Category Archives: Taxes

Liar-Left, Daft-Left Bellow: It’s the Unkindest Tax Cut of All

08 Friday Dec 2017

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A misapprehension of progressive leftists is that the tax reform bills under debate by the GOP will revoke something from the needy: the poor, cancer patients, the working class, the aged, you name it. Well, that is a misapprehension held by many earnest leftists, but it amounts to deceitful rhetoric from others. David Harsanyi, in an article about the Left’s penchant for corrupting the English language, attempts to set the record straight:

“Whenever the rare threat of a passable Republican bill emerges, we learn from Democrats that thousands, or perhaps millions, of lives are at stake. …

… the most obvious and ubiquitous of the Left’s contorted contentions about the tax bill deliberately muddles the concept of giving and the concept of not taking enough. This distortion is so embedded in contemporary rhetoric that I’m not sure most of the foot soldiers even think it’s odd to say anymore. …  Whatever you make of the separate tax bills the House and Senate have passed, though, the authors do not take one penny from anyone. In fact, no spending is being cut (unfortunately). Not one welfare program is being block-granted. Not one person is losing a subsidy. It’s just a wide-ranging tax cut without any concurrent spending cuts.“

The Left may have a basic math incompetency, or maybe they know better when they insist that the GOP plans will inflict a new burden on the middle class. The middle class actually receives larger reductions in taxes than higher strata. Veronique de Rugy highlighted this point recently:

“President Trump’s intention to give a real tax break to the middle class is counter-productive considering the middle class barely shoulders any of the income tax as it is. The top 10 percent of income earners—households making $133K [or more], not $1 million as most assume—currently pay more than 70 percent of all income tax revenue. The middle quintile pays, on average, 2.6 percent of the federal income tax.

And yet, in both the House and Senate plans the middle class receives the largest tax relief by reducing their marginal tax rates, increasing the child tax credit and doubling the standard deduction. The result is fewer taxpayers would be paying income tax at all, problematic from a small government perspective. It also means a more progressive income tax code than it already is.

The House plan also effectively jacks up the top marginal rate for some high earners by using a 39.6 percent bubble rate on the first $90K earned by single taxpayers making $1 million and married taxpayers making $1.2 million and a 12 percent rate like everyone else.“

I have listened to horror stories about school teachers who, in the past, were able to deduct supplies they purchased for their students. Now, the cruel GOP is trying to take that away! This argument neatly ignores the doubling of the standard deduction. Many teachers will find that it no longer makes sense to itemize deductions, and they will come out ahead. But for the sake of argument, suppose a teacher earning $50,000 itemizes and spends $2,500 on unreimbursed supplies for their students every year. At the Senate plan’s new rate in that bracket, the lost deduction will cost the teacher $550, but about $300 would be saved via rate reductions for every $10,000 of taxable income. The teacher is likely to come out ahead even if he unwisely passes on the improved standard deduction.

Liberal thought-whisperers have goaded their minions into believing that the GOP intends to cut Medicare funds by $25 billion a year going forward. The bills under discussion would do no such thing. However, in a rare gesture of fiscal responsibility, President Obama in 2010 signed the Statutory Pay-As-You-Go Act (Paygo), which may require automatic reductions in outlays when spending or tax changes lead to an increase in federal debt. The act has never been enforced, and Republican leadership in both houses insists that Paygo can and will be waived. Clearly, the GOP’s intent is not to allow the Paygo cuts to take place. Even the left-leaning Snopes.com is reasonably neutral on this point. But if Paygo takes hold, the lefties will have themselves to blame.

At the last link, Snopes also touches on one actual provision of the Senate tax plan, the repeal of the Obamacare individual mandate, or rather, the repeal of the “penalty tax” imposed by the IRS on uninsured individuals. The Supreme Court ruled that it is a tax in 2012, at the time giving rise to a mixture of delight and embarrassment on the Left. The ruling saved Obamacare, but the Left had been loath to call the penalty a tax. The supposed rub here is that repeal of the mandate will be greeted enthusiastically by many young and healthy individuals. Freed from coercion, many of them will elect to go without coverage, leading to a deterioration of the exchange risk pools and causing premiums paid by the remaining exchange buyers to rise. However, the critics conveniently ignore the fact that Obamacare individual subsidies will automatically ratchet upward with increases in the premium on the Silver Plan. So the panic related to this portion of the Senate tax bill is misplaced.

One other point about the mandate: because it coerces the payment of cross-subsidies by the young and healthy to higher-risk insurance buyers, the mandate distorts the pricing of risk, the incentives to insure, and the use of resources in the provision of health insurance and health care itself. This is how the proper function of a market is destroyed. And this is how resources are wasted. Good riddance to the mandate. The high-risk population should be subsidized directly, not through distorted pricing, at least until such time as a market for future insurability can be established. As Jeffrey Tucker has said, repeal of the mandate is a very good first step.

The loss of the medical expense deduction is not a done deal. While the House plan eliminates the deduction, the Senate plan reduces the minimum medical expense requirement from 10% to just 7.5% of qualified income, so it is more generous than under current law. I’ve seen bloggers commit basic misstatements of facts on this and other provisions, such as confusing this limit with a total limit on the amount of the medical deduction. This deduction tends to benefit higher-income individuals who itemize deductions, which will represent a higher threshold under the increased standard deduction. Of course, this deduction appeals to our sense of fairness, but like all the complexities in the tax code, it comes with costs: not only does it add to compliance costs and create a need for higher tax rates, but it subsidizes demand for medical care, much like the tax breaks available on employer-provided health care, and it therefore inflates health care costs for everyone. To the extent that these deductions and many others are still in play, the GOP plans fall short of real tax reform.

The GOP tax bills certainly have their shortcomings. I hope some of them are rectified in conference. The bills do not offer extensive simplification of the tax code, and they would not be truly historic: in real terms, an earlier version of the House bill would have been the fourth biggest cut in U.S. history relative to GDP, and I believe the version that passed the House is smaller. However, many of the arguments mounted by the Left against the bills are without merit and are often deceitful. The Left strongly identifies with the zero-sum philosophy inherent in collectivism, and the misleading arguments I’ve cited are plausible to the less-informed among that crowd. That brings me back to David Harsanyi’s point, discussed at the top of this post: “intellectuals” on the progressive Left find value in corrupting the meaning of words and phrases like “budget cuts”, “giving” and “taking”:

“Everyone tends to dramatize the consequences of policy for effect, of course, but a Democratic Party drifting towards Bernie-ism is far more likely to perceive cuts in taxation as limiting state control and thus an attack on all decency and morality.“

“There is a parallel explanation for the hysterics. With failure comes frustration, and frustration ratchets up the panic-stricken rhetoric. It’s no longer enough to hang nefarious personal motivations on your political opponents — although it certainly can’t hurt! — you have to corrupt language and ideas to imbue your ham-fisted arguments with some kind of basic plausibility.“

Weighing Tax Reform vs. Spending and Deficits

05 Tuesday Dec 2017

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The tax reform legislation likely to come out of the House and Senate reconciliation process will be far from ideal, but it will be much better than current tax law in several respects (see my last several posts listed in the left-hand margin). One complaint raised by Democrats and others, however, is that the GOP tax compromise will lead to higher budget deficits. Of course they are right, but Democrats fail as legitimate critics given their hypocrisy on the issue of deficit spending. And chronic deficits are ultimately a symptom of government excess. Deficits exist when the polity is unwilling to support the explicit taxes necessary to pay for the spending that politicians are willing and able to authorize.

Nevertheless, there is near-universal consensus that the tax plans passed by the House and Senate would add to the deficit if either were to become law, the biggest exception to that consensus being Republican leadership. The Joint Committee on Taxation (JCT) has estimated that the Senate plan would add $1.4 trillion to the deficit without the benefit of economic feedback. That shrinks to about $1 trillion with the dynamic feedback effect of resultant economic growth. Others believe the gap would be smaller, however. The Tax Foundation, for example, estimates the net cost in tax revenue at $500 billion. Veronique de Rugy quotes a dynamic score by Quantria/Inforum that would put the revenue loss at about $300 billion, based on the starting JCT static estimate. The Tax Foundation, as noted by de Rugy, believes the JCT errs in treating the U.S. economy as a closed economy in which business funding is limited to a fixed pool of domestic saving, and in assuming that the Federal Reserve would attempt to offset the economic growth spurred by the tax cuts. These JCT assumptions mute the economic and revenue responses to tax changes.

But whether you believe the JCT’s estimates or the others, the impact is relatively minor compared to the existing fiscal shortfalls brought on by government excess. Brian Riedl puts the proposed tax cuts in perspective. The 10-year deficit was already projected at $10 trillion, with little apparent concern from Democrats. Riedl notes that the opposition has repeatedly shown itself unwilling to address fiscal problems such as Obama’s deficit legislation, Bernie Sander’s $30 trillion health care plan, and a shortfall in Social Security and Medicare funding of $82 trillion over the next three decades:

“Critics who are unwilling to confront these mammoth spending deficits are in no position to lecture others on the deficit implications of a (comparatively modest) $2 trillion tax cut.“

Jeffrey Tucker, whose posts I usually enjoy, seems to assert that deficits are not worthy of great concern. He offers a negative and somewhat muddled assessment of Ricardian equivalence, the idea that deficit spending is neutral because the expectation of future taxes discourages private spending. Tucker’s position is rooted in impatience with the rhetoric of revenue neutrality, but I think his real point might not be too far from Reidl’s. To his credit, Tucker condemns “fiscal profligacy”. He says:

“To be sure, this is not a defense of fiscal irresponsibility. Debts and deficits are terrible. Fiscal conservatism is a good thing. The budget should always be balanced. But there is one proviso: none of this should happen at the expense of the wealth creators in society: you, me, and the business sector. Government should bear responsibility for its own profligacy.“

I will interpret that last remark generously to mean that Tucker would cut spending to shrink deficits, but he also advocates for the sale of federal assets, which I generally support.

Concern by some Republicans over the deficit effects of tax reform prompted a debate during the Senate negotiations over a so-called “trigger” that would have increased taxes automatically if revenue fell short of certain benchmarks. At the last link, Ryan Bourne explains what a bad idea that would have been. A future revenue shortfall could be attributed to any number of future developments, not all of which would be compatible with a tax hike as a fix. The trigger would also create uncertainty, dampening the positive revenue effects that would otherwise be operative. It’s a relief that the trigger idea was abandoned by the GOP.

Despite the corrosive effects of big government and excessive spending, there is a relatively painless solution to closing the fiscal gap, with or without GOP tax reform. (I use the word “painless” guardedly, because big government inflicts distortions and costs well beyond mere spending levels.) Dan Mitchell has updated his calculations showing that the annual deficit would be eliminated by a decline in the budgeted annual growth of spending from 5.49% to 2.67% over ten years, starting in 2019. That hardly seems draconian, but watch: progressives and even relatively reflective Democrats would call such growth reductions “heartless cuts”. Such is the intellectual integrity of the left.

Stumbling Through Pass-Through Tax Reform

22 Wednesday Nov 2017

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The GOP tax reform bill passed by the House of Representatives last week contains a reduced tax rate for “pass-through” business income. The discussion of this provision in my post of November 9 was accurate as far as it went, with one qualification: the highest marginal federal tax rate on pass-through profit income would be 25% under the bill, down from 39.6% currently. However, the bill contains complex rules for defining pass-through profit that qualifies for the lower rate, and my earlier treatment was woefully inadequate with regard to those rules.

The House bill seeks to address concerns that owners of personal-service businesses would be tempted to classify an “excessive” share of their income as profit rather than wages and salary. Profit would qualify for the new rate, but the wages and salary paid to the owner would not. Currently, all pass-through income is treated the same. Therefore, “safeguards” were inserted in the bill to prevent the presumed “abuse” that could occur under the bill (or see here or here). First, pass-throughs would be subject to a 70/30 rule: 70% of pass-through income would be treated as wage and salary payments; 30% would be treated as profit. That’s the simplest option. But it means that the true marginal rate on a dollar of income for an owner in the top bracket would be roughly 35.2% (0.7×39.6% + 0.3×25%). That’s much less favorable than my earlier post implied. It’s also less favorable than the corporate rate cut.

Alternatively, a business owner could use a schedule based on invested capital to determine a percentage of income qualifying for the 25% rate. This might benefit a physician invested in costly medical equipment, for example. However, other personal-service businesses are specifically assigned a percentage of zero. This list includes accountants, lawyers, financial advisors, and performers. Imagine that: the House approved a benefit for which lawyers cannot not qualify!!

Another important point is that many small businesses people do not earn enough to benefit from the 25% pass-through rate. Yes, they would see reductions in their marginal rates in lower brackets (and there would be fewer brackets), but in some cases the loss of deductions for items like state and local taxes would be more than offsetting. So it’s not clear how many pass-through business owners would actually benefit from the plan.

The Senate bill takes an entirely different approach. It reduces tax rates in lower brackets, but it would also allow pass-throughs to deduct a flat 17.4% from taxable income, effectively reducing the top marginal rate from 39.6% to 32.7%. Effective rates in all lower brackets would be reduced by the same percentage. There is no distinction in the Senate bill between wage and salary payments versus profits.

The post linked in the first paragraph left the impression that the House tax bill offered more relief for small businesses than the Senate bill, and that’s probably not true, at least for the most successful small businesses. However, the National Federation of Independent Business estimates that at least 85% of small business would not qualify for the 25% rate. Some businesses won’t qualify simply because they are too small to pay a rate exceeding 25%. And when a business qualifies, only 30% of its income will qualify for the reduced rate. Other pass-through businesses won’t qualify due to the nature of their services, another example of different tax treatment of different sources of income. The rules governing qualification for the 25% rate are distortionary and are hardly a simplification. The Senate bill, on the whole, probably does more for small business owners in lower brackets and probably many in higher brackets as well.

The Socially Seductive Tax Deduction

20 Monday Nov 2017

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The rat’s nest that is the federal income tax code is a testament to the counter-productive nature of central economic planning. Not only does the tax code force citizens to waste time and other resources on compliance activities. It also encourages us to direct resources into uses that would not be worthwhile in the absence of tax incentives, uses that are not worthwhile in a societal context.

A general rationale for many provisions of the tax code is that they serve some “worthwhile” public purpose. A special tax provision is created to subsidize activities contributing to that purpose. Since that reduces the flow of revenue, tax rates must increase as an offset. However, high tax rates are damaging to economic health in and of themselves. They blunt incentives and drive wedges between the values and rewards that guide all economic decisions.

The competing tax plans under debate in the House and Senate would eliminate or pare back deductions to varying degrees, enabling a reduction in tax rates. I applaud steps in that direction, though a consequence of doing so piecemeal is to invite later tinkering of the sort that got us into this mess in the first place. Both the House and Senate bills are piecemeal. Here is a run-down of some of the deductions that are under review in the GOP plans:

State and Local Tax (SALT) Deductions: this deduction prevents the imposition of federal “taxes on taxes”, which is a worthwhile consideration. However, SALT also gives lower levels of government a “discount” on tax burdens they impose on their citizens, thereby forcing that burden to be shared by members of other jurisdictions. According to the Tax Foundation:

“The deduction favors high-income, high-tax states like California and New York, which together receive nearly one-third of the deduction’s total value nationwide. Six states—California, New York, New Jersey, Illinois, Texas, and Pennsylvania—claim more than half of the value of the deduction.“

Defenders of this deduction note peremptorily that it is used by taxpayers in all fifty states, as if that should come as a surprise. Well of course it is! And those who are taxed most heavily benefit the most from this deduction, and those benefits are most concentrated in high-tax states. The House GOP bill would limit the SALT deduction to $10,000, while the Senate version would eliminate it entirely.

Mortgage Interest (MI) Deduction: Long ago, the idea took hold that ownership of a home was of greater inherent value than mere occupancy. It’s obviously true that owners have greater rights than renters over use of a property. Those benefits are internalized, and owner-occupants might well be more inclined than renters to take pride in, care for, and improve a property. That suggests a social or external benefit from home ownership, one that at least benefits others in the vicinity of a given property.

The MI deduction creates an incentive for debt-financed home ownership, but only for the minority of taxpayers who can benefit from itemizing deductions. It therefore tends to subsidize the housing choices of those at higher levels of income and those with larger homes. It has contributed little, if anything, to the homeownership rate. Here are Edward Glaeser and Jesse Shapiro describing the findings of their NBER Working Paper:

“Externalities from living around homeowners are far too small to justify the deduction. … the home mortgage interest deduction is a particularly poor instrument for encouraging homeownership since it is targeted at the wealthy, who are almost always homeowners. The irrelevance of the deduction is supported by the time series which shows that the ownership subsidy moves with inflation and has changed significantly between 1960 and today, but the homeownership rate has been essentially constant.“

This deduction has fostered a massive over-investment in housing relative to other assets and forms of consumption. The House tax bill would allow a deduction on interest payments for up to $500,000 of mortgage debt, but this limit would apply only to new mortgages. The Senate bill would not alter the deduction in any way. These steps are severely limited in their reform ambitions.

Medical Expense Deduction: To take this deduction, you must 1) be an itemizer; and 2) have eligible medical expenses exceeding 10% of adjusted gross income (AGI). Then, you can deduct only the excess above 10%. A relatively small percentage of taxpayers actually take this deduction, mostly wealthy, older individuals or couples. It can be argued that the deduction encourages overuse of medical resources in some cases, but there are certainly others in which it provides relief from the hardship of an illness requiring expensive care. On the other hand, the deduction might serve to discourage the purchase of supplemental Medicare coverage by individuals who can afford it but are willing to bet that they won’t need it. Part of that bet is covered by the deduction.

The House bill would repeal this deduction in its entirety. The Senate bill would leave it untouched.

Student Loan Interest Deduction: Currently, up to $2,500 of student loan interest can be deducted “above the line” by non-itemizers, but only if their AGI is within certain limits. Higher education is often claimed to have social (external) benefits. To some extent, the student loan interest deduction helps bring the cost of an eduction to within reach of a broader swath of the citizenry. These considerations provide the rationale for public subsidies for funding tuition and other costs with debt. The tax deduction is only one of many forms of education subsidies. Another is provided by the below-market rates at which students are able to borrow from the federal government.

The social benefits of higher education are strongly associated with the value it adds for the individual. It can be argued that as a society, we may have pushed college education well beyond that point. A large number of indebted students decide, too late, that continued enrollment has little value, so they drop out and often default on their federally-subsidized debt. Moreover, these loan subsidies stimulate the demand for college education, which leads to a certain amount of escalation in tuition and fees. These ill effects make elimination of this deduction a tempting way to broaden the income-tax base, enabling a reduction in tax rates.

The House bill eliminates the deduction for student loan interest, but the Senate bill leaves it intact.

Conclusion: There are plenty of shortcomings in both the House and Senate versions of tax reform. Three liberalizing goals of reform are tax simplification, elimination of provisions that benefit special interests, and of course lower rates. Most of the complexities in the tax code benefit special interests in one way or another. The deductions discussed above fall into that category and necessitate higher tax rates on personal income. That in turn makes the deductions more valuable to those who claim them. In terms of the liberalizing goals of reform, the House tax bill is wider ranging than the Senate version, though the Senate bill’s complete elimination of the SALT deduction is better.

The House GOP Tax Plan’s Disparate Treatment of Income Sources

09 Thursday Nov 2017

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Update: In writing the following post, I neglected to devote sufficient attention to the rules that would govern taxation of pass-through income under the House GOP tax plan. Those rules significantly alter some of the conclusions below. Those rules are discussed in a later post: Stumbling Through Pass-Through Tax Reform.

Double taxation of corporate income is a feature of the U.S. income tax code that is partially addressed in the tax reform bill proposed by the House GOP. Corporate income is taxed to the firm and again to owners on their receipt of dividends or when a company’s growth results in capital gains. Ultimately, the total rate of taxation matters more than whether it is implemented as single or double taxation of income flows. However, there is an unfortunate tendency to view corporate taxes as if they are levied on entitites wholly separate from their owners, so double taxation carries a stench of politically sneakiness. It also creates multiple distortions in the decisions of investors and the separately managed firms they own.

Non-corporate income taxation is reduced by the House plan even more substantially than the cut in taxes on corporate-derived income. However, the plan does not reduce taxes on high-earning professionals, many of whom are situated similarly to successful business owners and investors from an economic perspective.

Tax Burdens and Distortions

The federal corporate tax is not borne 100% by shareholders, as discussed in the previous post on Sacred Cow Chips. Some part of the burden is borne by labor via reduced wages. It is difficult to correct for this distortion in terms of calculating an effective marginal tax rate on corporate income. For example, suppose a new 35% tax would reduce corporate income from $100 to $65. The firm finds, however, that it can reduce wage payments by half of the expected tax payment, or $17.50. The firm would now earn $117.50 before tax and $76.38 after tax. Relative to the new level of pre-tax income, the tax rate is still 35%. It is no less than that by way of the reduction in wages, though the impact on the firm’s pre-tax income is mitigated.

The discussion here of tax rates, and even double taxation, is not intended as commentary on tax fairness. It might or might not be fair that the burden of the tax is shared with labor. Instead, the issue is the magnitude of the economic distortions caused by taxes. Tax rates themselves are a reasonable starting point for such a discussion, and they are easy to measure. Lower tax rates beget fewer distortions in economic outcomes than high tax rates. Low rates provide greater incentives to save and invest in productive assets, which enhances labor productivity, wages, and economic growth. Indeed, businesses go to great lengths to avoid taxes altogether, if possible, but typically those are non-productive uses of resources, which demonstrates the very distortions at issue.

Current and Proposed Marginal Tax Rates

Under current law, the top personal income tax rate on dividends is 20%. It is 23.8% if we include the Obamacare surtax. Adding that to the corporate rate yields the effective top tax rate paid by shareholders: 23.8% + 35% = 58.8%. The GOP bill does not alter the 23.8% top rate on dividends or capitals gains. By virtue of the corporate tax reduction, however, the plan would reduce the overall top rate on shareholders to 23.8% + 20% = 43.8%.

The income earned by investors in pass-through entities like proprietorships, partnerships and S-corporations is taxed as personal income under current law at rates ranging from 15% to 39.6% (43.4% at the top, including the surtax). Thus, under present law, the owner of a pass-through company is taxed less heavily at the top rate than the owner of a public company (43.4% vs. 58.8%). (I am ignoring the 15.3% FICA payroll tax owed by self-emloyed individuals in proprietorships or partnerships on incomes up to $127,200, and 2.9% above that level. The combined tax rates would be almost equal even if we include the FICA tax.)

The tax on pass-through business income would be reduced under the GOP bill via a cap of 25% on federal business income taxes. Presumably, this cap would nullify the House plan’s “bubble tax” of 6% on personal income between $1.2 million and $1.6 million of income, as well as the Obamacare surtax. Thus, the tax advantage for pass-through entities over corporations would be somewhat wider under the House plan than under current law (25% vs. 43.4%). (The FICA tax on owners of proprietorships and partnerships would not quite equalize the overall marginal tax rates over a certain income range.)

In addition, the House plan rewards the owners of pass-through businesses relative to individuals earning high levels of wage and salary income. If anything, the bill would penalize these individuals. For example, while the owner of a high-earning pass-through would face a 25% tax rate, a high-earning professional or corporate employee would pay the top marginal rate (39.6%) plus the surtax (3.8%) and possibly the bubble tax (6%). This is one reason why Scott Sumner says it looks as if the House plan was designed by Bernie Sanders!

The Upshot

The tax system should be neutral across different sources of income. Divergent effective tax rates on owners of corporations, pass-throughs, and high wage-earning individuals is undesirable and introduces arbitrary elements into private decision-making. If anything, the House GOP tax plan exacerbates those differences. By cutting marginal tax rates, it would reduce the magnitude of business tax distortions both for corporate and pass-through organizations and their owners, but the relative advantage of pass-throughs would increase relative to corporations, and owners of corporations and pass-throughs benefit relative to high-earning individuals. Let’s hope this is fixed as the bill evolves, but more balanced reductions in rates would require higher rates on business owners than contemplated in the current plan.

Labor Shares the Burden of the Corporate Income Tax

03 Friday Nov 2017

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As expected, a reduction of the corporate income tax rate from 35% to 20% is included in the GOP’s tax reform bill, a summary of which was released today. That rate cut would be a welcome development for workers, consumers, and corporate shareholders. It should be no surprise that the burden of the U.S. corporate income tax is not borne exclusively by owners of capital. In fact, it might hurt workers and consumers substantially while imposing relatively little burden on shareholders.

John Cochrane’s post on the incidence of the tax on corporate income is very interesting, though by turns it rambles and may be too technical for some tastes. He notes that the incidence of the corporate tax can fall on only three different groups: shareholders, workers and customers:

“As an accounting matter, every cent [of taxes] corporations pay comes from higher prices, lower wages, or lower payments to shareholders. The only question is which one.“

Cochrane quotes Lawrence Summers and Paul Krugman, both of whom are of the belief that the incidence of the corporate tax must fall primarily on capital and not on labor. That’s consistent with their view that a reduction in corporate taxes amounts to a gift to shareholders. But Cochrane isn’t at all convinced:

“The usual principle is that he or she bears the burden who can’t get out of the way. So, how much room do companies, as a whole, have to raise prices, lower wages, lower interest payments, or lower dividends?”

In fact, owners of capital can get out of the way. Capital is very mobile relative to labor. Here’s a counterfactual exercise Cochrane steps through in order to illustrate the implications of ownership bearing the incidence of the tax: if equity markets are efficient, share prices reflect all available information about the firm. If wages and product prices are unchanged after the imposition of the tax, then shareholders would suffer an immediate loss. Once the tax is discounted into share prices, there would be no further impact on current or future shareholders. Thus, future buyers of shares would escape the tax burden entirely. As a first approximation, the share price must fall to the point at which the ongoing return on the stock is restored to its value prior to imposition of the tax.

Cochrane notes that evidence on the reaction of stock prices to corporate tax changes is mixed at best, which implies that the incidence of corporate taxation falls more weakly on shareholders than many believe. That leaves consumers or workers to bear a significant part of the burden. Workers and consumers are mostly one and the same: economy-wide, higher prices mean lower real wages; lower wages also mean lower real wages. So I’ll continue to speak as if the incidence of the tax falls on either labor or capital, and we can leave aside consumers as a separate category. Cochrane says:

“It used to be thought that it was easy to lower payments to shareholders — ‘the supply of savings is inelastic’ — so that’s where the tax would come from. The newer consensus is that companies as a whole have very little power to pay less to investors, … so the corporate tax comes from lower wages or, equivalently, higher prices. Then, indirectly, reducing the corporate tax would increase capital, which would result in higher wages.”

Cochrane’s post and another on his blog were prompted by an earlier piece by Greg Mankiw showing that real wages, in an open economy, will have a strong negative response to a corporate tax increase. Here is the reasoning: the tax reduces the return earned from invested capital in the short run. Ideally, capital is deployed only up to the point at which its return no longer exceeds the opportunity cost needed to attract it. Given time to adjust, less capital must be deployed after the imposition of the tax in order to force the return on a marginal unit of capital back up to the given opportunity cost. That means less capital deployed per worker, and that, in turn, reduces labor productivity and wages.

Another issue addressed by Cochrane has to do with assertions that monopoly power in the corporate sector is a good rationale for a high tax on corporate income. You can easily convince me that the “average” firm in the corporate sector earns a positive margin over marginal cost. However, a microeconomic analysis of monopoly behavior by the entire corporate sector would be awkward, to say the least. Despite all that, Cochrane notes that monopolists have more power than firms in competitive sectors to raise prices, and monopsonists have more power to reduce wages. Therefore, the “tax the monopolists” line of argument does not suggest that labor will avoid a significant burden of a corporate tax. A safer bet is that firms in the U.S. corporate sector are price-takers in capital markets, but to some degree may be price-makers in product and labor markets.

Cochrane also emphasizes the inefficiency of the corporate tax as a redistributional mechanism, even if shareholders bear a significant share of its burden. It is still likely to harm workers via lost productivity, as discussed above. It is also true that many workers hold corporate equities in their retirement funds, so a corporate tax harms them directly in their dual role as owners of capital.

The cut in the corporate tax rate is but one element of many in the GOP bill, but a related provision is that so-called “pass-through” income, of the type earned via many privately-owned businesses, would be taxed at a maximum rate of 25%. These businesses generate more income than C-corporations. Currently, pass-through income is taxed as ordinary income, so capping the top rate at 25% represents a very large tax cut. As Alex Tabarrok points out at the last link, tax treatment should be neutral with respect to the form of business organization, but under the GOP bill, the effective gap between the top rate for pass-throughs versus corporate income would be even larger than it is now.

Critics of a reduction in corporate taxes should bear in mind that its incidence falls at least partly on labor, perhaps mainly on labor. The U.S. has the highest corporate tax rate in the industrialized world. That undermines U.S. competitiveness, as does the complexity of corporate tax rules. Tax planning and compliance burn up massive resources while drastically reducing the tax “take”, i.e., the revenue actually collected. The corporate income tax is something of a “show” tax that exists to appease populist and leftist elements in the electorate who consistently fail to recognize the unexpectedly nasty consequences of their own advocacy.

 

Insurance Subsidies: Taxes vs. High Premiums

16 Tuesday May 2017

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Here’s a question a friend posed: Why do we care whether health care coverage for high-risk individuals is subsidized by taxpayers versus premium payers via common (community) rating in a combined risk pool? For convenience, let’s call those two scenarios T and C. Under C there is no segmentation whatsoever, while T involves a division of individuals into two groups: standard and high risk. Both scenarios involve guaranteed issue, though T assumes that high-risk individuals must purchase their coverage in the appropriate market. I’ll tackle T first because separate treatment of the distinct risk archetypes yields results that are useful as a baseline.

Taxpayers Subsidize Pre-Existing Conditions

Under scenario T, suppose that all standard risks face the same expected outcome in each period. Everyone in that group pays based on their expected health care costs. In the end, some will have greater health care needs than others, but only a few will be truly unlucky, incurring extremely high health care expenses. On balance, the pooling of risk makes the arrangement sustainable. People enter into these contracts voluntarily because they are risk averse. No one forces them; they are capturing value from protection against financial ruin. The paid-in cash can be invested by the plan in the interim between premium and claims payments. The combination of premium payments and investment income must be enough to cover claims and allow the managers of the plan to defray their administrative costs and make a tidy profit. The profit matters because it attracts voluntary resources to bear on the problem of health-expense risk. Therefore, these insurance transactions are mutually beneficial to the insured and the owners of the insurer.

Conceivably, the smaller high-risk group could be handled the same way, as long as their aggregate health care expenses are predictable. Those expenses will be high, however, so the cost of coverage for individuals in such a pool might be prohibitive. One solution is to force taxpayers to subsidize coverage for this group. The transactions in this market are also mutually beneficial to the insureds and the insurers, just as in the market for standard risks. In both cases, the value to purchasers of coverage is no less than the cost of providing it, including compensation for any capital employed in the process.

In the simplified world of scenario T, we have an optimal insurance outcome for both standard and high-risk individuals. The downside is the cost of the subsidies to taxpayers, which distort a variety of incentives, including labor supply, saving and investment. These lead to misallocations, but they are spread across the economy rather than concentrated on the outcomes in a single market. Is this better than simply pooling all risks, as in Scenario C (common rating)?

Common (Community) Rating

Common rating means that all risks are combined into one pool and everyone is charged the same premium. High-risk individuals get to participate just as if they are standard risks. However, because the combined risk pool has greater expected health care costs on average than the standard risk population, the premium must be greater than the one charged to standard risks in Scenario T. Otherwise, the plan could not cover all expenses nor earn a profit. Worse yet, the standard risks now have an incentive to exit the market while high-risk individuals have every reason to leap in. This is called adverse selection, and it leads to the sort of insurance death spiral we’ve witnessed under Obamacare. And not only does the risk pool deteriorate: the incentive to offer coverage is diminished as well. Thus, an entire industry is rendered dysfunctional. Those who wish to pool together voluntarily in order to efficiently hedge their risks are, by law, prohibited from doing so. The next step might well be for government to mandate participation in an attempt to keep the plan afloat.

Those who favor forced redistribution (not my set) might have other reasons to prefer Scenario T, as it creates greater latitude for progressive tax funding of the subsidies. However, the subsidies themselves could be sensitive to income such that the risky but well-heeled pay more.

From a libertarian perspective, Scenario C has obvious drawbacks, starting with the coercion of insurers to provide coverage to the high-risk population at rates that do not compensate for risk. Then, too, the mis-pricing of risk places a burden on individuals of standard risk. With the pooling of all risks, community rating and coverage mandates result in individual and aggregate over-insurance against most types of risk, tying up scarce resources in insurance assets that could be invested more productively in other uses. In addition, resources are absorbed by compliance costs as authorities find it necessary to enforce the many rules made in hopes of proping-up an otherwise unsustainable arrangement.

Then There’s Single-Payer

It’s often argued that going beyond this point in Scenario C to a single-payer system will yield better outcomes at lower costs. Megan McArdle shreds this idea in a recent column: well over 40% of health care spending in the U.S. is paid by government already; the average growth of that share is even higher than private health care spending; the quality of care is often lower in the government health sector, and in any case, single payer systems around the world do not enjoy slower growth in costs. Rather, they started from lower levels of health care costs. Our relatively high level of costs in the U.S. evolved many years ago, before single-payer systems were adopted abroad. We have many more private and semi-private hospital rooms in the U.S., we often have greater availability of advanced technology, and waiting times for care tend to be significantly shorter.

The high standard of living in the U.S., i.e., our level of consumption, explains a lot of the gap in health care spending. Overall, our health care outcomes are good relative to other developed countries. Unfortunately, we’ve also pushed-up costs from the demand side by offering tax subsidies on employer-provided care, and government in the U.S. has had a role in “managing” health care since the time of the Woodrow Wilson Administration, largely to the detriment of cost control. Government control stultifies competition, creating monopoly-like conditions in both insurance and the provision of care. That manifests in higher profits, safer profits, or slovenly performance by organizations and agents that lack accountability to customers and market forces. Costs rise.

Liberty or Coercion

Libertarians will object to the tax in Scenario T, which like all taxation is coerced, but the taxes necessary to pay for adequate coverage for pre-existing conditions is minor relative to the potential costs of distorting the entire health insurance industry, repleat with the costs of government regulation and compliance that entails, and the potential for still more encroachment of government in health care.

Finally, the question posed by my friend about tax subsidies versus common insurance rating was prompted by a presumed “right to health care”. One must ask whether that right is legitimate. Kevin Williamson argues that scarcity interferes with any such claim. More to the point, in a free society, one cannot simply demand health care from another free individual. Our choices for distributing scarce health care fall into one of only two categories: voluntary and coerced. We should always prefer the former, which may take the form of charity or a mechanism under which care is provided via free exchange. The latter works very well when incentives are clear and pricing is efficient. For those who cannot participate in exchange for any reason, including pre-existing conditions that make coverage prohibitive, private charity is an alternative to government subsidies. At a minimum, charity should serve as an important relief valve for the burden on taxpayers. The Left, however, is always quick to condemn private charity as if it is somehow an illegitimate mechanism for solving social problems, but it is often superior to government action.

A Trump Tax Reform Tally

03 Wednesday May 2017

Posted by in Big Government, Taxes, Trump Administration

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The Trump tax plan has some very good elements and several that I dislike strongly. For reference, this link includes the contents of an “interpretation” of the proposal from Goldman Sachs, based on the one-page summary presented by the Administration last week as well as insights that the investment bank might have gleaned from its connections within the administration. At the link, click on the chart for an excellent summary of the plan relative to current law and other proposals.

At the outset, I should state that most members of the media do not understand economics, tax burdens, or the dynamic effects of taxes on economic activity. First, they seem to forget that in the first instance, taxpayers do not serve at the pleasure of the government. It is their money! Second, Don Boudreaux’s recent note on the media’s “taxing” ignorance is instructive:

“In recent days I have … heard and read several media reports on Trump’s tax plan…. Nearly all of these reports are juvenile: changes in tax rates are evaluated by the media according to changes in the legal tax liabilities of various groups of people. For example, Trump’s proposal to cut the top federal personal income-tax rate from 39.6% to 35% is assessed only by its effect on high-income earners. Specifically, of course, it’s portrayed as a ‘gift’ to high-income earners.

… taxation is not simply a slicing up of an economic pie the size of which is independent of the details of the system of taxation. The core economic case for tax cuts is that they reduce the obstacles to creative and productive activities.“

Boudreaux ridicules those who reject this “supply-side” rationale, despite its fundamental and well-established nature. Thomas Sowell makes the distinction between tax rates and tax revenues, and provides some history on tax rate reductions and particularly “tax cuts for the rich“:

“… higher-income taxpayers paid more — repeat, MORE tax revenues into the federal treasury under the lower tax rates than they had under the previous higher tax rates. … That happened not only during the Reagan administration, but also during the Coolidge administration and the Kennedy administration before Reagan, and under the G.W. Bush administration after Reagan. All these administrations cut tax rates and received higher tax revenues than before.

More than that, ‘the rich’ not only paid higher total tax revenues after the so-called ‘tax cuts for the rich,’ they also paid a higher percentage of all tax revenues afterwards. Data on this can be found in a number of places …“

In some cases, a proportion of the increased revenue may have been due to short-term incentives for asset sales in the wake of tax rate reductions. In general, however, Sowell’s point stands.

Kevin Williamson offers thoughts that could be construed as exactly the sort of thing about which Boudreaux is critical:

“It is nearly impossible to cut federal income taxes in a way that primarily benefits low-income Americans, because high-income Americans pay most of the federal income taxes. … The 2.4 percent of households with incomes in excess of $250,000 a year pay about half of all federal income taxes; the bottom half pays about 3 percent.”

The first sentence of that quote highlights the obvious storyline pounced upon by simple-minded journalists, and it also emphasizes the failing political appeal of tax cuts when a decreasing share of the population actually pays taxes. After all, there is some participatory value in spreading the tax burden in a democracy. I believe Williamson is well aware of the second-order, dynamic consequences of tax cuts that spread benefits more broadly, but he is also troubled by the fact that significant spending cuts are not on the immediate agenda: the real resource cost of government will continue unabated. We cannot count on that from Trump, and that should not be a big surprise. Greater accumulation of debt is a certainty without meaningful future reductions in the growth rate of spending.

Here are my thoughts on the specific elements contained in the proposal, as non-specific as they might be:

What I like about the proposal:

  • Lower tax rate on corporate income (less double-taxation): The U.S. has the highest corporate tax rates in the developed world, and the corporate income tax represents double-taxation of income: it is taxed at the corporate level and again at the individual level, perhaps not all at once, but when it is actually received by owners.
  • Adoption of a territorial tax system on corporate income: The U.S. has a punishing system of taxing corporate income wherever it is earned, unlike most of our trading parters. It’s high time we shifted to taxing only the corporate income that is earned in the U.S., which should discourage the practice of tax inversion, whereby firms transfer their legal domicile overseas.
  • No Border Adjustment Tax (BAT): What a relief! This was essentially the application of taxes on imports but tax-free exports. Whatever populist/nationalist appeal this might have had would have quickly evaporated with higher import prices and the crushing blow to import-dependent businesses. Let’s hope it doesn’t come back in congressional negotiations.
  • Lower individual tax rates: I like it.
  • Fewer tax brackets: Simplification, and somewhat lower compliance costs.
  • Fewer deductions from personal income, a broader tax base, and lower compliance costs. Scrapping deductions for state and local taxes in exchange for lower rates will end federal tax subsidies from low-tax to high-tax states.
  • Elimination of the Alternative Minimum Tax: This tax can be rather punitive and it is a nasty compliance cost-causer.

What I dislike about the proposal:

  • The corporate tax rate should be zero (with no double taxation).
  • Taxation of cash held abroad, an effort to encourage repatriation of the cash for reinvestment in the U.S. Taxes on capital of any kind are an act of repeated taxation, as the income used to accumulate capital is taxed to begin with. And such taxes are destructive of capital, which represents a fundamental engine for productivity and economic growth.
  • Retains the mortgage interest and charitable deductions: Both are based on special interest politics. The former leads to an overallocation of resources to owner-occupied housing. Certainly the latter has redeeming virtues, but it subsidizes activities conferring unique benefits to large donors.
  • Increase in the standard deduction: This means fewer “interested” taxpayers. See the  discussion of the Kevin Williamson article above.
  • We should have just one personal income tax bracket, not three: A flat tax would be simpler and would reduce distortions to productive incentives.
  • Tax relief for child-care costs: More special interest politics. Subsidizing market income relative to home activity, hired child care relative to parental care, and fertility is not an appropriate role for government. To the extent that public aid payments are made, they should not be contingent on how the money is spent.
  • Many details are missing: Almost anything could happen with this tax “plan” when the real negotiations begin, but that’s politics, I suppose.

Mixed Feelings:

  • Descriptions of the changes to treatment of pass-through” income seem confused. There is only one kind of tax applied to the income of pass-through entities like S-corporations, and it is the owner’s individual tax rate. Income from C-corporations, on the other hand, is taxed twice: once at a 15% corporate tax rate under the Trump plan, and a second time when it is paid to investors at an individual tax rate, which now range from 15% to almost 24% for “qualified dividends” (most dividend payments), but are likely to range up to 35% for “ordinary” dividends under the plan. So effectively, double-taxed C-corporate income would be taxed at total rates ranging from 30% to 50% after tallying both the C-corp tax and the individual tax. (This is a simplification: C-corp income paid as dividends would be taxed to the corporation and then immediately to the shareholder at their individual rate, while retained corporate income would be taxed later).

Presumably, the Trump tax plan is to reduce the rate on “pass-through” income to just 15% at the individual level, regardless of other income. (It is not clear how that would effect brackets or the rate of taxation on other components of individual income.) Is that good? Yes, to the extent that lower tax rates allow individuals to keep more of their hard-earned income, and to the extent that such a change would help small businesses. S-corps have always had an advantage in avoiding double taxation, however, and this would not end the differential taxation of S and C income, which is distortionary. It might incent business owners to shift income away from salary payments to profit, however, which would increase the negative impact on tax revenue.

  • Interest deductibility and expensing of capital expenditures are in question. Interest deductibility puts debt funding on an equal footing with equity funding only if the double tax on C-corp income is fully repealed. Immediate expensing of “capex” would certainly provide an investment incentive (as long as “excess” expenses can be carried forward), and for C-corporations, it would certainly bring us closer to elimination of the double-tax on income (the accounting matching principle be damned!).
  • There is no commitment to shrink government, but that’s partly (only partly) a function of having abandoned revenue neutrality. It’s also something that has been promised for the next budget year.
  • The tax reform proposal represents a departure from insistence on revenue neutrality: On the whole, I find this appealing, not because I like deficits better than taxes, but because there may be margins along which tax policy can be improved if unconstrained by neutrality, assuming that the incremental deficits are less damaging to the economy than the gains. The political landscape may dictate that desirable changes in tax policy can be made more easily in this way.

Shikha Dalmia wonders whether a real antidote for “Trumpism” might be embedded within the tax reform proposal. If the reforms are successful in stimulating non-inflationary economic growth, a “big if” on the first count, the popular preoccupations inspired by Trump with immigration policy, the “wall” and protectionism might just fade away. But don’t count on it. On the whole, I think the tax reform proposal has promise, though some of the good parts could vanish before a bill hits Trump’s desk, and some of the bad parts could get worse!

The Taxing Logic of Carbon Cost Guesswork

11 Saturday Mar 2017

Posted by in Environment, Taxes, Uncategorized

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An article by three prominent economists* in the New York Times this week summarized the Climate Leadership Council’s Conservative Case for Climate Action“. The “four pillars” of this climate plan include (1) a revenue-neutral tax on carbon emissions, which are used to fund… (2) quarterly “carbon dividend” payments to all Americans; (3) border tax adjustments to account for carbon emissions and carbon taxes abroad; (4) eliminating all other regulations on emissions of carbon. The “Case” is thus a shift from traditional environmental regulation to a policy based on tax incentives, then wrapped around a redistributive universal income mechanism.

I’ll dispense with the latter “feature” by referencing my recent post on the universal basic income: bad idea! The economists advocate for the carbon dividend sincerely, but also perhaps as a political inducement to the left and confused centrists.

The Limits of Our Knowledge

The most interesting aspect of the “Case” is how it demonstrates uncertainty around the wisdom of carbon restrictions of any kind: traditional regulations, market-oriented trading, or tax incentives. Those all involve assumptions about the extent to which carbon emissions should be restricted, and it’s not clear that any one form of restriction is more ham-handed than another. Traditional regulation may restrict output in various ways. For example, standards on fuel efficiency are an indirect way of restricting output. A carbon market, with private trading in assigned “rights” to emit carbon, is more economically efficient in the sense that a tradeoff is involved for any decision having carbon implications at the margin. However, the establishment of a carbon market ultimately means that a limit must be imposed on the total quantity of rights available for trading.

A carbon tax imputes a cost of carbon emissions to society. It also imposes tradeoffs, so it is similar to carbon trading in being more economically efficient than traditional regulation. A producer can attempt to adjust a production process such that it emits less carbon, and the incidence of the tax falls partly on final consumers, who adjust the carbon intensity of their behavior accordingly. For our purposes here, a tax is more illuminating in the sense that we can assess inputs to the cost imputation. Even a cursory examination shows that the cost estimate can vary widely given reasonable differences in the inputs. So, in a sense, a tax helps to reveal the weakness of the case against carbon and the carbon-based rationale for allowing a coercive environmental authority to sclerose the arteries of the market system.

The three economists propose an initial tax of $40 per metric ton of emitted carbon. The basis for that figure is the so-called “social cost of carbon” (SCC), a theoretical construct that is not readily measured. Economists have long subscribed to the theory of social costs, or negative externalities, and to the legitimacy of government action to force cost causers to internalize social costs via corrective taxation. However, the wisdom of allowing the state to intrude upon markets in this way depends on our ability to actually measure specific external costs.

Fatuous Forecasts

The SCC is based on the presumed long-run costs of an incremental ton of carbon in the environment. I do not use the word “presumed” lightly. The $40 estimate subsumes a variety of speculative assumptions about the climate’s response to carbon emissions, the future economic impact of that response, and the rate at which society should be willing to trade those future costs against present costs. The figure only counts costs, without considering the huge potential benefits of warming, should it actually occur.

Ronald Bailey at Reason illustrates the many controversies surrounding the calculation of the SCC. He notes the tremendous uncertainty surrounding an Obama Administration estimate of $36 a ton in 2007 dollars. It used an outdated climate sensitivity figure much higher than more recent estimates, which would bring the calculated SCC down to just $16.

A discount rate of 3% was applied to projected future carbon costs to produce an SCC in present value terms. The idea is that today’s “collective” would be indifferent between paying this cost today and suffering the burden of future costs inflicted by carbon emissions. This presumes that 3% is the expected return society can earn for the future by investing resources today. Unfortunately, the SCC is tremendously sensitive to the discount rate. Together with the more realistic estimate of climate sensitivity, a discount rate of 7% (the Office of Management and Budget’s regulatory guidance) would actually make the SCC negative!

Another U.S. regulatory standard, according to Bailey, is that calculations of social cost are confined to costs borne domestically. However, the SCC attempts to encompass global costs, inflating the estimate by a factor of 4 to 14 times. The justification for the global calculation is apparent righteousness in owning up to the costs we cause as a nation, and also for the example it sets for other countries in crafting their own carbon policies. Unfortunately, it also magnifies the great uncertainties inherent in this messy calculation.

Lack of Evidence

This guest essay on the Watts Up With That? web site by Paul Driessen and Roger Bezdek takes a less gracious view of the SCC than Bailey, if that is possible. As they note, in addition to climate sensitivity, the SCC must come to grips with the challenge of measuring the economic damage caused by each degree of warming. This includes factors far into the future that simply cannot be projected with any confidence. We are expected to place faith in distant cost estimates of heat-related deaths, widespread crop failures, severe storm damage, coastal flooding, and many other calamities that are little more than scare stories. For example, the widely reported connection between atmospheric carbon concentration and severe weather is demonstrably false, as are reports that Pacific islands have been swallowed by the sea due to global warming.

Ignoring the Benefits

The SCC makes no allowance for the real benefits of burning fossil fuels, which have been a powerful engine of economic growth and still hold the potential to lift the underdeveloped world out of poverty and environmental  distress. The benefits of carbon also include fewer cold-related deaths, higher agricultural output, and a greener environment. It isn’t surprising that these benefits are ignored in the SCC calculation, as any recognition of that promise would undermine the narrative that fossil fuels are unambiguously evil. Indeed, an effort to calculate only the net costs of carbon emissions would likely expose the entire exercise as a sham.

The “four pillars” of the Climate Leadership Council‘s case for climate action rest upon an incredibly flimsy foundation. Like anthropomorphic climate change itself, appropriate measurement of a social cost of carbon is an unsettled issue. Its magnitude is far too uncertain to use as a tool of public policy: as either a tax or a rationale for carbon regulation of any kind. And let’s face it, taxation and regulation are coercive acts that better be undertaken with respect for the distortions they create. In this case, it’s not even clear that carbon emissions should be treated as an external cost in many applications, as opposed to an external benefit. So much for the corrective wisdom of authorities. The government is not well-equipped to centrally plan the economy, let alone the environment.

  • The three economists are Martin Feldstein, Ted Halstead and Greg Mankiw.

Trumpist In a Taxpot

06 Thursday Oct 2016

Posted by in Taxes

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The media narrative around Donald Trump’s 1995 tax deduction of a business loss would have you think it had been the crime of the century. Last weekend, the New York Times presented an analysis of a Trump tax return from 1995 showing a loss of $916 million, which was eligible for “carry forward” to reduce taxes on his business income in future years. The Times characterized it as something of a scandal, and the Clinton campaign was quick to jump on board. However, the ability to deduct losses or carry them forward to deduct in future years are basic features of the U.S. income tax code. Hillary Clinton used the same tax provisions as recently as 2015, albeit on a smaller scale than Trump, and the Clinton’s have engaged in other forms of tax avoidance. The point here is that if your business realizes gains from some winning investments, but suffers losses on a few others, a basic and reasonable feature of the tax code is to allow the losses to offset a like amount of gains for tax purposes. Similarly, your winnings at the casino (assuming you report them) are not taxed without first netting out the bad bet you made at the roulette table. So far, so good.

When you or your business suffers a loss in a given year, the income tax code allows that loss to be carried forward to offset taxable income in subsequent years. Since the Times article, the term “net operating loss” has been thrown around in some circles as if it’s an arcane tax loophole, but it’s simply good tax policy. John Cochrane provides an example of an entity which alternately reaps gains of $1,000,000 in one year and losses of $900,000 in the next, with an average pre-tax income of $50,000. Without loss carry-forward, this entity would be forced out of business in short order by the IRS. The use of this provision is not uncommon, and it prevents the tax code, such as it is, from being even more threatening to enterprises and jobs that are otherwise viable. Suggesting the elimination of this provision leaves tax experts in disbelief. The effects would be punitive to many businesses, not just corporate behemoths, and would be destructive to the economy.

Cochrane also puts the “blame” for this much-maligned deduction where it should be: the existence of the income tax itself! A consumption tax would not be as sensitive to changes in income, as people tend to smooth their consumption levels over time.

Another question related to the Trump tax revelations would be more controversial, if true: that he might have engaged in so-called “debt parking“. That’s unproven, but Bronte Capital Management‘s John Hempton blogged that it’s highly likely that he did. The alleged sequence of events is as follows: Trump borrowed money and invested it in assets that resulted in massive losses. The losses meant the debt held by Trump’s lender was nearly worthless. If that debt had been forgiven and written off by the original lender, Trump would have been forced to report a large gain, offsetting the tax benefit of the loss on his assets. But as Hempton’s story goes, the lender did not write it off. Rather, in the meantime, Trump created an entity that bought the debt from the lender for pennies on the dollar. After the sale, the write-down taken by the lender was not attributable to Trump as income. Trump’s “entity” simply served as a place to “park” the debt, protecting Trump’s tax benefits via loss carry-forward.

Megan McArdle addresses this issue, but she first reinforces the policy wisdom of the loss provisions in the tax code. McArdle ridicules the notion that businesses seek to generate losses in order to obtain tax deductions. She then  debunks the debt-parking theory of Donald Trump’s tax management:

“This theory seemed to have a lot of credibility among folks on social media. Among the tax professionals I spoke to, it had none: the IRS would treat this sort of structure just as it would if a third party had forgiven the debt.

‘Look,’ says [tax attorney Ron] Kovacev, ‘you put a $900 million loss on your tax return, that’s audit bait. The IRS is going to look into it. The notion that you could just move the money and the IRS wouldn’t ask questions?’ There was a sort of incredulous pause before he finally said: ‘That’s hard to fathom.’“

One other question about the 1995 tax return is whether the $916 million loss proves that Trump is a lousy businessman. In fact, there is speculation that Trump’s losses around that time might well have been much larger than that. He suffered staggering failures in his casino business, his airline, and his investment in New York’s Plaza Hotel. It might not be so remarkable, however, to see a few losses on this scale for a developer investing in a variety of large projects. Big risk goes with the territory. Nevertheless, it doesn’t appear that Trump, having begun his business career with large amounts of family money, has achieved tremendous success with that capital over the years, on balance. Rather, it looks more like the kind of success an average investor would have achieved under the same initial circumstances. The losses claimed on his 1995 tax return obviously restrained his overall gains, but they don’t prove he’s a terrible businessman. He’s probably fairly average.

Both Trump and Clinton have exploited a rule in the income tax code that helps smooth after-tax profits and is a basic element of income tax rationality (given that it exists in the first place). It’s rather absurd for anyone to condemn them for it. Even more absurd for either of them to cast aspersions at the other on these grounds. Would Hillary Clinton do anything to restrict the longstanding ability to carry forward losses to deduct against future taxes? I’m thankful that I haven’t heard her say so!