September 04, 2008

Austin Bramwell tells us the tax code favors the rich at the expense of everyone else. As an argument he gives some examples that very likely loom large in his estate planning practice.

Anecdote and instance are rhetorically effective, but their moral depends on how the story is told. More particularly, a common problem with righteous complaints about special tax benefits is that whether something qualifies as a special benefit depends on how the system works in general.

For example: it’s true, as Mr. Bramwell complains, that charitable deductions are worth more to rich people than poor people. On the other hand, the reason they’re worth more is that poor people have other benefits (lower tax rates and the ability to take a completely arbitrary standard deduction) that are more valuable to them. Under such conditions, who’s being favored?

Another issue, which is abstract and sometimes verges on the philosophical, is the nature of what it is that is being taxed. The federal government collects an income tax, but the word “income” doesn’t define itself. What the lawmakers have in mind has to be inferred from the system they set up. So far as I can tell, the general fundamental tendency of the current system is to tax increases in economic wealth to those who get their benefit.

If that’s what the system is about, then if I make a widget at a cost to me of 5 dollars and sell it for 10 dollars, then wealth has increased 5 dollars, I’m the one who benefits, and I get taxed on it. Thus far no complications and no complaints.

On the other hand, if I take the 5 dollars and give it away, there’s no economic activity and no overall increase in wealth. It’s just turned out that it’s the recipient and not me who gets the benefit of the 5 dollar increase in wealth. It follows that in principle (if my explanation of the system is correct) it’s the recipient and not I who should get taxed.

One possibility for dealing with the situation is to refund to me the tax I paid and tax the recipient instead. The treatment of a gift to charity follows that general principle. The donor gets a deduction equal to the income contributed, so he pays no tax on that income. The charity also pays no tax on it, because it receives the income for the benefit of the public rather than its own benefit. The tax burden therefore falls on the ultimate beneficiary of the increase in wealth, the general public. (Since tax collections from donors have gone down, the tax burden on the general public, whose well-being has presumably been increased by the value of the contribution, goes up.)

In the case of a gift to my son, the system takes the simpler but roughly equivalent approach of leaving the tax with me and letting my son receive the 5 dollars without tax. On the whole, that approach results in a larger tax paid because donors generally get taxed at a higher rate than recipients. And the principle that tax is paid on increases in wealth is maintained.

So it seems that not all of the tax benefits Mr. Bramwell finds so one-sided and unjust need be viewed as special benefits at all. They can equally or better be understood as consequences of rational principles implicit in a tax system that for the most part aims to tax increases in wealth once but not more than once. (The analysis may be boring, but if you want to know whether you have a complaint you have to look at the system as a whole.)

Of course it’s true that other aspects of the system can’t be rationalized. Giving donors a deduction on unrealized appreciation on a charitable contribution makes no sense. And Congress should not have given up the attempt to tax pre-mortem appreciation on inherited property.

On the other hand, the irrationalities work both ways, as in the case of the second tax on corporate profits imposed when earnings that have already been taxed to the corporation are taxed again when distributed to individual shareholders as dividends. That’s a special tax detriment that no doubt mostly burdens the idle rich. And the biggest tax benefits, like the home mortgage interest deduction and the special tax treatment of various employment benefits, mostly favor the middle classes. (A list of major income tax expenditures can be found here.)

So what’s the conclusion? It’s true the tax system is irrational in various ways, and that the irrationalities confer unjustified benefits on particular groups of people like those who inherit appreciated property.

It’s still odd to say that the tax code systematically discriminates in favor of the rich, when the wealthy give up a greater proportion of their income in taxes. Indeed, according to the Tax Foundation, the top 1% pay a greater dollar amount in income taxes than the bottom 90%. It’s also odd to speak of reforming the tax system to bring about equal treatment of rich and poor, as Mr. Bramwell does, without a much clearer understanding of what the basis of taxation should be, and what would constitute equal treatment in the case of a system that on the whole taxes the rich at higher rates.


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