Pragmatism and Tax PolicyAugust 31, 2008
Is it just me, or does every article you read about income taxes seem to quote a handful of iron-clad statistics that refute a different article you just read quoting iron-clad statistics proving the opposite point? Republicans tell us that lowering income taxes has raised everyone’s economic boat since the days of President Reagan. Democrats tell us that no, all that really occurred was that the rich got richer and the poor got poorer. Economists and prominent academicians seem to be equally divided as to whether higher taxes are good or bad for the country. And, from the rhetoric we are hearing in the Campaign of 2008, I can’t figure out if I’m one of the people Barack Obama thinks is not paying his fair share or someone John McCain believes needs empowerment. However, as a tax advisor to the wealthy (these days, I assume that includes all of us who do not receive “refundable credits”, “stimulus checks”, or special representation in Congress) for over 15 years and a taxpayer for many more (taxpayer by definition being someone who actually pays income taxes — not to be confused with those who1 would, but for lack of an income be a taxpayer, or2 only file an income tax return in order to collect the aforementioned “refundable credits”), I do feel qualified to make a few observations about human nature as I have witnessed it in regard to income tax policy. Without statistical crutches, and in the cold light of this pre-election, autumn day, I encourage you to review your thoughts on growth, productivity, human nature, and the income tax. Possibly a few of these observations will resonate with your own life experience.
Liberty Governance 101: People are Pragmatic
There is a reason Benjamin Franklin once said, “If you would persuade, you must appeal to interest rather than intellect.” Pragmatism. The practical realities and consequences of human nature. Understand where natural inclinations and interests are going to drive people first. Otherwise, the best laid plans, the most rational of discourses will be swept away like a small tree trying to redirect the Mississippi River. This is a formidable challenge for centrally planned economies (witness the spectacular economic black hole created by the Soviet Union), but is also the trickiest of tightropes for politicians in a democracy, but for a different reason. In tightly controlled regimes like the former Soviet Union or North Korea, the ruling elite have the power to beggar the whole country through bad policy decisions combined with the people’s lack of freedom to adjust. In free market systems, however, bad policy decisions result in massive shifts of people and capital in light of the new environment. The country suffers — but not fatally — when those who drive our economy (translate: entrepreneurs) often create the exact opposite result of what the policymakers intended. Too often, the consequences of faulty policy fall on the poorest in our society. These unintended consequences could often be avoided if policymakers took into account the pragmatic human behavior they exhibit themselves and see every day in the marketplace.
The Real Cost of Government
“The real cost of government is measured by what government spends, not by the receipts labeled taxes.” – Milton Friedman. Somehow in our public debate, the proper question has been reversed. Now we ask, “What is the right amount of taxes?” when we should be asking “What is the right amount of government?” America was founded on the concept of limited Federal government, and somehow we have moved to the point where politicians believe the government should tell us how much of our money we can keep. Tax cuts are labeled in terms of how much they “cost the government” as if somehow government created wealth. The incredible danger in this way of tax-first thinking is that it keeps the focus off of maximizing the efficiency and effectiveness of government. Without tighter financial constraints, there is no incentive to optimize spending. Bureaucrats and politicians are spending other people’s money. The results speak for themselves as you would be hard pressed to find examples of truly effective large government programs. Education funding is a simple example. Despite our valiant efforts to outspend every other developed nation, the students produced in our country continue to lag woefully when compared to their international peers. The answer, we are told, is of course more money. Those of us responsible for earning and spending our own money understand the very practical, common sense problem: ownership and accountability.
“Success Tax” Creates More Inequality
Much has been made about income disparity in the United States and the idea that the gap between the rich and poor has increased in recent years. Leaving aside obvious questions such as how the U.S. compares to other countries on income disparity as well as mobility between economic classes, populist politicians immediately raise the cry to “tax the rich and give to the poor.” In 2008, this concept of increasing the “Success Tax” makes little economic sense unless you are running for office. For starters, our tax system is already very progressive, with almost half of Americans paying no income taxes. Based on your own life experiences with money, consider what it means for a growing number of citizens to have no monetary investment in America. Not in some utopian sociological abstract, mind you, but pragmatically: how exactly do you respond differently in time, care, and attention to those things in which you have a financial investment? Further, this financial disconnect has a human relational dynamic as well. “Social cohesion falls apart. The majority who pay nothing resent those with higher incomes; the minority who pay heavily resent those who don’t pay.” - Geoff Colvin (Fortune 4/14/08)
This year, tax policy Robin Hoods have gained considerable traction in their redistribution efforts through clever naming of “refundable tax credits” to disguise what are essentially pure handouts. Originally created by Republicans, the refundable credit has reached a whole new level in the Democrat playbook this year. As Peter Ferrara, Director of Entitlement and Budget Policy for the Institute for Policy Innovation wrote: “Such Credits are not tax cuts. Indeed, they should be called The New Tax Welfare. In effect, Mr. Obama is proposing to create or expand a slew of government spending programs that are disguised as tax credits. The spending on these programs is then subtracted from the total tax burden, in order to make the claim that his tax plan is a net tax cut overall. When ‘tax credits’ primarily go to this group in the form of checks from the government (rather than a reduction in their tax burden) it is simply an abuse of the language to call the spending a tax cut.” Then, consider the economic effect as income redistribution takes capital from more productive users and gives it to less productive users. By definition, the economy suffers. And, in your experience, who suffers most in a bad economy?
While we are being practical (as opposed to political) it is also helpful to remember that, as Louis-Vincent Gave once wrote, “Income disparities are a tremendously creative force.” People come into the world with nothing, and the vast majority of us must begin working very early in life to satisfy needs and then wants. It is as though we are genetically programmed to seek reward for our labors. At a pragmatic level, therefore, income tax policy can align with human nature by encouraging education and opportunity, not class envy or handouts.
The Pragmatism Slope
There is the policy side of taxes and then there is the response. People do take action in response to tax changes. I have found that based on marginal tax rates as well as the overall perceived equity of the system, there are really two levels of taxpayer response at the ends of a continuum. Put simply, Avoidance and Evasion. At a minimum, taxpayers desire to pay the least amount possible; if the tax becomes too egregious, some will cross the line to illegal tax evasion. In between is a whole list of tactics and strategies that lower tax receipts for the government while its most productive citizens work to keep what they earn. I classify these as Official Tax Shelters, Un-official Tax Shelters and Illegal Tax Shelters along the Pragmatism Slope (see graphic below).
Although statistical research to prove the concept is unavailable, this Slope represents my theory of taxpayer behavior.
Official Tax Shelters include strategies such as increasing charitable contributions and deferred compensation plans, or municipal bonds (interestingly, Andrew Mellon, Treasury Secretary during the Great Depression, tried to decrease taxes while eliminating the exemption on muni bond interest in an effort to increase revenues — very pragmatic). Un-official Tax Shelters include tactics that shift income to other family members or entities, inflate business expenses, or lower economic activity (the story is told that Ronald Reagan turned down acting roles when he was in the 90% tax bracket because he was not yet ready to be a government employee). Finally, Illegal Tax Shelters include unreported income, “offshoring” money, and the promoted tax schemes that make the IRS top ten lists each year.
Whether a tax haven in Liechtenstein, a questionable expense deduction, or an exotic investment strategy — people will work to stay ahead of the taxman. And, they will pay professional tax advisors to assist them with the process. The Pragmatism Slope explains this progression as marginal rates increase and the rewards make the avoidance/evasion viable.
Especially when there is freedom of movement, most people act in their own interests most of the time. Understand their interests, and importantly, how to align their interests with the economic growth of the country, and you have a framework for solid policymaking. Further, keep in mind that the most productive and engaged members of our society also have the most flexibility to adapt (mentally and fiscally) to policy changes, both good and bad. It is therefore imperative that we consider their interests and economic drivers when developing tax policies that are fair, growth oriented, and safety net conscious. To do otherwise is to virtually guarantee unpleasant, unintended consequences. Finally, we should not be surprised when taxpayers (including politicians and those who fund them) work to minimize their tax bills.