Friday, January 23, 2009

Tax planning for the rich and the poor

Professor James Maule comments on the tax-planning options available to high-income taxpayers

The fact that "high-income households tend to be fairly adept at arranging their affairs to avoid paying tax," though true, ought not dissuade Congress and the new Administration from making that adeptness a useless skill. High-income individuals have this adeptness for several reasons. First, they can afford to hire people willing to craft tax avoidance schemes. Second, they can afford to enter into arrangements from which typical taxpayers are excluded because they lack funds. Third, they can afford to contribute huge sums to political campaigns, thus acquiring a louder voice in the democracy than has the typical citizen. Fourth, they benefit from existing tax loopholes, tax breaks, Code complexity, and IRS inability to defend the Treasury.

The answer is simple, though surely unpleasant. Eliminate deductions for tax advice fees. It's bad enough people pay for advice on how to escape civic duty, but it adds salt to the wound to finance those expenditures through a tax deduction. Make it more difficult for these folks to stash their funds into tax shelters by leaving them with fewer dollars to use as tax avoidance tools. In other words, increase the marginal rates on incomes over $1,000,000, ideally in progressive stages. Require total transparency with respect to campaign contributions, revealing the names of those who contribute to PACs, foundations, and other conduits used to funnel money into campaigns, and publish the lists on April 13. Clean up the tax law, removing the loopholes, breaks, and complexities that provide cover for the tax avoidance merchants. Increase funding for the IRS so that it can track down and deal with tax shelter promoters, offshore schemes, fraudulent returns, and other gimmicks used to make a person with high income pay taxes at rates lower than those imposed on the middle and lower income echelons.


The tax planning options available to low-income taxpayers present a stark contrast to those of high-income taxpayers. Ironically, as we have seen, some low income taxpayers actually face effective marginal tax rates as high or even higher than those of the rich. (Of course, the effective AVERAGE tax rates of low income taxpayers are generally lower than those of the rich, but it is the effective MARGINAL tax rate that matters for incremental tax planning decisions.)

Our Union College Volunteer Income Tax Assistance (VITA) site serves working families and senior citizens with incomes of up to $40,000. Some of our low-income taxpayers face challenges including disabilities or English as a second language, which make understanding the tax code far more challenging than for, say, someone like Treasury Secretary-designate Geithner. In recent years, low income taxpayers have also been more likely to be audited than the rich. The tax system our clients face is complicated and they don't have the money to pay for high-powered tax advice to help them navigate it, so my economics students and I, supported by IRS SPEC training, software, and support, do the best we can to help them file their tax returns accurately.

The marginal tax rates that low income taxpayers such as our clients face are an unpredictable crazy-quilt patchwork that makes any kind of rational tax planning for the future extremely challenging.

One year a low-income taxpayer may be facing an effective marginal tax rate of up to NEGATIVE 40% due to refundable credits such as Earned Income Tax Credit and the Additional Child Tax Credit. State refundable credits can further amplify this effective negative marginal tax rate.

The following year that very same taxpayer could face a POSITIVE effective marginal tax rate much higher than even the wealthiest taxpayers, due to the phase-outs of refundable credits combined with the statutory tax rates and FICA taxes.

Why such a difference from year to year?

It could be a child turned 17, 19, graduated, or moved out of the taxpayer's home to live with another relative. Or maybe the taxpayer took on a small part-time job that pushed the income a few thousand up, just enough to move from the phase-in to a phase-out portion of the Earned Income Credit schedule. Or perhaps the taxpayer got married (marriage can often be a tax disaster for some low income taxpayers, although it can generate tax bonuses for other low income taxpayers!.)

State refundable credits as well as means-tested programs such as Medicaid, Section (8) housing subsidies, heating assistance, etc. can further amplify the federal marginal tax rate to the point where the total effective marginal tax rate may exceed 100% for some low-income families.

Furthermore, many of the much-vaunted tax breaks built into the tax code to encourage education, home ownership, charitable donations, energy consevation, etc. generally have little or no impact for low-income taxpayers.

Such taxpayers hopefully bring their proverbial "shoebox full of receipts" into their tax preparer's office and watch him enter all that information into a tax software program, but all too often, there is no actual net impact of those supposedly "tax-favored activities" on the taxpayer's tax liability or refund. Commercial preparers may charge them substantial fees for entering all this information into the relevant tax forms, but all too often, low-income taxpayers will discover that their expenses and record-keeping efforts to deal with those special breaks were a pure waste of their money and time. Moreover, since low-income taxpapers rarely get any incremental tax breaks for itemizing miscellaneous deductions, the deductions for tax preparation fees will almost always be worthless to them.

At our VITA site, we are happy that we can provide a free service to "crunch the numbers" for the taxpayers to find all possible legal tax provisions to help our taxpayers on their 2008 tax returns, but we are generally unable to provide much helpful tax planning advice for the future, due to the unpredictable crazy-quilt of marginal tax rates, both negative and positive, that our clients face.

The chaotic provisions of the tax code combine with uncertainties about the taxpayer's 2009 income and family situation which can frequently leave us unsure even about such basic questions as to whether the taxpayer will face a negative or a positive effective marginal tax rate next year, let alone predict the incremental impact of whether paying college tuition, putting money into a flexible spending medical or daycare account, or saving for retirement will increase or decrease their tax refund or tax liability next year. And telling them whether getting married will increase or decrease their tax liabilities in the future is definitely "above our pay grade," as the saying goes, because there are so many interacting complex features of the tax code as well as uncertainties about future earnings and unearned income of both spouses, whether custodial living arrangements of children from prior marriages will change, etc.

The bottom line: the tax system is too complicated and creates too much uncertainty for everyone. The poor face more uncertainty than the rich.

Due to the AMT and/or clawbacks, a high income taxpayer may be unsure whether his 2009 effective marginal tax rate will be somewhere in a range from 28% to 40%. (But a high-paid tax law expert will be happy to fine-tune that estimate.)

But a low-income taxpayer may be unsure whether his 2009 effective marginal tax rate will be anywhere in a range that extends from negative 40% (or even lower when state refundable credits are taken into account) all the way up to over positive 100% (when all means-tested programs are taken into account.) (And I suspect even the highest-paid and most knowledgeable tax law experts would throw up their hands and say, "That's above my pay-grade," if asked to provide a prediction which could narrow the uncertainty range to a 12% band for the lower income taxpayer.)

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