Is Romney to Blame for Paying Low Taxes or is 72,536 Pages of Tax Code to Blame? What's the Real Solution? Thanks to AMT, Man Pays 102% Tax Rate

I am not a fan of Mitt Romney. Thus I am not displaying bias when I say the ire over what Romney pays in taxes is misplaced.

Caroline Baum has an excellent article on Bloomberg today that points to real source of the problem: Never Mind the Tax Cheats -- Go After the Tax Code

Millionaires paying an effective 15 percent tax rate because their income is from investments? Blame the tax code. Carried interest, a form of income that accrues to hedge fund and private equity managers, taxed at the more favorable capital gains rate? The tax code's the culprit.

Yes, there are a lot of tax cheats out there who aren't playing by the rules. What Obama objects to -- Warren Buffett playing a lower effective tax rate than his secretary -- is ordained by the grotesque, 72,536-page tax code.

In researching a recent column, I went back to "The Flat Tax," published by economists and Hoover Institution fellows Robert Hall and Alvin Rabushka in 1985. They proposed a revenue-neutral flat tax of 19 percent. All income would be taxed once, and only once, at the same rate and as close to the source as possible. "Whenever different forms of income are taxed at different rates or different taxpayers face different rates," they write, "the public figures out how to take advantage of the differential."

Bingo. I'm no tax expert -- I have trouble gathering all the necessary information to take to the accountant once a year -- but I know enough to recognize that the tax code is the problem, not the folks who capitalize on its myriad of loopholes.

Whether it's a flat tax or a national retail sales tax, simpler is better: for each of us and for the economy overall. So the next time the president says he wants everyone to play by the rules, please tell him it's the rules that are broken -- not to mention the rule-makers.

Tax Law Keeps Piling Up

click on chart for sharper images

Image from Tax Law Pile Up

Are the Rules Broken or the Rule-Makers?

If one need collect taxes as close to the source as possible, the same can be said for the source of the problem. Congress cannot resist tinkering, with anything and everything.

The image above shows what 90 years of tinkering have done. Heck, from 1984 until now, 46,236 pages of tax code have been added.

There are breaks for mortgages, charitable deductions, hedge funds, the oil industry, home builders, and too many things to mention. Instead of fixing the problem at the source, Congress added an "Alternative Minimum Tax".

102% Tax rate?

New York Times reporter James Stewart says he was "dismayed" by his own tax rate as compared to Romney, so he invited readers to send e-mails disclosing their tax rates and circumstances. Stewart was "deluged with submissions".

One respondent, James Ross, a founder and managing member of Rossrock, a Manhattan-based private investment firm that focuses on commercial real estate and distressed commercial mortgages beat everyone hands down.

Let's pick up the story from there as reported by the NYT in At 102%, His Tax Rate Takes the Cake

“My entire taxable income, plus some, went to the payment of taxes,” Mr. Ross said. “This does not include real estate taxes, sales taxes and other taxes I paid for 2010.” When he told friends and family, they were “astounded,” he said.

That doesn’t mean Mr. Ross pays more in taxes than he earns. His total tax as a percentage of his adjusted gross income was 20 percent, which is much lower than mine.

That’s because Mr. Ross has so many itemized deductions. Since taxable income is what’s left after itemized deductions like mortgage interest, charitable contributions, and state and local taxes are subtracted, it will nearly always be smaller than adjusted gross income and demonstrates how someone can pay more than 100 percent of taxable income in tax. Mr. Ross must hope that his interest expense will pay off down the road and generate some capital gains.

How could Mr. Ross pay so much? I thought I was the victim of a perfect storm of punitive tax policies, but Mr. Ross’s situation is worse.

Like me, he lives and works in New York City, which all but guarantees a high tax rate. Nearly all of his income is earned income and thus fully taxable at top rates. (He said that’s not always the case, but given the recent dire condition of real estate, in 2010 he had few capital gains and his carried interest didn’t yield any income.) Unlike me, he can’t make any itemized deductions, which means his adjusted gross income exceeds $1 million, the level at which New York State eliminates all itemized deductions, except for 50 percent of the value of charitable contributions. Mr. Ross said he gave 11 percent of his adjusted gross income to charity.

That means Mr. Ross can’t deduct any interest expense on the money he borrows to finance his real estate investments, which is substantial, nor can he deduct any other expenses or other itemized deductions except for part of his charitable contributions. This means he pays an enormous amount in state and local taxes. Since those are among the deductions that are disallowed when computing the federal alternative minimum tax, Mr. Ross is in turn especially hard hit by the A.M.T.

Mr. Ross said he asked his accountant what he could do. “He said, ‘Fire everyone here and move to Florida,’ ” according to Mr. Ross. He employs 10 people in his New York office.

Seriously Inane Proposals

One extremely misguided soul proposed in a comment on my blog the other day that it would be "fair" if everyone paid the same percentage of their income for things.

Under this proposal, one would need to provide proof of income to buy anything. Then, those with $1 income would get everything for free because a percentage of $1 does not go far. Those who make a $million would pay $400 or whatever for a loaf of bread. Clearly this proposal is inane, yet such misguided ideas are likely behind the absurd complexity of the AMT.


Simple Solution

The simple solution is to scrap the tax code entirely and start all over, with a blank slate.

The only fair way to do things is for everyone to be treated equally. No breaks for homeowners, no alternative minimum tax, no graduated taxes just simple set of flat taxes.

Since we need to promote more savings, I would rather see a national sales tax as opposed to an income tax. Regressive? Nope. It does not have to be.

I propose no tax on food, medicine and medical supplies, shelter, and clothes. Since a huge percentage of income of the poor goes to food shelter and clothes, no one can scream "regressive".

Still, everyone would be treated equally, unlike say a mortgage deduction which only benefits homeowners. Everyone does eat, and need shelter.

How about a combination flat income tax and national sales tax, perhaps split 50-50 keeping the tax collection revenue neutral?

Those who "buy things" other than food, shelter, and clothes (notably the wealthy), would perforce pay a higher share yet everyone would be treated equally under the law.

Moreover, a sales tax is as close to the source as one can get. So is an income tax with no deductions.

What we cannot do is think 72,536 pages of tax code can be fixed. It can't. It's time to start all over with a blank slate and ideally 500 pages of tax code or less.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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