Category: income tax

Profits and Savings Diverge

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November 20, 2022

by Stephen Stofka

This week’s letter is about household savings and corporate profits. As a share of GDP, savings are near an all-time low while profits are at an all-time high. Elon Musk, the CEO of Tesla, appeared in court this week. No, this wasn’t about his acquisition of Twitter. It concerned a shareholder lawsuit against Tesla regarding the $50B stock option package the company awarded him in 2018. In 2019 the company’s total revenue – not profit – was less than $25B. In 2022, annual revenue was $75B. At a 15% profit margin, the company must continue growing its revenue at a blistering pace to afford Mr. Musk’s incentive pay package. Large compensation packages like this are only a few decades old. Let’s get in our time machine.

In 1994, Kurt Cobain, the 27 year old leader of the rock group Nirvana, died from an overdose of heroin. Something else was dying that year – corporations were breaking free of national boundaries and moving production to countries other than their home nation. This was the last stage in the evolution of multinational corporations, or MNCs. In earlier decades, companies had licensed or franchised their brand. Perhaps they had set up a sales office in a foreign country. Now they were becoming truly global. Fueling that expansion was an increase in equity ownership by large institutional investors. To accommodate these changes, their governance structures changed. Executives capable of leading this global growth were rewarded on a parallel with superstar sports talent. That was the conclusion of Hall and Liebman (2000, 3), two researchers at the National Bureau of Economic Research. 

Let’s look at two series over the past sixty years – personal savings and corporate profits. If we think of a household as a small enterprise, personal savings is the residual left over from the household’s labor. Likewise, corporate profits are the residual left over from current production. In 1994, the two series diverged. Corporate profits (the blue line in the graph below) kept rising while personal savings plateaued for a decade. Each series is a percent of GDP to demonstrate the trend more easily.

Executive Compensation

In the mid-1990s, corporations began to issue a lot more stock options to their executives. Some think that a change in the tax code might have precipitated this shift in compensation.  In 1994, Section 162m of the IRS code limited the corporate deductibility of executive pay to $1 million (McLoughlin & Aizen, 2018). By awarding non-qualified stock options to their executives, companies could preserve the corporate tax deduction. However, the slight tax advantage did not account for the rapid increase in options awards. Hall and Liebman found that the median executive received no stock option package in 1985. By 1994, most did. The tax change was secondary – a distraction. Institutional investors wanted more growth and more profits and companies were willing to reward executives with compensation packages similar to sports stars (Hall & Liebman, 2000, 5). Some of these superstars included Jack Welch of General Electric,  Bill Gates of Microsoft, Michael Armstrong of AT&T.

Income Taxes – Less Savings

In 1993, Congress passed the Deficit Reduction Act that raised the top tax rate from 31% to almost 40%. Personal income tax receipts almost doubled from $545 billion in 1994 to almost $1 trillion in 2001. The booming stock market in the late 1990s produced big capital gains and taxes on those gains. For the first time in decades the federal government had a budget surplus. However, more taxes equals less personal savings so this contributed to the flatlining of personal savings during that period.

Household Debt Supports More Spending

During the 2000s, personal savings remained flat. On an inflation adjusted basis, they were falling. Too many people were tapping the rising equity in their home to pay expenses and economists warned that household debt to income ratios were too high. Savings as a percent of GDP fell to a post-WW2 low. As home prices faltered and job losses mounted in late 2007, people began to save more but their debt left them with little protection against the economic downturn. During 2008, personal savings began to increase for the first time in fifteen years. More savings meant less spending, furthering the economic malaise that began in late 2007.

Multi-National Corporate Profits

During those 15 years corporate profits rose steadily as companies increased their global presence. Beginning in 1994 U.S. companies began shifting production to Mexico where labor was cheaper. In 2001, China was admitted to the World Trade Organization (WTO) and production outsourcing continued to Asia. Despite the profit gains, companies kept their income taxes in check. In 2021, corporate income taxes were at about the same level as in 2004. That contributed to the rising budget deficit during the first two decades of this century.

Federal Deficit

The prolonged downturn in 2001-2003 and the financial crisis and recession of 2007-2009 put a lot of people out of work. This triggered what are called “automatic stabilizers,” unemployment insurance and social benefits like Medicaid, housing and food assistance. The federal government went into debt to pay for the Iraq War, pay benefits to people and help fill the budget gaps in state and local budgets. The tax cuts of 2003 enacted under a Republican trifecta* of government control reduced tax revenues, further increasing the deficit. During George Bush’s two terms, the debt almost doubled from $5.7 trillion to $11.1 trillion.

In coping with the recovery from the financial crisis, the government added another $8.7 trillion to the debt. That negative saving by the government helped add to the personal savings of households but too much was spent on just getting by. Following the Great Financial Crisis (GFC), the trend of the government’s rising debt (blue line below) matched the trend in personal savings (red). Sluggish growth and lower tax revenues caused the two to diverge. While the debt grew, personal savings lagged.  

Before and During the Pandemic

Following the 2017 tax cuts enacted under another Republican trifecta, personal saving rose, then spiked when the economy shut down during the pandemic and the federal government sent stimulus checks under the 2020 Cares Act. In the chart below, notice the spike in debt and savings. By the last quarter of 2020, personal savings had risen by $600 billion from their pre-pandemic level of $1.8 trillion. In late December, President Trump signed the $900 billion Consolidated Appropriations Act (Alpert, 2022) but that stimulus did not show up in personal savings until the first quarter of 2021. In March 2021 President Biden signed the $1.7 trillion American Rescue Plan. Personal savings rose $1.6 trillion in that first quarter, the result of both programs.

After the Pandemic

Some economists have said that the American Rescue Plan was too much. In hindsight, it may have been but we don’t make decisions in hindsight. As more schools and businesses opened up, households spent far more than any extra stimulus. They spent $1.2 trillion of savings they had accumulated before the pandemic and savings are now at the same level as the last quarter of 2008 when the financial crisis struck. Thirteen years of cautious savings behavior has vanished in a few years. On an inflation-adjusted basis, personal savings is at a crisis, almost as low as it was in 2005. In the chart below is personal savings as a ratio of GDP.

The Future

In the past year savings (red line) and corporate profits (blue line) have resumed the divergence that began almost three decades ago. Profits were 12% of GDP in the 2nd quarter of 2022. Savings is near that all time low of 2005. Rising profits benefit those of us who own stocks in our mutual funds and retirement plans. However, the divergence between the profit share and the savings share is a sign that the gap between the haves and the have-nots will grow larger.

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Photo by Jens Lelie on Unsplash

  • A trifecta is when one party controls the Presidency and both chambers of Congress.

Alpert, G. (2022, September 15). U.S. covid-19 stimulus and relief. Investopedia. Retrieved November 19, 2022, from https://www.investopedia.com/government-stimulus-efforts-to-fight-the-covid-19-crisis-4799723. See Stimulus and Relief Package 4 for the December 2020 CAA stimulus. See Stimulus and Relief Package 5 for the American Rescue Plan in March 2021.

Hall, B. J., & Liebman, J. B. (2000, January). The Taxation of Executive Compensation – NBER. National Bureau of Economic Research. Retrieved November 19, 2022, from https://www.nber.org/system/files/chapters/c10845/c10845.pdf. Interested readers can see Moylan (2008) below for a short primer on the recording of options in the national accounts. Until 2005, these options were recorded as compensation for tax purposes but not recorded on financial statements so they did not initially affect stated company profits.

McLoughlin, J., & Aizen, R. (2018, September 26). IRS guidance on Section 162(M) tax reform. The Harvard Law School Forum on Corporate Governance. Retrieved November 18, 2022, from https://corpgov.law.harvard.edu/2018/09/26/irs-guidance-on-section-162m-tax-reform/

Moylan, C. E. (2008, February). Employee stock options and the National Economic Accounts. BEA Briefing. Retrieved November 19, 2022, from https://apps.bea.gov/scb/pdf/2008/02%20February/0208_stockoption.pdf

Tower of Babel

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October 23, 2022

by Stephen Stofka

This week’s letter is about taxes and income. Each month, the Federal Reserve (2022) releases an estimate detailing how people spend their money and the sources of their income. I was surprised that 17% of personal income is from government transfers like Social Security and other programs. This is 2% more than the income people receive on their assets. A bit of history for context.

In the 1960s, 2/3 of income was from wages and salaries. Each decade, the wages and salaries component declined 5% until this past decade when wages and salaries were just 50 cents out of every dollar of income.

A greater portion of employee compensation shifted from discretionary income to dedicated non-taxable benefits like health care insurance and pensions. In the early 1960s employer benefits were 10% of wages and salaries. Now they are 21%. Despite the rise in the non-taxable share of compensation, workers give up more out of their paychecks to taxes.

A growing share of income goes to FICA taxes

In 1960, workers paid 6% of their paychecks to FICA taxes. The Medicare program, about 20% of our FICA taxes today, would not be enacted until 1965 when President Johnson ushered in his Great Society programs. Within five years analysts realized that lawmakers had wildly underestimated the costs of the program. By 1980, increases in Social Security and Medicare taxes increased the FICA portion to 12% of paychecks. Today, workers pay 15% of their paychecks in FICA taxes (see note).

In 1960, all other taxes were 11% of total income in 1960, had climbed to almost 13% in 1980 then to over 14% by the year 2000 and are now 15% of total income. In the past twenty years, the rich have paid a growing share of income taxes but their effective tax rate has changed little. Why? When lawmakers put a heavier burden on rich people, they lobby for legal income exclusions and Congress obliges.

Top 10% pay a growing share of income tax

In 2001, the top 1% paid 33% of income taxes. In 2019, they paid 39% (IRS, 2022). In 2001, the top 10% (the Tennies, I’ll call them) paid 64% of personal income taxes. In 2019, they paid 71%. Whether it is the super-rich or the rich, their share of income tax has grown by 6 -7%. That’s not the end of the story.

Growth in incomes of the top 10% is far higher

The Tennies have seen their share of gross income increase from 42.5% in 2001 to 47.3% in 2019, a gain of almost 5 percentage points. They have paid a rising share of the nation’s income taxes but the rise in taxes is less than the rise in personal income (BEA, 2022). In the 2001-2003 period the income tax paid by the Tennies averaged 5.6% of national personal income. In the 2017-2019 period, that tax share was 6.3%, a difference of just .7%. It is a cheap price to pay for a 5% gain in the nation’s total income.

Effective Tax Rate of the top 10% is steady despite rise in Income

In the 2001-3 period the Tennies averaged an effective tax rate of 13.5%. In the 2017-19 period, that effective rate had declined to 13.2% despite a 2% rise in the top marginal tax rate from 35% in 2001 to 37% in 2019. Raising the marginal tax rate on the highest income brackets has little net effect yet it was a campaign issue for Mr. Biden and many Democrats. Political scientists call it position-taking.

The party of no taxes produces higher deficits

Despite their rhetoric about reducing the deficit, Republicans have adopted a no new taxes on anyone pledge that ensures the deficit will get worse. True to form, the budget deficit has grown more under Republican administrations over the past four decades. The party also has a record of slower economic growth but that is mostly due to the two terms of the George Bush administration. Mr. Bush’s failures caused many Republicans to abandon more mainstream Republican values and adopt a mean spirited attitude of radical defiance exemplified by the Tea Party and the Republican Study Committee.

Action requires Compromise

The “Just Say No” Republican factions permit little compromise so the party cannot get significant legislation passed. In the first year of Mr. Trump’s Presidency, Republicans held all three legislative bodies but were stymied by their internal squabbles. In November of 2017, they hastily assembled the corporate tax reform package, TCJA, to show their constituents that they were capable of legislating and to give Mr. Trump some accomplishment that he could tweet  about.

A look ahead

If Republicans take control of the House after the upcoming elections, we can expect more of the same dysfunction under Speaker Kevin McCarthy. Libertarians in the Republican Party want a limited role for the federal government as specified in Article 1, Section 8 of the Constitution. They have little tolerance for national abortion laws and other bullying social legislation that Republicans have promised. The uncompromising factions within the Republican Party ensure that the party cannot govern. They are like drivers in a car with a manual transmission who don’t know how to clutch and shift. Democratic lawmakers, on the other hand, drive down the road, focused on staying perfectly centered between the white lane markers of equality and equity. The rich benefit when party leaders cannot assemble a cohesive coalition of interest groups and voters. The economic interests of the top 10% are protected when voters remain fragmented. Party elites and partisan interest groups speak in languages that are understandable only to a narrow constituency. By promoting dissension, social media has helped create a Tower of Babel.

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Photo by Osman Rana on Unsplash

BEA: U.S. Bureau of Economic Analysis, Personal Income [PI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PI, October 19, 2022.

Federal Reserve. (2022). Personal income and its disposition. FRED. Retrieved October 19, 2022, from https://fred.stlouisfed.org/release/tables?rid=54&eid=155443&od=#. The FICA tax percentage includes the employer and employee portion of the tax. The employee effectively bears the burden of the entire tax.

IRS. (2022). SOI tax stats – individual income tax rates and tax shares. Internal Revenue Service. Retrieved October 19, 2022, from https://www.irs.gov/statistics/soi-tax-stats-individual-income-tax-rates-and-tax-shares#Early%20Release. Table 4.2, Selected Descending Cumulative Percentiles of Returns Based on Income Size Using the Definition of AGI for Each Year.

Our Fair Share

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January 19, 2020

by Steve Stofka

The holidays are over. This week our city picked up Christmas trees set by the curb. The sun set after 5 PM, the first time since the time change in the first week of November. The sun is returning to the Northern Hemisphere. Despite the variations in the amount of sunshine throughout the year, we all get the same amount of sunshine over the course of a year. Not so with our tax bills.

Estimated taxes were due this week. The self-employed, retired people and others who earn income with no taxes withheld must pay estimated taxes every quarter. This past year the IRS audited less than ½% of returns, a lifetime low. That sounds great because none of us wants to endure an audit. The very word strikes fear in the hearts of many taxpayers, but most of us have a small chance of being audited regardless. We don’t pay enough in taxes for the IRS to do much more than a paper audit, a request for supporting documentation.

The IRS is not a popular agency and became less popular when the agency discriminated against Tea Party and progressive groups during the 2010 election (Farhi, 2017). House Republicans repeatedly cut the agency’s budget, but that retribution has had serious budget consequences. The National Bureau of Economic Research estimated that the government could raise an additional $1 trillion in tax revenue – that’s about 20% of total revenue – with stricter enforcement of existing law (Heeb, 2019). In 2019, the Federal deficit, or budget shortfall, was $1.1 trillion (BPC, 2020). Stricter enforcement would have effectively erased that deficit.

The race for the Democratic Party’s nomination for President promises to center around several themes. The first is the horse race against President Trump, whose incumbency gives him a distinct advantage when running for re-election. The press often seems more concerned with the contest than the underlying issues of a campaign. Taxation is a recurring discussion in each election. More or less? What is a fair share? More, more, more social programs, taxation and regulation, or less, less, less social programs and taxation and more defense spending and power for large corporations?

What is fair? As children we have a keen sense of fairness – our “monkey brain.” We are social creatures who feel scorned at what we perceive as unequal treatment. Equal and fair are not the same thing. A fair share is not the same as an equal share. If I can afford to buy $50,000 worth of goods in a year, why should I have to pay more sales tax than someone who only buys $30,000? We make equal use of a city’s public services. Why should we be treated unequally? Well, we have become accustomed to paying an equal percentage of what we buy in the stores as a sales tax.

Why don’t we follow that same approach for income taxes? States like Colorado do charge the same rate of state income tax regardless of income. Is that fair? Some cities like Denver charge a head tax, a flat fee income tax for anyone who works within the district. Should we follow the same approach throughout the nation? Warren Buffett and I would pay the same amount in income taxes. Is that fair?

Should prices for public utilities be adjusted based on income? If my neighbor makes twice what I do, should they pay twice for the same amount of water? Currently, we are charged the same rate. The income and property taxes of those over 65 are often given a discount. In some districts, a person who reaches 65 finds that they can lower their property tax by 50%. Is that fair?

Elizabeth Warren, a candidate for the Democratic Party’s presidential nomination, proposed that all student debt be eliminated. Should students who went to more expensive private schools be rewarded more than students who borrowed less because they went to a state college? Should students who borrowed less because they worked part time while going to school be penalized? Is that fair?

In Matthew 20:1–16, Jesus tells a parable of the workers in the vineyard. Workers who came to work in the morning agreed to an amount of money for a day’s work. Workers who came to work later in the day were also promised the same amount of money for working the rest of the day. Jesus was making a point that each person will be rewarded equally in the kingdom of heaven no matter when in their lifetime they come to God’s love. No matter what your religious orientation, is that fair?

Each election we get to vote on what’s fair. Some people don’t vote because they say that their opinion doesn’t matter. It certainly doesn’t if they don’t vote so they have proved their case. If I vote and my neighbor doesn’t, my vote effectively counts double. In a few weeks, the Democratic primaries will start. The first two are in Iowa and New Hampshire, states with small populations and an even smaller number of people who participate in the caucus system. The votes of a few thousand people can make or break a candidate’s campaign. In a democratic nation of 320 million people, is that fair?

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Notes:

Bipartisan Policy Center (BPC). (2020, January 9). Deficit Tracker. [Web page]. Retrieved from https://bipartisanpolicy.org/report/deficit-tracker/

Farhi, P. (2017, October 5). Four years later, the IRS tea party scandal looks very different. It may not even be a scandal. Washington Post. [Web page]. https://www.washingtonpost.com/lifestyle/style/four-years-later-the-irs-tea-party-scandal-looks-very-different-it-may-not-even-be-a-scandal/2017/10/05/4e90c7ec-a9f7-11e7-850e-2bdd1236be5d_story.html

Heeb, G. (2019, November 19). The US could raise $1 trillion more in taxes through stricter IRS enforcement, according to a new study. Markets Insider. [Web page]. Retrieved from https://markets.businessinsider.com/news/stocks/us-could-raise-1-trillion-more-tighter-irs-enforcement-study-2019-11-1028700145

Photo by Maria Molinero on Unsplash

Pay Up

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February 10, 2019

by Steve Stofka

When I was growing up in New York City, each kid’s name was shortened to one syllable, two at the most. New York is a busy town; people didn’t have time to pronounce long names. Guillermo became Will or Bill.  An exotic name like Anastasia was shortened to a rather pedestrian Ann. Melodic names like Florinda became Flo. In a sign of the changing times, N.Y. Representative Alexandria Ocasio-Cortez has became known as AOC. That’s a generous three syllables!

She has proposed a 70% Federal income tax on Adjusted Gross Income over $10 million. That’s a straight 70% haircut on only the income above that threshold. Deductions, credits and favorable tax treatment for capital gains could apply to income below $10 million but everything above that is a bada-bing-bada-boom 70%.

How much revenue would that generate? I used IRS sample data from 2016, the latest available (Note #1) and calculated an extra $218 billion collected on 15,000 returns for tax year 2016 (Note #2). This would have been an additional 14% over the $1550 billion collected in individual income taxes that year (Note #3). It would make up for the corporate taxes that are not being collected because of the 2017 Tax Act.

If AOC’s proposal were passed by the House, it would not make it out of the Senate Finance Committee, which is controlled by Republicans. If it did become law, it would incentivize the accountants and lawyers of the super-rich to craft clever solutions to avoid the tax. Most of them can buy citizenship in another country. They can put income in tax havens (Note #4). They can make hefty political campaign contributions to buy loyalty in Congress.

The rich complain about taxes. Yes, they do pay much of the income taxes collected. It should be all of the income taxes. The 16th Amendment was “sold” to the American people as a tax that would apply only to the rich, the top 1% of incomes. When the amendment was passed in 1913, half of the population worked in farming and thought that the tax would never impact their lives. It didn’t until a few months after the U.S. entered World War 2.

Under FDR, the tax base increased ten-fold and now affected 42% of the population. FDR called it the “greatest tax bill” (Note #5). The American people didn’t think so. Many were not paying their income taxes. As the fate of nations lay bloody on the altar of history, FDR regarded tax delinquency as a personal disloyalty. He turned to economist John Kenneth Galbraith who suggested that employers should be forced to become the tax collector for the government. In 1943, Congress passed legislation requiring that employers withdraw taxes from their employees’ paychecks. Employing more than 7% of the workforce, the Federal government was the largest employer (Note #6). Before employees could feed their families or pay their rent, the government had its taxes.

It’s time for Democrats and Progressives to undo what they did under FDR. World War 2 ended 75 years ago. Let’s return to the original intent of the 16th Amendment and impose most of the income tax burden on the rich.

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Notes:
1. 2016 IRS tax data by adjusted gross income
2. A screenshot below of the IRS spreadsheet with my calculations of revenue collected.
3. A breakdown of 2016 federal revenue
4. The Rolling Stones, Bono, and Mark Knopfler of Dire Straits took advantage of tax havens to avoid paying hefty U.K. taxes on royalties
5. Highlights of IRS history
6. Federal Employees CES9091000001 series / PAYEMS (All employees) series in the FRED database

IncTaxbyAGI2016.xls

Tax Reform Is Calling

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by Steve Stofka

December 17, 2016

On our journey on the sea of life, we sometimes hear the siren call of politicians who promise simple taxes. “File your taxes on a postcard” their voices echo across the waters as they invite us to their island. Our journey is long and treacherous, so we are drawn to the prospect of simple tax filing.

Some taxpayer boats weave through the sharp rocks that lay just off the sandy shores of the simple tax island. They are greeted by the politicians who give them postcards to celebrate their arrival. Many boats are caught in the turbulent waters and are swallowed up by the tax monsters lurking in the sea.  “Alas!” they wail as they curse themselves for their attraction to the politicians’ call.

So the story goes with the tax bill that Republicans hope to pass next week. I didn’t think that the bill would get this far.

Many paycheck employees will find the new tax rule simpler. Student loan interest will continue to be an “above the line” deduction from income. The child tax credit will be doubled to $2000. To satisfy Republican Sen. Marco Rubio’s demands, more of this credit will be refundable to those taxpayers who pay little or no income tax.

Those in high tax states will suffer under the new tax bill, which allows only $10,000 in combined deductions for state, local and property taxes (SALT). Deductible mortgage interest will be capped as well. Tax policy has long subsidized homeowners over renters and favored those in coastal states (NY Times article).

Many taxpayers will find it more advantageous to take the newly doubled standard deduction of $24,000.  Under the new law, 529-college funds can now be used for K-12 tuition and qualified expenses.

Caught in the rocks and turbulent waters are professionals and business owners, who have adopted “pass-through” ownership structures to legally minimize taxes under current law. This group accounts for 30% of all business income. As this Journal of Accountancy article notes, court rulings and IRS guidance can be complex and contradictory. The new tax bill only complicates the familiarity of the existing complexity.

These non-paycheck earners receive all or part of their business income through a Sub-S corporation, an LLC, or partnership. Unlike a conventional C-corporation, these businesses “pass through” their profits to the owner/partners who pay at a personal tax rate. Under the new tax bill, some of that income may be subject to a 20% exclusion from taxes.

Under the new tax bill, the tax rate for C-corps will be reduced to 21%. Depending on individual circumstances, some owner groups may find it advantageous to adopt a C-corp ownership structure.

25 million sole proprietors  account for 11% of non-farm business income. Many are low-profit or part-time businesses which will remain sole proprietors. Higher volume businesses may want to revisit their ownership strategies with their accountants.

Corporations will benefit from the reduced tax rate but the accountants for publicly held corporations are dreading the prospect that the new tax law will be signed before the new year. Under GAAP accounting rules, those corporations must estimate the effect of the tax changes and present those estimates at the next earnings announcement which are scheduled for late January or February. Number crunchers can cancel that Cabo vacation during Christmas week.

The rich benefit because they pay an outsize portion of income taxes. According to the IRS (2016 tax stats on this page) , taxpayers with adjusted gross incomes (AGI) above $500K were only .8% of the 150 million individual returns. Their AGI was 19.4% of the $10 trillion in income reported, but they paid 36.5% of the $1.4 trillion in Federal income taxes.

TaxSumByAGI2016

These high incomes will get a reduction in taxes from 39.6% to 37%. The very rich – those with an AGI above $10 million – get half of their income from capital gains, which are not affected by the new tax law. Despite promising to do so, lawmakers did not reduce or repeal the 3.8% Obamacare tax on investment income for high income taxpayers. Based on 2016 tax data, they probably could not forgo the tax revenue and keep the ten-year cost of the bill under $1.5 trillion.

In short, the new bill will create two classes of taxpayers – the postcard and non-postcard payers. Some tax preparers and accountants may worry that the new law will reduce their business. Rest assured – Congress does not know how to write tax laws that are not complex. Thank God for politics!

Rocky Tax Road

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November 19, 2017

The House passed a tax cut bill this week as the Senate Finance Committee passed a separate version that must still go to the full Senate for a vote. There’s a hard road ahead for this bill to reach the President’s desk.

The Process…

The full Senate will take up the bill after Thanksgiving. If the Senate passes the bill, there are still more steps. Bills submitted by Congress must have identical language from both the House and Senate.

The House passed its tax bill first, so the Senate could adopt the House version and approve it. Highly unlikely. If the Senate passes a bill, both bills will likely go to a House-Senate conference committee to resolve differences in the two bills and produce a unified bill. The Republicans will hold a majority on that committee and do not need Democratic votes.

If the committee can produce a unified bill, it will be sent to the House and Senate for a vote. If either body rejects the bill, it can be sent back to the joint committee, but that rarely happens. The bill would be effectively dead.

Republican leaders regard passage of the bill as critical to the 2018 Senate races. After the Republican majority failed to pass a health care bill earlier this year, big dollar donors have advised party leaders that they are closing their wallets if the party cannot pass a tax bill. Fundraising for the 2018 campaigns kicks off in a month.

The Provisions…for business

Both bills cut the corporate income tax to 20%. Both bills will tax pass-through and passive income at 25% or 32%.

Pass-through income consists of profits earned by businesses that flow to the business owner as personal income. Half of all pass-through income goes to the top 1% of incomes.

Passive income can be the profits from rental property, or dividends paid by an REIT (Real Estate Investment Trust). Under current law, such income is taxed at personal rates as high as 40%.

Republican Senator Ron Johnson opposes the bill as it came out of the Finance Committee. The bill gives an estimated $1.3 trillion in tax cuts to corporations, more than three times the $362 billion in tax cuts to taxpayers with pass-through income. Each sector currently pays half of the taxes on business profits. Small businesses and farmers get 25 cents of the tax cut dollar, while big corporations get 75 cents.

With only a two-person majority, Senate Republicans cannot afford to lose more than two votes and pass this bill. Susan Collins from Maine, a state dominated by small businesses, has echoed Johnson’s objections. Rand Paul from Kentucky says he will not vote for a bill that increases the deficit, which this bill does. Unless there are some key changes made to the Senate bill during the Thanksgiving break, the bill is unlikely to pass.

Both bills keep the 1031 exchange clause which allows real estate owners to avoid capital gains taxes on the sale of a property when they reinvest the gains in a similar class property. Owners of equities do not enjoy this tax subsidy. An investor who sells a stock, mutual fund, or ETF must pay any capital gains even if the investor buys another equity with the gains.

The Provision…for individuals

The House bill promises to save a median income family $1182 in taxes. Not about $1200. $1182. The precision of that number indicates that it is more a selling tool than a reality. The Senate version will likely tout something similar.

Half of taxpayers will notice little change in either bill because they pay almost no income taxes. Both bills retain the Earned Income Tax Credit (EITC). Lower income taxpayers will see no relief from the bite of FICA taxes.

The standard deduction is doubled but personal exemptions are eliminated and the child tax credit is increased by $600 per child but only for five years. Have you got that? Paul Ryan, the House Majority Leader, assured us that the tax bill would be simpler. Sound simple to you?

The Senate bill includes a repeal of Obamacare penalties for not having health insurance. Oddly enough, this saves the government $332 billion over ten years. Wait, how does that happen? The Congressional Budget Office (CBO) estimates that many younger people who would be eligible for subsidies under Obamacare will simply forgo insurance if the penalty is eliminated. Republican leaders get two birds with one tax stone. Senators can register their disapproval of the most hated part of Obamacare and the savings enable the Senate bill to meet the deficit requirements under reconciliation rules.  These rules allow the Senate to pass legislation with a simple majority.

As I noted two weeks ago, both bills eliminate or reduce the current deduction for state and local taxes (SALT). High tax states like California, New York, New Jersey, Connecticut and Massachusetts have no Republican Senators. If Republican leaders lose the votes of Johnson, Collins and Paul, they would have to reinstate a full SALT deduction to have any hope of gaining one or two Democratic votes.

The Senate eliminates the SALT deduction entirely and uses the tax money to continue the deductions for medical expenses, student loans, mortgage interest and charitable donations. The House bill eliminated these deductions but allowed some SALT deduction in order to appease Republican House members from high tax states.

The House bill simplifies the tax brackets from the current seven to four. The Senate version has seven brackets.

The Conclusion…

Imagine a rough dirt road after a lot of rain. The tax bill has just turned off the paved highway and onto the dirt road. Expect a lot of muttered cursing, pushing and digging to move a tax bill to its final destination, the desk of President Trump.

 

A Proposal

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May 28, 2017

The Republican led Congress has promised tax reform in the coming year.  This week I’ll introduce an income tax program that I think will clarify the debate.

Let me begin with those on the left side of the political aisle who talk about the rich paying their fair share.  The kernel of the Democratic social plan is a promise to take care of the poor by giving them benefits. Even if I don’t get any of those benefits, I like voting for politicians who help out the poor because I’m a good person.

If I ask House Minority Leader Nancy Pelosi or Senate Minority Leader Chuck Schumer “Where should the money come from?” they answer “People with too much money.” Nancy and Chuck know which people have enough money and which ones have too much.

BBLR has long been a rallying cry for those on the right. The acronym means “broaden the base, lower the rate.” As Majority Leader in the House and as Vice-Presidential candidate, Paul Ryan has espoused this philosophy. Here is a PolitiFact article on the issue during the 2012 presidential race. Tax reform champion Grover Norquist has advocated for the same principle.

The term “broaden the base” means to have more people paying at least some income tax so that they have skin in the game, so to speak. In a very progressive tax system, people who pay little or no taxes will vote for politicians who promise them benefits. After all, it is OPM, or other people’s money. In Democratic circles, BBLR stands for a mean tax system. Here’s the debate between Nancy and Chuck on the political left, and Paul and Grover on the right:

Paul and Grover: A minority of people are being forced to pay for federal programs that benefit other people who pay almost nothing into the system.  Those people will vote for more programs because it costs them nothing.

Nancy and Chuck: Republicans are bad people because they want to tax poor people. Poor people already pay Social Security and Medicare taxes so they are paying into the system.

Paul and Grover: Medicare and Social Security taxes are essentially forced saving programs that will return that money to the taxpayer in the future. Payroll taxes do not support the other functions and expenses of government like defense and the justice system.

Nancy and Chuck: Those taxes all go into the same pot.

Paul and Grover: Democrats have always been careful to separate Social Security and Medicare programs in their rhetoric. You champion the preservation of these programs as though they are separate. You can’t have it both ways. Either they are separate or they are not.

Nancy and Chuck: You Republicans are really mean and you are pawns of rich people.

These debates usually end in name calling, particularly during election season.  Some of the rhetoric is political branding but each side remains convinced that their way is the best way.

Let’s turn to recent history and take the chance that facts might get in our way. The non-partisan Congressional Budget Office (CBO) routinely analyzes proposed House and Senate laws for their estimated impact on the budget. In this report the CBO separated income, government transfers and taxes paid into income quintiles. (Click here if you want to know more about a quintile).

CBOIncTaxQuintile2013

In the table above, the lowest and highest quintiles received the least amount of money in government transfer payments like Social Security. The highest quintile had ten times more before-tax income than the lowest quintile but paid 87 times more tax than the lowest quintile. Notice that the CBO analysis includes all taxes paid to the federal government, including Social Security and Medicare.

Pretend you are a reporter. Ask House Minority leader Nancy Pelosi “How much more should the rich pay than the poor, Ms. Pelosi? If 87 times is not fair, what is fair? 100 times? 200 times?” Each of us is an expert on what “fair” means.

In the past 35 years, despite all the rhetoric, state and federal policies have had only a small effect on income inequality. The GINI index is a standardized measure of the inequality in a data set. The scale runs from zero, perfect equality, to one, or perfect inequality. The CBO report showed a 35 year history of the separate effects of benefit and tax policies on inequality. In 1980, tax policy reduced inequality by 10%. 35 years later, the reduction was 9%. Despite major tax reform in 1986, the tax increases of the early 1990s and the tax decreases of the early 2000s, tax policy has had little to no effect on inequality.

CBOGiniIndexChange

Changes in social policy that directs government transfer payments have helped ease inequality in the past 35 years, but the CBO analysis finds the combined change from tax and benefit policies negligible. They reduced inequality by 25% in 1979. 35 years later the total reduction was 26%. The difference could be a measuring error.

Tax reform is tough because it involves contentious issues. We argue about tax rates and the income brackets for those rates. We argue about deductions and tax credits. Like pornography, we may not be able to define “fair” but each of us knows it when we see it. We can agree on what “cat” means but not “fair.”

I propose something different, something that will give us less to argue about. Let’s recognize that there are socio-economic classes and assign a portion of federal tax revenues to each income quintile. Using the CBO’s analysis, the 1st and lowest quintile paid 8/10ths of 1% into the kitty. It is such an insignificant amount that we might has well make it zero. What this means is that poor people would pay no income tax and no payroll tax. Paul Ryan led the effort on last year’s Better Way tax proposal which included the same concept:  poor people should pay nothing.

If we can agree on that, we have four things left to argue about: the percentages that each of the remaining four quintiles would pay. Let’s begin the discussion by looking at the CBO analysis of the federal revenue “pie” in 2013.. The second lowest income quintile #2 paid 4% of total individual federal income and payroll taxes, the middle quintile paid 9%, quintile #4 paid 17-1/2%, and the top #5 quintile paid 69-1/2%. I rounded the percentages.

There will be a fight over these percentages but we will be fighting over four concrete numbers, not 100 million interpretations of what the word “fair” means as it relates to thousands of pages of tax code. Once that portioning is settled, a bipartisan committee representing each quintile can argue over the details of how they raise their portion of the anticipated revenue.

Taxpayers in the highest quintile may want tax breaks for angel investors who invest in early startup companies. Sounds like a worthy cause. The members of that quintile’s committee can argue amongst themselves as to whether they can afford to carve out tax breaks for that subgroup and still raise the required revenues. Should some of the income of hedge fund managers be taxed at a lower rate like capital gains? Under the current tax system, that is an emotional issue. Why should those guys get a special interest tax break? Under this proposal, I don’t care because I’m not in that quintile. A hot button issue turns into a yawner for most Americans.

A majority of taxpayers in the middle quintile might want the mortgage interest deduction. Those people can put political pressure on that quintile’s committee members to include that carve out. The majority in the next lower quintile might prefer tax breaks on child care. Should capital gains be taxed at a lower rate? This group has little in the way of capital gains so they might prefer that all income be taxed the same. Those in the lowest three quintiles who pay small tax percentages might be attracted to the simple grade school arithmetic used by some states to calculate their state income tax. Adjusted gross Income x 10% = $tax, as an example. Tax filing made simple.

Could this proposal make the tax code more complicated than it already is? Yes, but most of the complications won’t affect each person. Under the current system, my tax software asks me questions about tax credits and situations that have nothing to do with me or my family. Why? Because all of the tax code applies in theory to all of us. Under this proposal, my tax software would know what quintile I was in and the tax rules that applied to me and my family.

But what if people move from one quintile to another? How will they plan? Incomes do change. A person gets a raise, a better job, goes to school, loses a job or retires. A simple rule would help: a person’s quintile this tax year is based on their income the previous year.

The setting of the quintile brackets could be done by another simple rule. The IRS can not provide summaries and analysis of tax data for a particular tax year till about two years have passed. Each year we could adjust the income brackets of each quintile by the annual inflation rate based on the most recent tax year data available.  Families with fairly predictable income will know in advance what their tax expense will be in the coming year.

What about the Earned Income Tax Credit (EITC) program for poor people? This program largely offsets the payroll taxes that poor people pay with tax credits paid directly by a person’s employer. The program is fraught with abuse. Under this proposal, payroll taxes for the lowest income workers are eliminated so the offsetting tax credits aren’t needed.

Will those workers in the lowest quintile still be eligible for Social Security?  Sure.  There is still a record of their labor income, which is the basis for determining Social Security payment amounts.

Tax reform has come infrequently because the tax code tries to be all things to all people. The top 40% pay most of the individual income taxes so naturally they lobby for special interest tax breaks which are slipped quietly into the tax code.  Under this proposal, those special interests can lobby all they like, just as long as they meet their revenue targets.

Is it fair that someone making a half a million dollars gets a tax break on their vacation home on the Outer Banks in North Carolina? Of course not. Under the current system, I get angry about that. Under this proposal, I simply don’t care. If that person is getting a break, some other equally rich person is having to pay for that tax break. None of my business.

As it is now, we struggle to understand the various tax proposals. Politicians talk in non-specific terms about what is fair, or they speak in slogan tax talk like BBLR. Tax reform rhetoric has become a rallying cry to get out the vote.

This proposal will not stop the political fights. We will continue to debate the amount of  federal spending, the role of government and what tax revenues should be spent on. We will fight bitterly about the percentages of tax revenue expected from each quintile. But this proposal will direct the debate to specific percentages that most of us can understand. So let’s put on our debating gloves and get into it!

 

 

January Employment and Economic Production

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February 9th, 2014

The ISM manufacturing report for January reported a severe decline from the robust readings of past months.  New orders suffered the most, dropping from a strong reading of almost 65 in December to just a bit above the neutral reading of 50.  Prices jumped significantly.  Manufacturing’s drop off in new orders comes on the heels of a similar decline in the service sector in December.  This is the third report in the past thirty days that came in below even low estimates, the other two being pending home sales and December’s employment gains.  At mid week, ISM released their January estimate of the health of the service sector which is the bulk of the economy.  Happily, this showed continued growth, helping to offset concerns about a broad slowdown in the economy.

The CWI that I have been tracking continues to show an overall strength, declining slightly to 58 from the rather vigorous reading of 60 last month.  As I noted a few weeks, this index anticipated a winter lull before picking up energy again in early spring.

A reader had difficulty understanding the wave like graph of the CWI.  I indexed it to a starting base then indexed that to the SP500 average in 1997.  Perhaps this will help visualizing the long term response of the SP500 to underlying economic activity.

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ADP reported a gain of 175,000 private jobs in January, below the strong 227,000 job gains of December.  There was only a slight revision to ADP’s previous report, confirming the suspicion of some that the greater flaw lies in the BLS figures for December.

On Friday, the Bureau of Labor Statistics (BLS) released their estimate of 113,000 job gains in January, far below the consensus of about 180,000.  Here’s a story from the Atlantic that captures some of the highlights.  Forgive some of the misspellings, if they are still there by the time you read it.

As I did last month, I’ll show the average of monthly job gains estimated by the BLS and ADP.  ADP does not report government jobs so I’ve just added those in from the BLS report.

The decline below the replacement level of 150,000 may be a temporary response to severe weather conditions in the populous east coast and Chicago region.

The market responded quite favorably to this labor report. A slackening labor market prompted hopes that the Federal Reserve will not accelerate their easing of bond buying.  A large revision of job gains in November was a big positive in the report.  Another positive was the half a million increase in the core work force, those aged 25 – 54.  Men accounted for most of this increase.

The number of people working part time because they can’t find a full time job dropped by a half million but there are still more than 7 million people in this situation.  A 232,000 decrease in the number of long term unemployed was heartening although many lost their unemployment benefits at the end of the year and may have had little choice but to take whatever job they could find.

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Doug Elmendorf is the head of the Congressional Budget Office (CBO) that advises the Congress in constructing the budget, making appropriations, and the anticipated or actual economic effects of policy.  In advance of his testimony before the House Budget Committee this past week, the CBO released the highlights of their report. Some talk show hosts and conservative media were trumpeting a loss of 2.3 million jobs due to Obamacare.  In his testimony, Mr. Elmendorf explained that the 2.3 million jobs mentioned in the CBO report are not lost jobs because the CBO does not estimate any reduction in the demand for employees because of Obamacare. The CBO estimated the number of hours that employees would voluntarily reduce their hours in order to meet qualifications for subsidies under Obamacare and divided those total hours by what a full time employee would work in a year.  Since there is a surplus of labor in this country, this voluntary reduction would help those who are either looking for a job or want to work more hours.  The CBO sees no impact on part time jobs that can be attributed to Obamacare.

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Republicans and some Independents have repeated the claim that the rich are paying most of the personal income taxes in this country. IRS 2010 data (Table 2 ) doesn’t seem to support that contention.  The top 5% of taxable returns with taxable incomes greater than $200K had taxable income of $1.9 trillion, or 36% of the total $5.3 trillion in taxable income.  On that income, the top 5% paid $513 billion in Federal income tax, 49% of the total.  In a flat tax system, the top 5% would have paid a bit more than $360 billion.

When Republicans use the code words “broaden the tax base” what they mean is that they want a flat tax so that rich people pay the same percentage of tax as poor people.  Several states have such a flat tax system.  To Democrats, a broadening of the tax base means making more of the income of rich taxpayers subject to progressive tax rates.

When Democrats use the code words “paying their fair share” they mean that the rich should pay proportionately more than the additional load of about 32% that they are currently paying.  To Republicans “fair share” means a flat tax.

What the IRS data shows is that the rich are not paying most of the income taxes in this country.  Often tax policy and social benefit programs are lumped together, confusing the issue in the minds of many.  The Tax Foundation did an analysis of the net benefit and expense of taxation and benefit programs.  They report that:

As a group, the bottom 60 percent of American families receive more back in total government spending than they pay in total taxes.

Government tax and spending policies combine to redistribute more than $2 trillion from the top 40 percent of families to the bottom 60 percent.

The methodology that the Tax Foundation uses presumes that everyone benefits equally from public spending like defense, police and the courts.  An alternative assumption that people benefit according to their income results in a $1.2 trillion redistribution, about 40% lower, according to the Tax Foundation.  (Kudos to the Tax Foundation for making both computations.)

What the report does not do – because it is just so hard to do – is calculate age and circumstance related movements of taxpayers from the top 40% to the bottom 60%.  Consider a taxpayer – I’ll call her Linda – making $100,000 who is in the top 40%.  She loses her job and starts collecting unemployment for several months.  Her income now puts her in the bottom 60%.  “Past Linda” was supporting the bottom 60% but “present Linda” is now part of the bottom 60%, according to the methodology used by the Tax Foundation.  Yet if we isolate this one taxpayer, we can say that “past Linda” was actually supporting “present Linda.”  When Linda was making $100K, she presumably paid a lot in income and other taxes, including unemployment taxes paid by her employer.  The Federal Government does not keep records that would allow this kind of inter-temporal analysis.  As a result, we get a distorted view of what is actually happening.

Let’s look at an older taxpayer – I’ll call him Sam – who retires.  Sam was making $80K before he retired and was in the top 40%.  With social Security income and income from savings, Sam now makes $36K in retirement, which puts him in the bottom 60%.  Is Sam being supported by the top 40%?  Statistically he is.  However, most of us would say that Sam is simply living off the benefits that he paid into during his working life.

I appreciate the exhaustive work that the Tax Foundation does but the problem is more complex than they present.  Furthermore, many people are not aware of the difficulties and complications of calculating who supports whom.  Some use this analysis to present the case that the majority of Americans are sucking on the teats of the few well off.  Presidential contender Mitt Romney’s unguarded comment about “the 47%” who are living off the efforts of others did not serve him well in the past election yet a sizeable percentage of voters believe this.

The 16th Amendment passed a century ago allowed the Federal government to tax the income of individuals directly and it was intended to be progressive.  Relatively few paid any income taxes in the first decades after the enactment of the income tax.  Whether one likes the progressivity of the tax code, one has to recognize that the law was intended to be that way when it was passed.

I would like to see the repeal of the 16th Amendment for two reasons: 1) protect individuals from the power of the Federal government; 2) slow the consolidation of money in Washington.  Money brings power and power begets patronage, if not downright graft.  We can never get rid of patronage, only retard the concentration of patronage. Studying 5000 years of history, we have learned that the concentration of power in any political institution ultimately leads to the downfall of that institution.  Only corporations can exist with such a concentration of power and even they sometimes fall when top leadership in a company becomes resistant to change.

Perhaps we could adopt a taxing system where the Federal government taxes the states based on the population in each state.  If a state has 10% of the country’s population, then they would owe 10% of any tax used to replace the current income tax.  Let the states determine how they will collect the money.  Racism has been a constant nemesis of this country and legal protections could be enacted which would prevent states from taxing citizens based on race or sex.  Head taxes have a tawdry reputation because they were often used to disenfranchise poorer voters.  If the population count of a state was simply used as an allotment mechanism and not applied directly to each citizen, I think that this could be a fairer and safer system of taxation.  Certainly, legislation could be passed preventing the denial of rights to a citizen based on a tax.

Could Doug Elmendorf and his cohorts at the CBO build a model based on such a system?

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Tidbit:

And we’re talking about nine million individuals who are eligible for both Medicare and Medicaid. They are responsible for a significant amount of spending in both programs — approximately 46% of Medicaid and close to a quarter of Medicare spending annually.  Estimates range that that is anywhere from 300 to $350 billion a year total that we’re [CMS] spending. 
Melanie Bella, Director of the Federal Healthcare Office at the Centers for Medicare and Medicaid Services, Federal Coordinated Healthcare Office Conference 11/1/2010

Gimme More Government Limits

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Many companies do not want limited government.  A smart company dumps as many costs as it can into the public sector, thereby increasing its profits.  WalMart is one such smart company, going so far as to provide their many low paid employees with literature on government social programs that will help the employee cope with the low wages WalMart pays.  Smart companies crusade local governments to upgrade their fire departments and the delivery pressures of their water systems in order to save the company money on its business insurance.  The cost is shifted and spread out to the public and the owners of companies in the upgraded area put the profits in their pocket. Smart established companies like regulations which establish a barrier to entry for their competition, particularly in businesses that have low capital requirements to start up.  Smart companies lobby local and state governments for more licensing laws which present one more cost and regulatory hurdle for small businesses trying to gain a competitive foothold in an industry.  Smart companies argue that licensing is needed for public safety.  Would you want an unlicensed fishing guide?  Of course not!  Here is a partial list of occupations requiring a state license in my state.

The IRS is now requiring most tax preparers to be licensed as a Registered Tax Return Preparer, which includes “competency tests for all paid tax return preparers except attorneys, certified public accountants (CPAs) and enrolled agents who are active and in good standing with their respective licensing agencies.” (IRS Source)  How many independent tax preparers who do tax returns for a few months a year will bother with the cost and time to establish and maintain their credentials?  Many low income workers, especially those with marginal reading skills, feel more comfortable having a tax preparer fill out the amount of their W-2s and do the relatively simple calculations required to file the short form 1040A.  The IRS could have exempted those preparing 1040As, but it didn’t.  Did the IRS enact these regulations in response to a law passed by Congress?  No.  Surely the IRS must have studied this problem for several years before issuing these new regulations?  The IRS spent all of six months before issuing these rules.  One can only wonder who and what prompted such a swift review and enactment of these regulations.  The logic is the oldest one in business:  reduce the supply of preparers and those that remain can charge higher fees.

I am not a tax preparer so I don’t have a dog in this fight.  I’m sure there are instances of tax preparers filing more complex tax returns which the preparer does not have the knowledge to prepare.  But why use an axe when a paring knife will do?  The only solution may be tax reform, the holy grail of simplicity and practicality that continually eludes our elected representatives.

Income Tax and the Constitution

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The Constitution of the United States was designed to protect the individual states who feared the power of a large central government.  In keeping with that design, the Constitution enumerates the various powers of the Federal Government. This past week a majority of the Supreme Court decided that the health care law known as Obamacare was constitutional, basing its decision on the taxing power granted by the Constitution and the 16th Amendment.

A fundamental presumption of writing the Constitution is the self-preservation of the new nation as such.  Various powers of defense, the ability to make war and treaties with foreign countries are some of the enumerated powers granted to the Federal Government to ensure the country’s continued existence.  What is not enumerated but assumed is the right, the duty of the Federal Government to protect the country as a whole.  At a time of armed conflict within a fractured nation, President Lincoln understood this point more clearly than most – that the utmost responsibility of a President is not spelled out in the Constitution that he had sworn to uphold.

There are two common faults that have caused the downfall of all nations, particularly nation empires: 1) the internal struggle for power by factions; and 2) the inexorable concentration of wealth and property.  The second leads to the first.

In the Federalist Paper No. 9, Alexander Hamilton wrote “It is impossible to read the history of the petty Republics of Greece and Italy, without feeling sensations of horror and disgust at the distractions with which they were continually agitated, and at the rapid succession of revolutions, by which they were kept in a state of perpetual vibration, between the extremes of tyranny and anarchy.”  Periods of calm within those empires were short-lived, “soon to be overwhelmed by the tempestuous waves of sedition and party-rage.”  As we look at and listen to the debates regarding health care, what do we see?  Party-rage.  Day after day, proponents on both sides of the issue make claims that are either blatantly untrue or a tortured stretching of fact.  There are so many dubious claims that reporters at Politifact.org  can only examine the more widely spread claims.

In Federalist Paper No. 10, James Madison, the chief constructor of the Constitution, wrote: “Among the numerous advantages promised by a well constructed Union, none deserves to be more accurately developed than its tendency to break and control the violence of faction.”  Further, he writes “Complaints are every where heard … that the public good is disregarded in the conflicts of rival parties.”  He explained what he meant by the word faction: “By a faction, I understand a number of citizens, whether amounting to a majority or minority of the whole, who are united and actuated by some common impulse of passion, or of interest, adverse to the rights of other citizens, or to the permanent and aggregate interests of the community.” 

What is to be done?  Madison wrote “There are two methods of curing the mischiefs of faction: the one, by removing its causes; the other, by controling [sic] its effects.  There are again two methods of removing the causes of faction:  the one by destroying the liberty which is essential to its existence; the other, by giving to every citizen the same opinions, the same passions, and the same interests.”  The first of these methods is undesireable; the second is impractical. Madison concluded “The latent causes of faction are thus sown in the nature of man.”  He does not condemn people for this tendency to form factions; a well constructed government must deal with this part of man’s nature.

Madison saw “A zeal for different opinions concerning religion, concerning Government, …an attachment to different leaders ambitiously contending for pre-eminence and power [who] have in turn divided mankind into parties, inflamed them with mutual animosity, and rendered them much more disposed to vex and oppress each other, than to co-operate for their common good.  So strong is this propensity of mankind to fall into mutual animosities, that where no substantial occasion presents itself, the most frivolous and fanciful distinctions have been sufficient to kindle their unfriendly passions, and excite their most violent conflicts.  But the most common and durable source of factions, has been the various and unequal distribution of property.  Those who hold and those who are without property, have ever formed distinct interests in society. [Many different interests] grow up of necessity in civilized nations, and divide them into different classes, actuated by different sentiments and views.  The regulation of these various and interfering interests forms the principal task of modern Legislation, and involves the spirit of party and faction in the necessary and ordinary operations of Government.” [emphasis added]  These astute observations by Madison are true today just as they were two hundred years ago.

In its own self-preservation, a government must ameliorate the “unequal distribution of property” which Madison considers to be the chief cause of factions.  How is a government to do that and preserve the respect for property rights that Madison and the framers deemed essential to a free people?  Madison wrote “From the protection of different and unequal faculties of acquiring property, the possession of different degrees and kinds of property immediately results: and from the influence of these on the sentiments and views of the respective proprietors, ensues a division of the society into different interests and parties.”  As with factions, this contradiction is an essential process of being a free people.  To use the same sentence construction as Madison: there are two methods for removing the causes of the concentration of wealth and property:  the one, by abolishing individual property rights which are essential to a nation of free people; the other, by giving every citizen the same amount of property.  The first is undesireable; the second invalidates the first principle and impractical, as Communist societies discovered.

A well constructed government uses its taxing authority to fund its operation and control the inevitable concentration of wealth and property. Many conservatives of today argue on principle that government’s role is not to transfer wealth from one person to the next.  They ignore the history of the decline of many nations whose wealth concentration reached a critical mass that ignited revolution.  They forget that the first principle of a nation is its own preservation; that a nation MUST transfer enough wealth to slow its concentration among a small portion of its citizens.  By its very nature, a property or income tax takes, by threat of force, the property of a person.  The principle of respect for individual private property rights can not be sustained in the ideal if a nation is to survive.

The income tax, or 16th, amendment was “sold” to the state legislatures as a way to tax corporations and very wealthy individuals.  For corporations, the income tax was to be an excise tax or a fee for the exemption from liability that a corporate structure afforded its stockholders.  Today many conservatives advocate a flat tax or a less progressive tax rate structure, citing the uneven distribution of the tax burden on the rich.  When the legislatures voted on this amendment, they did so on the premise that almost all people would not be subject to the income tax.   Corporations and those with extremely large incomes were to shoulder the entire burden of the income tax.  Those state house members who voted for ratification would be shocked that the top 1% of income earners paid only 38% of the personal income tax collected in 2008 (National Taxpayers Union).  They would be indignant that corporations paid only 22.1% of the combined total of personal and corporate income taxes collected in 2008 (IRS Statistics  Table 1).  When the 16th Amendment was sold to the American people in 1910 through 1913, these two groups combined were to shoulder most, if not the entire, burden of the income tax.  In 2008, they paid a little less than 52%.

In the coming months billions of dollars will be spent to sway or negate our vote.  The people and corporations who spend these vast amounts of money will try to convince us that we should vote a certain way on principle, out of loyalty to a particular ideal, party or policy.  Those who spend this money are not evil – they are simply promoting their own interests, hoping that they will convince each of us that we share an interest with theirs.  Given a choice of two competing parties, some voters will be undecided, feeling lukewarm or conflicted about the interests of either faction.  We may wish for some alternative to these dominant factions, or a menu where we could pick and choose the narrow interests that most closely align with ours.  It is the nature of mankind that we can not either live or vote in the ideal; that we must make compromises and choose the faction which most closely aligns with our interests.

From the beginnings of this nation, parties have arisen, trying to wrest control of the government, hoping to grab control of its power for their own self-interest.  For its own self-preservation, a well constructed government MUST constantly strive to distribute competing interests and power; since money and property form the core of power, a government must spread just enough money from the richest of its citizens and corporations to the rest of its citizens.   How well a government can do so determines whether the nation survives.