Thoughts on taxes II

In my first Thoughts on taxes post, I listed reasons why I prefer a simple and broad tax system.

In this post, I will elaborate on the first reason I listed for preferring a simple tax code:

  •  No matter the complexity of the income tax system, government collects about the same percent of the overall economy’s income (GDP) in taxes.

Since World War II, our country has had a fairly wide variation in complexity and rates in its income tax code. Yet, the chart on this page shows individual income taxes collections have stayed in a relatively narrow range between 8% and 10% of GDP.

Politicians often say they want to raise tax rates to increase tax collections. This chart suggests that rates — at least for the various tax codes since about 1950 — don’t have significant effects on government’s take of the economy as a percent of GDP.

So, making moderate changes to get more (or less) revenue doesn’t seem to work.

This doesn’t seem to be widely known and is rarely brought up when discussing tax rate proposals.

It also doesn’t seem intuitive. It’s fair to ask, how could it be that tax rate changes don’t seem to have much effect on the total percent of income collected in taxes?

Great question. I’m not sure I know the full answer, but a key part of it is that the complexity of the tax code itself.

Different types and amounts of income are taxed at different rates and we all have choices that allow us at least some flexibility on how much taxes we pay. We’ll tend to favor the types and amount of income that we feel are a good deal on an after-tax basis.

If the tax rate for dividend income, for example, is lower than the tax rate on capital gains (both are investment income) — then it’s worth our while to favor dividends over capital gains. Investment advisers will encourage us to switch investment strategies to invest in companies that pay dividends to help us minimize our tax bill. Management teams will respond by distributing more money back to owners through dividends than share repurchases.

Consider the recent example where Great Britain raised the tax rate to 50% on those making more than a million pounds. The number of folks reporting more than a million pounds dropped in one year from 16,000 to 6,000 and taxes collected from this group declined from 13.4 billion to 6.5 billion pounds.

The article states:

It is thought that many of the highest earners moved abroad or reduced their taxable incomes to avoid paying the new levy.

So, while the tax rate went up, the amount of income exposed to this tax rate when down meaning the weighted average tax rate in England probably didn’t change that much.

There are other decisions we can make that change our tax rates. How much you donate to charity, how big of a mortgage you decide to get, deciding not to sell a stock because you won’t make enough after taxes on the gain, how much you decide to save in tax deferred retirement accounts and how much you decide to contribute to your HSA or cafeteria plan are some of the more common decisions that have clear tax implications.

Raise tax rates on folks like Warren Buffett, a vocal tax increase advocate, and he’ll just donate more to charity to lower his tax rate.

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7 thoughts on “Thoughts on taxes II

  1. “Raise tax rates on folks like Warren Buffett, a vocal tax increase advocate, and he’ll just donate more to charity to lower his tax rate.”

    Wait, and this is bad???

    Wouldn’t it be great if we could encourage such a wealthy person to donate more to charity?? It sounds to me like an excellent outcome.

    • First, let’s clear up one misconception. It’s virtually certain that Mr. Buffett’s charitable donations do NOT lower his tax rate. They may lower his taxes, but not his tax rate. His charitable donations don’t save him anything. They simply allow him to look like a generous guy and allow him to have his favorite charity spend the dollars rather than the government.

      But let’s consider the dollars that Warren could donate to charity. Warren can either pick out a charitable organization to spend these dollars (even with a charitable organization, there is waste, fraud and inefficient/inappropriate use of money) or he can send them to Washington as taxes and let the politicians spend these same dollars or – if there was no income tax – he could choose how to best allocate these dollars.

      Based on their historical records of putting money to use for productive purposes, that is to say things that have benefitted us all, who would who rather have determine how Warren’s money is put to best use:

      Warren Buffett

      Charitable Organizations

      Politicians

      IMHO, the reason our tax system is so complex is because that complexity with its loopholes, exemptions, etc. allows politicians to collect more rent.

      • As to tax rate: I assume that what was meant (I didn’t say they lowered his tax rate) was that they lower his effective tax rate (as opposed to marginal rate or average nominal tax rate). Effective tax rate is just taxes paid divided by gross income, and so more deductions of any kind lower effective tax rate, since it lowers taxable income and so taxes paid, but leaves gross income unchanged.

        As to who should get Buffett’s money: I would prefer that he could choose among the groups, so that they have to compete for his money and hopefully this should lead to them using it more efficiently and effectively.

        Government spends so much on the rent-seeking you speak of which partly in order to avoid having to compete, and instead force people to give their money to them-. They also carve out loopholes, yes, but not mainly loopholes for charity, it is usually loopholes for corporations and for special interest projects for their buddies, that again do not help the poor and disadvantaged, who are also not the main beneficiaries of any ‘social programs’ that are amongst the rest of government spending. Government spends on military, many wasteful special-interest projects, some healthcare, mainly for the elderly, and retirement, and subsidies for corporations,

        I would rather Buffett could give his money to a proper charity, using charity navigator or some other pretty objective source to see how they spend their money, and make government compete for that money if they really need it….

        • Hi Liberty – I agree and I apologize for attributing Seth’s comment to you. I would caution you about charitable organizations, however, and encourage you to read “Unhealthy Charities” by DiLorenzo and Bennett. Here’s a paper by Bennett: http://www.whale.to/cancer/bennett.html. In my own experience, some of our large charities can be quite uncharitable (witness the long delays and small percentages of earmarked donations in payments made to 9/11 victims by the American Red Cross) and very deceptive in terms of their administrative costs. When I worked closely with the American Cancer Society, I was this first hand. During fund raising for their Relay for Life event, ACS officials told donors to make their donations payable to individual team captains rather than to the ACS. They were told that they could still claim a deduction on their tax returns even though they knew better (when I confronted them with this fact, they admitted that gifts made too individuals as opposed to the ACS really aren’t tax deducible). Their stated purpose for having donations made out to team captains was that the team captains would use some of this money for administrative costs of the event and then give the rest to the ACS. Thus, the administrative costs would not appear on the ACS books and their percentage of donations used for charity would appear higher. The other problem is that several people witnessed team captains pocketing cash donations – even those for which they handed out a “receipt”. As far as the Red Cross goes, their local directors are rewarded and retained primarily for their fund raising while their effectiveness in carrying out the stated charitable mission is a distant second.

          Now, let’s turn to “non-profit” hospitals, e.g. the Adventist Health system for example. Just like any other corporation, non-profits are run by people who get paid by the corporation. So, money gets paid to the corporation and then the corporation pays salaries and bonuses to corporate employees. The difference is in the taxes that get removed at the corporate level. For a regular C corp, this is very significant. For a “non-profit”, this is trivial. A better term for “non-profit” is “untaxed” (the tax rate is actually 1-2% versus approx 35%). Corporations ARE people. They are just people organized in a particular way for legal and tax purposes. Why should a group of Adventists be able to run a group of hospitals and avoid the business expense of a huge corporate tax while another group of people be forced to incur that expense? Neither the individual Adventists, who ultimately are able to take home higher salaries (because their business didn’t get hit with a big corporate tax), nor the non-Adventist individuals are non-profit people. The people ultimately getting the money are all “for profit” individuals. The CEO for the Adventist Health System receives approx. $2 MILLION in salary (plus other compensation). Does that sound like he’s non-profit?

          As far as hospitals are concerned, I’ve worked with religious “non profit” hospitals, county hospitals and “for profit” hospitals. I can’t say that any of them are more or less charitable with the care they write off than the others, i.e. the supposed reason for giving the non-profits a tax break – that they provide charitable (free or discounted) care to the needy – does not appear to be justified.

          The debate boils down to a tax code that allows politicians to gain more power by brokering agreements with industries and groups that pay rent in exchange for tax breaks versus a broad based (everyone has some skin in the game and is directly affected by any tax increase or decrease) tax code that aligns incentives with economic progress (rewards productivity instead of punishing it and punishes non-productivity instead of rewarding it) and removes political favors and rent seeking from the equation.

          Should charitable organizations get a tax break? Yep, we all should.

          Seth – It may be semantics, when one refers to “tax rate” as opposed to “effective tax rate” is that typically taken to refer to one’s tax bracket or what. Also, in the example we are discussing, for purposes of what Mr. Buffett has left at his disposal, what difference does it make whether Mr. Buffett’s taxable income is reduced because a business expense reduced his net business income or because he made a deductible charitable donation? Certainly, we get different numbers when we place total income versus taxable income in the denominator of “taxes paid/income” equation. My understanding is that, for individuals, effective tax rate means total taxes/taxable income.

          • Hi Mike — The point of the post is that ‘actual tax rates’ do not have much effect on the effective rate of taxes collected on whole as a % of GDP.

            I have no problem with people donating to charity. That was given as an example of how people make legal and non-nefarious adjustments in their life that end up keeping the overall effective tax rate for the economy in it’s narrow historical band of 8%-10%.

            The specific reason I gave donation to charity as an example is that I believe when most people think about ‘adjustments made to avoid taxes’ they think of exploiting loopholes and fraudulent and illegal activity. However, as liberty demonstrates, donating more to charity isn’t one of those. Most people would at least say that’s not a bad thing. However, it is one of the reasons why the total effective tax rate of GDP doesn’t vary much.

  2. Good comments. To be clear, here are the two points of my last sentence (and the post):

    1. People who think they can increase government revenue by increasing tax rates have underestimated the taxpayer’s ability to make adjustments in their life to counter the increase in rates. In this example, donations to charity — while not necessarily good or bad (could be bad if it’s bureaucratic foundation that is more focused on keeping its directors rich) — offsets the goal of raising taxes through higher tax rates.

    2. I also meant it is a jab to Buffett. He has been a vocal advocate of raising tax rates so that the wealthy will pay their fair share in taxes, yet he takes action to minimize his tax bill, which I find hypocritical.

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