The Progressive Policy Institute this week released a “Tax Complexity Index,” which provides a count of tax expenditures by state. The results are in line with what you might expect: state tax codes have a lot of deductions, credits, exclusions, rebates, and other goodies that make the code more complicated.
According to the report, the number of expenditures tallies into the hundreds in most states. Washington has the highest number of expenditures for which there is data available, between 550 and 600. PPI says seven states do not publish a comprehensive list of all their tax expenditures, so they rank those states “most complex” (though my initial reading is that PPI missed the New Hampshire tax expenditure report, and while they ding Indiana for not having a full expenditure report, they don’t mention that it does have one for its individual income tax). Alaska is the “least complex” state, with between 0 and 50 expenditures.
It’s important to note that while counting the number of expenditures can tell you some things about the tax code, not all expenditures are bad policy. A net operating loss deduction, for example, makes the tax code more neutral by allowing businesses that suffer in recessions to offset those losses in profitable years. Exemptions in the sales tax for business to business transactions are also essential because they make sure the sales tax doesn’t get levied multiple times in the production chain (a no-no that economists call “tax pyramiding”). Both of these are counted as “complexities” in the PPI study, but it’s not like they are unprincipled privileges cooked up in a smoke-filled room. We do more a more nuanced parsing out of tax structures in our State Business Tax Climate Index.
Caveats aside, there are a few good nuggets here. I particularly like this one quote, which gives insight into why reforming tax codes is so hard:
Some progressive analysts tend to look at tax expenditures as an indirect form of government spending that obviate the need for new programs and administrative bureaucracies. Conservatives see them as a way of cutting tax burdens on families and businesses.
This appeal to politicians on both sides of the aisle means that carve-outs are enacted quite often, which results in increased complexity. Ironically, complexity is the number one complaint from taxpayers on both sides of the aisle. In the long run, this means that wholesale tax reform is needed to simplify things.
More on tax complexity.
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Where do federal government tax dollars come from? In 2013, the largest share of revenue came from individual income taxes and payroll taxes, accounting for $2.26 trillion in total. The smallest share came from estate and gift taxes at $19 billion.
This has changed significantly over time. In 1940, excise taxes were the largest source of federal revenue. Today, excise taxes account for about 3 percent of federal revenue and individual income taxes are the largest single source of revenue.
What the federal government buys with your tax dollars has also changed over time. In 1962, the largest federal expenditure was defense spending at 49 percent of the budget. Today, spending on health (27 percent) and Social Security (23 percent) make up the largest segments of government spending.
The progressivity of our tax code has also changed over time. Since the mid-1980s, the share of income taxes paid by the top 10 percent of taxpayers by income has gone from 54.7 percent to 70.6 percent while the share of taxes paid by the bottom 90 percent of taxpayers has gone from 45.3 percent to 29.4 percent.
The progressivity of the tax code is still prevalent when you consider income, with high-earners pay a large share of federal income taxes. For example, taxpayers who make over $200,000 a year earn about 28 percent of the all income, but they pay about 55 percent of all income taxes.
The composition of taxpayers has also changed overtime. In 1960, a large majority of tax returns came from married filers. Today, 62 percent of tax returns come from single filers with the remaining 38 percent coming from married filers.
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Did you know that you can donate to the treasury voluntarily? The website pay.gov takes checking accounts, credit cards, and debit cards. You can also donate on your tax forms, which are due today.
Obviously, not many people choose to do this. It’s not reasonable to expect people to voluntarily part with money, even if they would prefer higher tax levels all around. The highest level of voluntary donations ever recorded was $7.75 million, in 2012. It’s perfectly fair to think of government as solving collective action problems, allowing us to do good things with diffuse benefits that otherwise wouldn’t be done without compulsory payment. For example, Jonathan Cohn at The New Republic argues today that taxes are a good cause.
But it is worth mentioning that there are a lot of good causes, and a lot of things that solve collective action problems, and they do great things that otherwise wouldn’t be done - and they receive many voluntary donations. Americans donated over $316 billion to charities in 2012 – over forty thousand times what they donated voluntarily to the government.
When Americans are willing to donate a little extra in order to help solve problems, some of them choose to donate to our own government. But for every dollar that goes to Uncle Sam, forty thousand dollars go elsewhere. Our government is empowered with all sorts of legal abilities that the United Way and the Salvation Army don’t have, and it should be able to accomplish many things that the private charities cannot. However, when Americans are given a choice, they send their money to the United Way.
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Tennessee lawmakers recently voted to repeal the state’s version of the so-called “jock tax.” The tax will be repealed effective immediately for NHL players, but will remain in effect for NBA players until June 1, 2016.
The jock tax is a colloquial expression used to describe the income tax levied on visiting professional team members. Each state with both an income tax and a professional sports team levies a jock tax. However, Tennessee’s version of the tax levied the same $2,500 flat rate on all team members, and was capped at $7,500 per year. For lower paid team members this led to a substantial financial burden. In fact, the NHL Players Association argued that a large percentage of its players actually lost money when they played in Tennessee.
Tennessee’s tax was also odd because it singled out NHL and NBA players while exempting NFL players. Even the repeal of the tax is a little odd because it singles out NBA players for taxation for two more years while now exempting NHL and NFL players. This is largely due to lobbying by the state’s NBA team, the Memphis Grizzlies. The Grizzlies’ executives favor the tax because the proceeds go directly to the team, which uses them to fund upgrades to the arena and to bring in concerts and other events.
There have also been questions about the constitutionality of Tennessee’s version of the tax. The lead sponsor of the repeal bill stated that his primary motivation was to put an end to a law that he believed was unconstitutional. He believed that the tax would not withstand a legal challenge because of the fact that NFL players were exempt, while NHL and NBA players were taxed.
He is not the only one who believes the tax is constitutionally suspect. An article in the Marquette Law Review argued that the tax violated the commerce clause because it taxed nonresidents differently than residents. A resident athlete would be taxed a maximum of $7,500 spread out over 41 home games, while a nonresident athlete would be taxed a maximum of $7,500 spread over only a few games. This would result in the nonresident athlete effectively being taxed a much higher per game rate than the resident athlete.
The law review article also argued that the tax was unconstitutional because it was not fairly apportioned to work being done in Tennessee. The principle of external consistency holds that a state should only tax the portion of income that is fairly attributable to economic activity within the state. Since the state levies a flat tax equal to almost all of a lower-paid player’s game-day income, there is a complete lack of apportionment to economic activity in Tennessee.
Even though it would have been better to repeal the tax altogether, rather than continuing to tax NBA players for another two years, once the tax is fully repealed it will result in much better tax policy. At least lawmakers in Tennessee took a step toward that laudable goal.
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The tax code is huge and complex. But how huge and complex is it?
Andrew Grossman, the legislation counsel for the Joint Committee on Taxation that helps write tax laws, attacked us in Slate yesterday for saying that the tax code runs 70,000 pages, countering that it’s “only” 2,600 pages.
So how long is it really? There are a couple ways to look at it.
Statutes: There’s the literal statutes that Congress has passed (Title 26 of the U.S. Code). The Government Printing Office sells it spread over two volumes, and according to them, book one is 1,404 pages and book two is 1,248 pages, for a total of 2,652 pages. At perhaps 450 words per page, that puts the tax code at well over 1 million words. (By way of comparison, the King James Bible has 788,280 words; War and Peace runs 560,000 words; and the Harry Potter series is just over 1 million words.)
Statutes and Regulations: However, a tax practitioner who relies just on the tax statutes will go to jail, because so much of federal tax law is in IRS regulations, revenue rulings, and other clarifications. Congress will set down a policy and leave it to the IRS to write all the rules to implement it. These regulations aren’t short: the National Taxpayer Advocate did a Microsoft Word word count of the tax statutes and IRS regulations in 2012, and came up with roughly 4 million words. Again at roughly 450 words per page, that comes out to around 9,000 pages. The National Taxpayer Advocate also noted that the tax code changed 4,680 times from 2001 to 2012, an average of once per day.
Statutes, Regulations, and Caselaw: But, a lawyer who relies just on cases and regulations isn’t a very good lawyer, because most court decisions are made on the basis of previously decided cases. The respected legal publisher Commerce Clearing House (CCH) puts out such a compilation, the Standard Federal Tax Reporter of 70,000 pages, with notations after each statute containing relevant cases and other information. CCH itself considers this volume to be representative of “the tax code,” since an expert needs to know all 70,000 pages to understand the tax code in full. CCH has put out colorful charts illustrating its growth over the years. We used that information for the basis of a chart we did illustrating tax complexity over time.
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As tax day arrives, it’s worth considering how the federal government spends your tax dollars. The chart below presents the breakdown of federal spending in 2014 as estimated by the White House’s Office of Management and Budget (OMB).
In 2014, the largest budget item is spending on health, which takes up 27 percent of the $3.65 trillion in projected outlays. The next largest item is Social Security at 23 percent of the spending.
Defense spending comes in at 17 percent of spending, closely followed by income security at 15 percent, which includes programs such as unemployment insurance, food stamps, housing assistance, and disability insurance.
The “Everything Else” category – 8 percent of federal spending – includes transportation, commerce, agriculture, international affairs, education, etc. Veterans benefits and interest payments make up the final ten percent of outlays.
When combined, Social Security, income security, and health programs make up 65 percent of federal spending in 2014. In order to add context to this discussion, it’s beneficial to see how these numbers have changed over time.
If we look at 1962 (the first year for this data set), federal spending looked significantly different.
In 1962, military spending accounted for 49 percent of spending, a 32 percentage point difference from 2014.
Health is another other big mover. In 1962, spending on health related programs covered 1 percent of spending. The drastic change is largely due to the creation of Medicare and Medicaid in 1965.
Income security programs and Social Security consisted of 9 and 13 percent of the spending, respectively. Veterans benefits and Interest took up a similar percentage of the budget at 11 percent combined.
In the chart below, you can see how the composition of the budget changed in the 50 plus years between 1962 and 2014. See here for our report on where the tax dollars come from.
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The way businesses write off their investment expenses is one of the more arcane and obscure aspects of our tax code. It is also one of the biggest tax barriers to investment. Businesses are not allowed to write off investments immediately, as they do with labor expenses, but instead must delay those deductions for years or even decades, depending on the industry and the type of asset. Because a deduction delayed is a deduction reduced, it means the tax code is fundamentally biased against physical investment, in a big way.
It is one reason why the U.S. has nearly the lowest level of investment in the developed world. Another reason is the corporate tax rate, which is the highest in the developed world. Most reform efforts of late, including that of House Ways and Means Chairman Dave Camp, have opted to reduce the corporate rate but further delay investment deductions. In general, such a tradeoff is not good for investment.
This is why Congress has turned its attention to more targeted investment incentives, such as bonus depreciation, which would allow businesses to immediately expense 50 percent of the cost of equipment and software. The remainder would be written off in the normal manner, over a few years. Bonus depreciation is part of the so called tax extenders that expire every year and which are now up for renewal in the both the House and Senate. The Senate bill would extend almost everything for two years through 2015, including bonus depreciation.
Economists Robert Hall of Stanford University and Narayana Kocherlakota of the Minneapolis Federal Reserve recently described the benefits of moving toward a system of immediate expensing of investments:
A tax break for businesses that invest in research and development, new equipment and physical structures could be "an effective form of stimulus" for the U.S. economy, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said Saturday.
"The future course of the U.S. economy is not predetermined by the events of the past seven years. Both history and theory have the same lesson: It is possible to undo what might now appear to be permanent changes," Mr. Kocherlakota said in remarks prepared for delivery Saturday at a National Bureau of Economic Research conference in Cambridge, Mass.
Mr. Kocherlakota was discussing a new paper by Stanford University economist Robert E. Hall titled, "Quantifying the Lasting Harm to the U.S. Economy from the Financial Crisis." Mr. Hall's paper concluded that lower labor-force participation and slower productivity growth may linger long after the 2007-2009 recession.
In response, Mr. Kocherlakota said economic models "imply that it is physically possible for future U.S. economic activity to be distinctly higher than what might be expected to unfold." The "key policy question," he said, is this: "Is the United States, as a society, willing to forgo the leisure, home production, and/or near-term consumption required to generate materially higher future economic activity?"
Assuming it is, he said, various macroeconomic models suggest "an effective form of stimulus" would be a lower government tax rate on "physical investment."
"I don't mean 'reducing the tax rate on the income from financial wealth."' Mr. Kocherlakota said. "Nor am I referring to reducing the tax rate on dividend income, capital gains, or corporate profits. Such reductions may have effects other than reducing the tax rate on physical investment.
"Rather, I'm referring specifically to reducing the tax rate on the process of transforming current goods into future goods. In practice, the government can accomplish such a reduction in a relatively targeted fashion by allowing businesses to completely expense any investments into equipment, structures, or R&D."
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In filing one’s taxes, it may be necessary to distinguish between breast implants that are merely “large,” and breast implants that are “extraordinarily large.”
The relevant ruling on this subject came in 1994 in a case known as Hess v. Commissioner. The plaintiff, a self-employed exotic dancer, had implants that expanded her bust size to the size 56FF. For tax purposes, she treated these as a deductible business expense on her schedule C. The IRS contested her deduction.
The purpose of deductions for business expenses is to avoid multiple levels of taxation on goods that are put together cooperatively by several businesses. This is good tax policy.
However, a substantial difficulty in this is determining the difference between consumption goods and legitimate business expenses. A carpenter should be able to deduct the cost of wood he uses to create furniture to sell – tax is paid on the income used to purchase it, and no further tax is necessary. But deductions are not a free excuse to make all of one’s income tax exempt by listing a bunch of personal purchases, and the IRS is right to be skeptical of abuse of this provision.
The relevant issue in Hess was whether breast implants – traditionally thought of as a luxury good bought for personal benefit – could be considered a legitimate business expense. Given that the plaintiff was an exotic dancer, she had a fair argument. But in general, taxpayers aren’t allowed to treat personal appearance expenditures as business expenses unless they aren’t suitable for personal use. Hess, arguing pro se, convincingly established that her implants were inconvenient in everyday life due to the sheer enormity of her breasts. The courts ruled in her favor:
Because petitioner's implants were so extraordinarily large, we find that they were useful only in her business. Accordingly, we hold that the cost of petitioner's implant surgery is depreciable.
There is good reason to believe the courts got this one right. As a matter of good tax policy, those expenses that go towards a taxable final good or service should not be hindered with additional taxation.
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