income.

2. Mr Buffett is a long-term investor, so he rarely sells and realizes a capital gain.  His unrealized capital gains are untaxed.

3. He is giving away much of his wealth to charity.  He gets a deduction at the full market value of the stock he donates, most of which is unrealized (and therefore untaxed) capital gains.

4. When he dies, his heirs will get a stepped-up basis.  The income tax will never collect any revenue from the substantial unrealized capital gains he has been accumulating.

You can make an economic case for # 1 and # 2. But, at a minimum, how about eliminating # 3 and 4 for people with estates worth > $1 billion.

"USA: a fiduciary duty to minimise tax?"

Robert Goddard of the UK-based Corporate Law and Governance blog notes that:

A hearing took place yesterday in the UK parliament at which individuals from Google, Starbucks and Amazon were questioned on corporation tax: see here. The focus was on the corporation tax paid by these organisations in the UK and the corporate structures adopted across Europe and internationally. The impression was given more than once that directors are subject to a legal duty to minimise costs including tax.

Is this so? The existence and scope of such a duty has been considered by the courts in Delaware this year. First, in Freedman v Adams (Del. Ch. Mar. 30, 2012, available here, pdf) and second in Seinfeld v. Slager (Del. Ch. June 29, 2012, available here, pdf). In the latter case Vice Chancellor Glasscock stated (pages 8 and 9, footnote citations removed):

This Court has concluded that 'there is no general fiduciary duty to minimize taxes.' There are a variety of reasons why a company may choose or not choose to take advantage of certain tax savings, and generally a company’s tax policy “typif[ies] an area of corporate decision-making best left to management’s business judgment, so long as it is exercised in an appropriate fashion.' I am not foreclosing the theoretical possibility that under certain circumstances overpayment of taxes might be the result of a breach of a fiduciary duty. I am simply noting that a decision to pursue or forgo tax savings is generally a business decision for the board of directors. Accordingly ... Delaware law is clear that there is no separate duty to minimize taxes, and a failure to do so is not automatically a waste of corporate assets."

FWIW, I posted a lengthy note on Seinfeld v. Slager a while back, in which I conclude that it was correctly decided.

Assessing Winkler's tweets re corporate taxes

Over on Twitter, my friend and UCLAW colleague Adam Winkler has been tweeting about corporate taxes:

In theory, the USA has "the second-highest statutory combined corporate tax rate – 39.2 percent – after Japan’s rate of 39.5 percent" among the OECD countries (link). In principle, this could make US firms less competitive than firms in key economic competitors.

In practice, however, the USA generally has been at or below the OECD average when one looks at corporate tax revenue as a percentage of GDP (link).

In addition, as Adam correctly notes, many US corporations don't pay corporate taxes in many years. Of course, those corporations' CFOs don't just wake up one morning and decide not to pay taxes. The actual tax rate paid by corporations depends not just on the nominal marginal rate table, but also on the deductions and credits Congress has put into the tax code. (So when liberals complain about corporations not paying taxes, they need to direct those complaints to Congress and the White House. The latter, after all, are the ones that wrote the tax code.)

Corporate tax pork has many disadvantages. It encourages firms to expend resources on rent seeking rather than productive economic activity. It favors established firms/industries, who typically pay lower tax rates than newer firms/industries with less political capital. As Cato wrote a while back:

...  targeted tax breaks are certainly bad policy. Because they provide special treatment for politically powerful industries, such tax breaks run counter to the notion that all taxpayers should be treated the same.

Furthermore, targeted tax breaks create distortions in the workings of the economy. Government steps in and creates an uneven playing field by granting tax breaks to particular industries. As a result, our economy's resources do not go toward their most efficient use, which makes it more difficult for America's businesses to be successful.

A plan that eliminates targeted tax deductions and credits, while simultaneously reducing marginal corporate tax rates so as to be revenue neutral, would thus be an ideal two-fer: It would create a domestic level playing field, while also making US corporations more competitive with global counterparts.

Unfortunately, as public choice theory makes clear, Congress "profits" by selling targeted legislation to powerful firms/industries. Congress simply has no incentive to adopt rational economic policies. And that's true whether the Democrats or the Republicans are in charge.

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.