Thursday, September 22, 2011

Obama’s Economic Reduction Plan

Private Equity vs. Government Redistribution

- By: Larry Walker, Jr. -

“A farmer went out to sow his seed. As he was scattering the seed, some fell along the path, and the birds came and ate it up. Some fell on rocky places, where it did not have much soil. It sprang up quickly, because the soil was shallow. But when the sun came up, the plants were scorched, and they withered because they had no root. Other seed fell among thorns, which grew up and choked the plants. Still other seed fell on good soil, where it produced a crop—a hundred, sixty or thirty times what was sown. He who has ears, let him hear.” ~ Matthew 13:3-9

For many, the American Dream consists of the hope of freeloading off of the good fortune of others for their entire lives. Yet for some, the dream is comprised of one day saving enough capital to invest in a business of their own. And for a few, the dream is to one day save enough to invest through a private equity group. For those aspiring towards business ownership, sometimes a little help is needed, and that help, in many instances comes though private equity firms.

So why would anyone dream of investing in a private equity firm? Well one big reason is that under current law, around 58% of the profits realized by private equity firms are taxed as long-term capital gains rather than as ordinary income. Long-term capital gains are currently taxed at the maximum rate of 15%, while ordinary income is taxed as high as 35%. The lower tax rate on long-term capital gains helps to compensate for the opportunity cost of investing for the long haul, and also enables a greater portion of the profits to be reinvested into the next venture, which can ultimately lead to the accumulation of a great deal of wealth.

Another reason many dream of investing in private equity groups is because they feel a calling to help fellow Americans reach their dreams. Unlike bloated, deficit-financed, short-sighted, big government wealth redistribution schemes, private equity is good for America. However, if the carried interest (the long-term capital gains earned through investing in private equity) were to suddenly be taxed at the same rates as ordinary income, then there would no longer be an incentive to invest in long-term private business endeavors.

Private equity firms fund and co-manage thousands of private businesses in the United States, employing millions of American workers, and these businesses are dependent upon stable long-term investments. If big government takes away the incentive to save and invest in long-term endeavors, then there will be no long-term investment. It simply won’t be worth the risk. And without long-term private equity investment, thousands of businesses, millions of jobs and the American Dream will be choked out of existence.

Carried Interest vs. Ordinary Income

Ordinary income is mostly comprised of net business income, fixed compensation, interest, dividends, rents, royalties, and short-term (less than a year) capital gains. Unlike ordinary income, there is greater risk involved with long-term (more than a year) capital investments. Private equity firms typically make investments over a 3 to 7 year term. The risk of tying up capital savings for many years is that the investment might be lost entirely, or may not return any profit at all. So is carried interest the same as ordinary income? Centuries of sound and settled tax policies say no. But Barack Obama, a novice, with no business experience, and a track record of failed economic policies; and Warren Buffett, a retiring billionaire, who has profited from lower taxes on carried interest during his lifetime, say yes. So who’s right, centuries of proven economic science, or 32 months of butt kissing and B.S.?

The Obama-Buffett Rule presumes that carried interest is the same as ordinary income and should be taxed at ordinary income tax rates of up to 35%, instead of at capital gains rates of up to 15%. The contention that the profits earned through long-term capital investment, which involves placing previously taxed income at risk through investing in risky business ventures, which employ hundreds of thousands of American workers, and which help drive the American economy, should be taxed at the same rate as fixed compensation, such as wages earned from labor, is quite a leap. The problem with Obama’s latest Socialist twist is that unlike fixed compensation, which is properly taxed as ordinary income, carried interest, garnered through private equity investments, only rewards general partners if, at the end of the term, the fund actually results in a net gain.

To break this down further, you have on the one hand wage earners, who work 40 hours per week, get paid weekly (or semi-monthly), consume most of their pay, and have taxes withheld from each paycheck. And on the other hand, you have private equity partners who work on a project for 3 to 7 years, expending capital and sweat equity, aiding in the employment of thousands of tax paying workers, helping make tax paying businesses profitable, and ultimately hoping to, at the end of the term, regain their investment along with a handsome profit. So is carried interest the same as ordinary income? Is all income created equal? Is Capitalism the same as Socialism? Do words still have meaning?

Private Equity in Action

Within the State of Georgia there are approximately 30 private equity firms, which have invested an estimated $26 billion in Georgia-based companies, which back approximately 340 private companies, which employ more than 175,000 U.S. workers. If more capital is diverted away from private equity investments, through errant tax policies, and instead invested in tax-free securities or some other jurisdiction, then where will the capital to fund these Georgia businesses come from? It’s not likely to come from banks, which are currently paying investors taxable interest of between .01% and 1.0% on savings. And it’s not likely to come from the federal government which is currently $14.7 trillion in debt. Thus, when private equity capital is finally taxed out of existence, there will be no capital, and most of these 340 companies will cease to exist, along with 175,000 jobs.

In the State of Illinois there are approximately 137 private equity firms, which have invested an estimated $72.9 billion in Illinois companies, which back approximately 450 private companies, which employ more than 350,000 workers in the U.S. The State Employees’ Retirement System of Illinois had nearly $525 million invested in private equity as of June 30, 2008, about 5 percent of the System’s total pension fund portfolio of more than $11.4 billion. And as of June 30, 2009, the Illinois’ Teachers Retirement System had $2.34 billion invested in private equity, about 8.2 percent of TRS’ total portfolio of nearly $29 billion. Are the billions of dollars that Illinois pension funds invest in private equity firms any more or less important than any other American citizen’s savings? I think not. If the government takes away the incentive of private equity partners, then where will this capital go? If you say, “To the Banks”, again you err. If you say, “Directly into businesses”, then who will oversee and manage these investments, the government? Yeah, right, just like Solyndra.

It’s Math!

And then there’s this hogwash about wealthy people paying lower tax rates than middle income earners. Does anyone really believe this? All you have to do is glance over at one of our “progressive” tax rate schedules, to know that’s not the case. Since our tax rate structure is “progressive”, the rates increase along with income. One’s combined tax rate is never the same as their bracket rate. In other words, you may be in a 25% bracket, but that doesn’t mean you’ll fork over 25% of your taxable income. As you can see below, married couples with ‘ordinary taxable income’ of $25,000 pay a tax of 11.6%, those with $50,000 pay 13.3%, and those with $100,000 pay 17.2%; while married couples with ‘ordinary taxable income’ of $250,000 pay a tax of 24.0%, those with $1,000,000 pay 32.0%, and those with $10,000,000 pay 34.7%.

In terms of dollar amounts, on the low-end, 11.6% of $25,000 translates into $2,900, while on the high-end, 34.7% of $10 million works out to around $3.5 million. So is paying $2,900 in taxes greater than or equal to paying $3.5 million? It’s math! One must also consider that five times out of ten, that $2,900 liability gets magically turned into a tax refund of up to $8,000, as nearly half of all American workers are either not liable for any income tax whatsoever, or fall into the negative category. So perhaps the words “fair share” could be more appropriately expressed as “unfair and not-shared”.

From Taxing the Rich
From Taxing the Rich

Although it may seem fair for Obama and Buffett to compare a private equity partner with $10,000,000 of carried interest, to a married couple with taxable wages of $100,000, it’s really not. It’s like comparing oranges to apples. Although the wage earning couple will pay federal taxes of 17.2% versus the carried interest earners 15.0%, in the end, the couple will have paid a total of $17,250 in taxes, versus $1,500,000 for the private equity partner. So is $17,250 greater than $1,500,000? “It’s math!”

The real difference is that a private equity partner may then turn around and reinvest most or all of the remaining $8,500,000 into the same company that the married couple works for, thus enabling them to continue their very employment. In terms of economics, the multiplier effect on private equity investment generates many times the tax revenue paid by the partner himself. Just add up the taxes collected on all the additional wages, salaries and business profits he helps to generate. But if that capital be muzzled, the result will be less free-enterprise and even higher levels of unemployment. Thus, while earning a salary is productive, it’s nowhere near as productive as carried interest. Perhaps there’s a reason why some of our tax policies are the way they are! “It’s math!”

If Obama and Buffett really wanted to compare apples to apples, then they would be comparing a married couple with carried interest income of $10,000,000, to a couple with long-term capital gains income of $10,000,000. Each will pay $1,500,000 in taxes. So is fairness still an issue? The truth is that no American is prevented from saving his or her own money and investing in activities generating similar capital gains. Anyone can do it, and will reap an equal reward -- a maximum 15% long-term capital gains tax. But if the government ever takes away this incentive, or begins to discriminate against certain forms of long-term gains, then you can kiss the American Dream goodbye.

Government Subsidies vs. Private Equity

If the government steps in and confiscates a larger chunk of the profits earned by private equity firms, then there will be that much less capital to reinvest in new acquisitions. And what will the government do to make up the shortfall? Will the government invest in and manage new enterprises? Perhaps, the federal government will subsidize more companies like Solyndra, but then who gets the ‘return on subsidy’ (ROS), if and when the government is successful? Will every taxpayer get an equal slice of the pie? That’s highly doubtful. More than likely, the money will simply be absorbed into the federal government’s irresponsible $1.3 trillion per year budget deficits, or into its $14.7 trillion national debt, or used to pay unemployment compensation, or to dole out more food stamps, neither of which will create new jobs. In other words, the money will be pilfered and consumed rather than invested in viable job creating enterprises. And we all know that America needs more jobs, not more debt, unemployment compensation and food stamps.

Private equity investors fund American businesses which employ millions of American workers. By investing in non-public companies they typically hold their investments with the intent of realizing a return within 3 to 7 years. Shouldn’t there be some reward for committing previously taxed income for 3 to 7 years, in order to help businesses grow, and to enable employment for millions of workers, with no guarantee of a profit let alone return of the original investment? I say, yes. Obama and Buffett say, no. Where they err in their quest for “fairness” is in that 42% of the profits earned by private equity investors are already taxed at ordinary tax rates, while just 58% represents carried interest. They also fail to realize that such profits are typically reinvested back into the cash account to fund the next acquisition. You would think that at least Buffett would understand this concept, since most of his earnings have been likewise reinvested.

Hell No!

With Obama’s brand of math, one would surmise that if the government could just confiscate the $1.4 trillion in annual private savings, and use it to pay the $1.4 trillion of annual government deficits this would somehow bring about “balance”. But all it would really bring about is a permanent state of depression, mass government dependency, and even greater deficits once the government runs out of other people’s money. And considering that the best the federal government could possibly do, by confiscating additional tax revenue, is to immediately absorb it into its irresponsibly amassed $14.7 trillion in accumulated deficits, over $4 trillion of which was squandered by Obama himself, the answer to the request for more revenue is still, “Hell No”. Cut spending, stop squandering the tax dollars we’re already paying, and stop regurgitating the same old lies over and over again.

Although the federal government does employ a couple of million workers, about 59% of the money used to pay them is already confiscated from taxpayers, while the other 41% is merely borrowed from the Federal Reserve Bank and from countries like China. Every dime taken away from private investors and spent by the government is a dime taken away from private businesses and private sector workers. Once the point of no return was breached, back in 2010, there was no longer enough personal income to cover the amount of federal debt, on a per capita basis, and if this is not corrected soon, it will lead to the death of the American Dream. If there is already not enough income to pay the government’s debt, then why is Obama begging for higher taxes? When there is nothing left but government, then what? Will the government pay everyone a subsidy of say $50,000, and then proceed to levy a 100% tax on everyone in order to fund itself into infinity? Isn’t this exactly where Obama’s plan leads?

The failure of Obamanomics can be summed up in a few short phrases: If it produces jobs, tax it. If it keeps producing jobs, regulate it. And when it stops producing jobs, subsidize it. Thus Obama’s plan for deficit reduction, like his Jobs Act, is just another gimmick leading to economic reduction, job destruction, government dependence, poverty and the end of the American Dream. Obama gave it his best, but his best just wasn’t good enough for America. Hey Obama, "Hell no, and good riddance."

*** BTW - Raising the tax rate on carried interest from 15% to 35% would result in a 133.33% tax hike, or to 39.6% would equal a 164.0% hike, just in case anyone is still considering this madness. ***

“There is a limit to the taxing power of a State beyond which increased rates produce decreased revenue. If that be exceeded intangible securities and other personal property become driven out of its jurisdiction, industry cannot meet its less burdened competitors, and no capital will be found for enlarging old or starting new enterprises. Such a condition means first stagnation, then decay and dissolution. There is before us a danger that our resources may be taxed out of existence and our prosperity destroyed.” ~Calvin Coolidge (Address to the General Court beginning the 2nd year as Governor of Massachusetts January 8, 1920)

References:

Private Equity Info

Private Equity Growth Capital Council

Related:

The Problems with Raising Taxes on Carried Interest, Part II

Saturday, September 10, 2011

Why Congress Shouldn’t Just Pass Obama’s Jobs Bill, Again

- 6 Temporary Stimuli, 17 Tax “Cuts”, and Zero Results

- By: Larry Walker, Jr. -

As I carefully chronicled in, “Obama: The Era of Flimflam Economics, Part II - Untimely and Proven to Fail”, the policy theory, known as economic stimulus, was designed by economists as a tool for implementation at the onset of a recession, with the goal of either softening its effects, or averting a downturn altogether. However, in the real economy, economic stimulus has yet to be proven successful at doing either. In February of 2009, partisan windbag, Barack Obama declared, "What do you think a stimulus is?", implying that the idea was for the government to borrow and spend near a trillion dollars on anything, but then later at a Jobs Council, after the money had been squandered, he admitted that, “Shovel-Ready Was Not as Shovel-Ready as We Expected”.

Short-Term Stimulus vs. Long-Term Policy

To summarize, it was near the end of 2007, when prominent economists began advising the federal government that the economy was heading into a recession, and that it could be avoided if the government would implement an economic stimulus program. They proffered that in order to work successfully, such a stimulus needed to be targeted, timely, and temporary. As far as timeliness was concerned, tax refund checks needed to reach taxpayers in a matter of weeks not months. But economists must have forgotten that they were dealing with the federal government. How in the world would the federal government be able to: (1) agree on and pass legislation, (2) send it on to the IRS for interpretation and implementation, and (3) expect for tax refund checks to start rolling out in a couple of weeks, especially in the middle of the tax filing season?

The first economic stimulus package of the Great Recession was proposed in January of 2008. Even though a similar stimulus plan was attempted and failed in 2001, nevertheless, Congress was suckered in through panic mode once again. This time they would fling $150 billion to the wind, but by the time the checks reached taxpayers, in April of 2008, it was too late, the recession had commenced. Looking back, it turns out that the recession officially commenced in December of 2007 and didn’t end until June of 2009. So why is it that millions of job losses, millions of home foreclosures, hundreds of bank failures and trillions of dollars in government debt later, politicians still seem to be hell bent on the premise that temporary stimulus policies work?

In February of 2009, a year after the first failed tactic, Barack Obama enacted a second stimulus plan. The American Recovery and Reinvestment Act of 2009 turned out to be nothing more than a gigantic, nearly $1 trillion, spending program. Although his borrow-and-spend policy was designed to be temporary, it was neither targeted nor timely. So the questions then and now are: Why was the federal government still trying to implement a stimulus program 14 months after the recession began, when every honest economist knows that the idea is to inject stimulus either prior to or just as a recession commences? By February of 2009, was it possible for a stimulus plan to prevent something which had already occurred? And lastly, why is the federal government still toying with the idea today, some 27 months after the recession has ended?

It should be rather obvious by now that economic stimulus programs don’t work in the real world. Although the theory may look impressive on a chalk board, the federal government is not an efficient institution for implementing a positive jolt to the economy, let alone much of anything else. It should also be clear that there are economic recovery policies which have been proven to work, time immemorial, once a recession has passed. For example, The Tax Reduction Act of 1964, The Economic Recovery Tax Act of 1981, The Tax Reform Act of 1986, The Deficit Reduction Act of 1993, and the Jobs and Growth Tax Relief Reconciliation Act of 2003 were all long-term plans which stabilized and grew the economy following recessions.

What’s lacking today is a long-term tax policy which would inject a sense of stability and predictability to the economy at large. Small businesses don’t make plans based on hope and change, what we need is to know what our income tax rates and incentives will be for the next 8 to 10 years. Yet, Obama has wasted nearly 3 years already, passing one temporary measure after another, and now it's more of the same. As far as I’m concerned, it’s over for Obama. With the knowledge that long-term tax policies have been used as effective recovery tools following recessions, and that short-term stimulus programs have never been successful, why in the world is Obama trying to subject the nation to another stimulus prototype now, some 3 years and 9 months after the Great Recession began? Is it because we’re on the verge of another recession? And if we are on the verge of a double-dip, knowing that temporary stimulus programs don’t work in the real world, why would we ever allow Obama and Congress to waste more time, and money that we don’t have, with yet another futile stab?

From Main Street to Washington, DC

Having been an accountant and tax advisor for many small businesses, including my own, through at least the last two recessions, I know first hand which tax policies have worked and haven’t, and which have been important to small businesses versus the completely useless. For example, after passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, there was a sense of stability, and future plans could be implemented without the lingering fear that something would change or be taken away the following year. Its key policies which helped small businesses, within my orbit, were as follows:

  1. Stable and well defined Personal and Corporate Income Tax Rates and Brackets.

  2. Accelerated Depreciation through Section 179 and Bonus Depreciation within clearly defined limits and timeframes.

  3. Increasing and well defined limits on IRA and Qualified Retirement Plan contributions.

  4. Stable and declining tax rates on capital gains, and qualified dividends.

  5. Defined and stable tax credits such as the energy efficiency credit, child tax credit, education credit, and the life-time learning credit.

  6. Stable, declining and well defined Estate tax rates and brackets.

In contrast, the policies I have witnessed since February of 2009, have made planning next to impossible and pretty much pointless. For example, we knew that the tax rates and most of the policies implemented by #43 would expire at the end of 2010, so that was pretty much the end of the planning cycle, however the recession cut many plans short well before 2010. In fact, many small businesses didn’t make it through 2008, and some went under in 2009. As for the survivors, well what we’ve all been waiting for are the permanent policies which will carry us through the next decade. But thus far, all we’ve seen is a series of temporary tax measures, many with erratic nonsensical start and end dates, and most of which have been completely useless at a time when gross business income has for the most part been depressed.

Obama’s 17 Phantom Tax Cuts for Small Business

Obama has implemented 17, so called, tax cuts for small business. For the complete list, see the Feb. 25, 2011, posting on the official White House blog entitled, "Seventeen Small Business Tax Cuts and Counting." The post is touted as enumerating 17 small business tax cuts and credits created or extended through legislation signed by Obama, since February of 2009. But what is important to remember is that it’s not how many tax cuts have been implemented, but rather, whether or not they have been effective. Overall, I would have to give the Obama policies a grade of “D”. Obama’s 17 small business tax policies (or as he calls them “cuts”), and their effectiveness from my point of view follows, but first, here’s a short summary:

  • Eight of them were included in American Recovery and Reinvestment Act (aka the economic stimulus), the Affordable Care Act (aka the health care law), and the Hiring Incentives to Restore Employment Act (aka the Hire Act). Among the cuts: the exclusion of up to 75 percent of capital gains on key small business investments; a tax credit for the cost of health insurance for small business employees, and new tax credits for hiring Americans out of work for at least two months.

  • Another eight came via the Small Business Jobs Act, signed by President Obama in September of 2010. These included: adding deductions for business cell phone use; creating a new deduction for health care costs for the self-employed; allowing greater deductions for business start-up expenses; eliminating taxes on all capital gains from key small business investments, and raising the small business expense limit to $500,000.

  • Three months later, he signed a tax bill that raised the expense limit to 100 percent of small business new investments until the end of 2011. It also extended the elimination of capital gains taxes for small business investments through the end of 2012.

From the Recovery Act, HIRE Acts, and Affordable Care Act

1. A new small business health care tax credit

We didn’t have any businesses qualify for this credit. The calculation was very complex, so it wasn’t readily known whether any businesses would qualify until after the end of the tax year. It’s kind of difficult to shoot for something when even your accountant says, “I don’t know. I’ll let you know as soon as the IRS puts out some regulations showing us how it will be calculated.” And then well into the following year, “I’ll get back to you as soon as the IRS releases the appropriate tax forms.” One business came close to qualifying, but the employees’ salaries turned out to be too high. Who knew?

The small businesses I deal with don’t normally determine what their employees salaries and benefits will be based on temporary government policies. And they don’t sit around waiting on the IRS to publish forms and regulations when a decision is needed right away. In other words, when a business needs 4 more engineers, due to demand, negotiations don’t center on keeping salaries below a certain threshold in order to qualify for a one-year, one-time tax credit. And negotiations for health care plans center more on the affordability of monthly payments, and are not recklessly entered into with the hope of receiving a one-time tax credit, to be realized in some subsequent year.

Most small businesses in my sphere don’t offer health insurance, simply because it’s cost prohibitive, so the idea of a one-time tax credit, to offset the cost of something unaffordable to begin with, turned out to be pretty much a waste of orating skills, paper and ink. It sounded good though, and I guess that’s what counts with Obama and his cronies.

2. A new tax credit for hiring unemployed workers

I would say three businesses may have qualified for this credit, and mostly by luck. Others thought they would qualify, but it turned out that the new hires had not been unemployed for at least 60 days which disqualified them. I got lucky by hiring someone who had been unemployed for more than 60 days, and was luckily hired a few days after the law went into effect. But it wasn’t like I was hunting for someone who would qualify, and didn’t even know about the credit at the time because the details were not readily available. Again, I don’t know of any small businesses that hire people based on temporary tax credits, most hire people when they are needed to meet the objectives of the organization.

Also, since our payroll tax software wasn’t set up to account for the credit, because it was implemented after the start of the tax year, and since IRS Form 941 was not updated when the credit went into effect, it turned out to be more of an accounting nightmare than anything else. Personally, I would have gladly forgone the credit in exchange for not having to figure out how to account for it. Thank God that’s over with. Can we please just have some stability so we can run our businesses without something changing every few months?

3. Bonus depreciation tax incentives to support new investment

Section 179 depreciation has generally been sufficient. Although, bonus depreciation is advantageous at times, it’s more advantageous when a business has a loss, which is generally not the goal. If net income is high enough to write-off all equipment purchases, why would anyone choose to write-off half? Like I said, there is an application, but it mostly applies when net income equals zero, and one wishes to accelerate a loss. There were a few takers, but come to think of it, most of those went out of business due to the losses already incurred.

Uncertainty - From a planning standpoint, the other looming question was that, if the Bush tax cuts were going to expire at the end of 2010, might the depreciation expense perhaps be better utilized in the year rates were set to increase rather than while rates were low? Thus it may have made more sense to just delay any purchases until 2011, or 2012 rather than accelerate the write-offs while tax rates were still relatively low. Again, a stable long-term tax policy trumps temporary measures any day.

4. 75 percent exclusion of small business capital gains

This was of no use whatsoever from my vantage point. One would have to purchase qualified small business stock after February 17, 2009 and before January 1, 2011, and then hold it for five years in order to take advantage. None of our small businesses make a living through buying and selling small company stock. The only practical use I could see was for owners planning to sell their stake in a company, but they would have had to acquire that stake between the dates above, so it wasn’t much use to existing business owners. My first impression was that it was a policy designed for those looking to make a quick exit and perhaps relocate overseas, but the five year hold time destroyed that dream. If you’re interested in how convoluted this provision turned out to be, there’s an interesting article here.

5. Expansion of limits on small business expensing

Did anybody in Washington, DC get the memo that surviving small businesses just got hammered for two years straight, and thus had no money left, and no desire to go out on credit for new equipment, if credit could even be obtained? All I can say is that the old limit of $25K seemed to be more than sufficient to cover replacement items. I haven’t witnessed any considerable expansion plans since 2006.

Uncertainty - From a planning standpoint, the other looming question was that, if the Bush tax cuts were going to expire at the end of 2010, might the depreciation expense perhaps be better utilized in the year rates were set to increase rather than while rates were low? Thus it may have made more sense to just delay any purchases until 2011, or 2012 rather than accelerate the write-offs while tax rates were still relatively low. Again, a stable long-term tax policy trumps temporary measures any day.

6. Five-year carryback of net operating losses

This was yet another policy more useful for those who lost money and were on their way out of business, than for those fighting but keeping their heads above water. I took this as more of a policy of defeat than future success. I guess the government figured that a small tax refund from five years ago would encourage small businesses to keep hiring while losing money in the meantime. I had a couple of businesses utilize the five-year carryback, but unfortunately they are no longer in business.

7. Reduction of the built-in gains holding period for small businesses from 10 to 7 years to allow small business greater flexibility in their investments

This was another waste of paper and ink. This policy only helped out S-Corporations who were formerly taxed as C-Corporations, and had built in gains at the time of conversion. A built in gain is the difference between the fair market value of an asset and its tax basis at the time of the conversion. I’m sure some businesses out there took advantage, but really, how many C-Corporations switched to S-Corporation status? I think I advised one to do it maybe 10 years ago, but other than that it hasn’t always been the best move due to built-in gains, undistributed net profits, the number of shareholders, or the owner’s personal tax situation. The majority of the small businesses in my neck of the woods have been S-Corporations from inception, generally based on my advice. So did anyone actually benefit from this provision? I have serious doubts.

8. Temporary small business estimated tax payment relief to allow small businesses to keep needed cash on hand

Since estimated tax payments are made throughout the year in order to reduce or eliminate the amount owed when the tax return is due, the full amount being due by March 15th, why would I advise any small business to skimp? I had no takers here either. Most small business owners who make estimated tax payments want their taxes covered by tax time, and don’t want to skimp on estimated tax payments during the year, and then get stuck with a gigantic tax bill later. If a business took advantage of this and then didn’t have funds to pay on March 15th it would only snowball into perpetual tax debt. ‘Once you get behind, you never catch up.’ So this was another waste of paper and ink. Hey, do we look stupid or what? Why not just cut the doggone tax rates, and stop playing games?

From the Small Business Jobs Act

9. Zero capital gains taxes on key investments in small businesses

Zero is right! Like I said in number 4 (above), it was of no use whatsoever when 75% of the gain was excluded, from my vantage point. To slip through this loophole, one would have had to purchase qualified small business stock after September 27, 2010 and before January 1, 2011. Since there were only three month’s to gear up, and it was the holiday season, I’m pretty sure no one took advantage, but if you did, please shout it from the rooftops. None of our small business clients make a living through buying and selling small company stock. The only practical use I could see was for an owner planning to sell their stake in the company, but to gain any benefit, they would have to acquire that stake between the dates above, and so it wasn’t much use to existing small business owners. My first impression was that it was a policy designed for those looking to make a quick exit and perhaps relocate overseas, but the five year hold time once again destroys that dream. This was another waste of paper and ink. If you’re interested in how convoluted this provision turned out to be there’s an interesting article here.

10. Raising the small business expensing to $500,000

I didn’t have any small business clients who were able or desired to purchase anywhere near $500K of new equipment. Since this doesn’t apply to real property, it’s generally well beyond the needs of most of the small businesses in my area. Thus, I had no takers. This might be a great policy for well capitalized startup businesses, but the number of startups has been on the decline, and most that I know of haven’t had that much capital. Since the write-off is limited to a businesses net income, $500K is generally beyond the earnings of most first year enterprises. This is generally a good policy to implement in the middle of a recovery in order to maintain growth, but not in the midst of a weak economy. Thus to me, it amounted to another waste of paper and ink.

11. An extension of 50 percent bonus depreciation

Hey, didn’t we try this already? See number 3 (above).

12. A new deduction for health care [insurance] expenses for the self-employed

This is actually a bit misleading. It should read 'deduction for health “insurance” expenses', not 'health “care” expenses'. Since most of the small businesses we advise are S-Corporations, owner-employees with company paid health insurance, were already allowed a 100% deduction for health insurance long before this Act. The amount paid is included in their wages, but not subject to Social Security and Medicare taxes, and is allowed to be written off in full on their personal returns. This results in a total offset on the personal return, and a higher wage deduction on the S-Corporation return. I suppose it helped some sole-proprietors, Schedule C filers who have health insurance, but it didn’t affect anyone within my practice. Why walk when you can fly?

13. Tax relief and simplification for cell phone deductions

Most small businesses actually using cell phones for business purposes were already deducting the business usage portion. This provision only helped to avert a threatened crack down on the deduction which would have made it more costly to maintain records proving every call was business related, but since the crackdown never occurred, the effect upon small businesses was a sigh of relief, but no additional savings. In other words it saved us from having to spend more to comply with yet another ridiculous government regulation, but was really just a wash. Nothing was really saved, and nothing gained, in other words, it may have sounded good, but the effect was nil.

It’s akin to the government making 1099’s mandatory for all vendors, cancelling the regulation before implementation, and then claiming to have saved businesses money. No. You didn’t save us money. What you did was give us two years of uncertainty and unneeded stress, that’s what you gave us. That’s why government should just get out of the way.

14. An increase in the deduction for entrepreneurs’ start-up expenses

Although this policy temporarily increased, in 2010, the amount of start-up expenditures entrepreneurs could deduct from their taxes from $5,000 to $10,000, most of the start-up expenses that come across my desk are in the $100’s not thousands. And in cases where there are larger amounts, but little initial year net income, taking the write-off over 60 months is sometimes more plausible, especially when one doesn’t know whether tax rates will be higher in subsequent years, which by the way, we still don’t know.

15. A five-year carryback of general business credits

This policy allowed certain small businesses to “carry back” their general business credits to offset five years of taxes. I didn’t have any business clients qualify for any of the general business credits last year, and none who were really targeting them. In fact, the last business I can remember taking advantage of one of these credits was advised to do so through a tax scam. They paid the scammer an upfront fee in same amount as the credit they were assured to get back from the IRS. But in the end, all they got was an IRS audit resulting in the disallowance of the credit, had to pay the IRS back, and then had to sue the scammer to be made whole. I’m sure there are legitimate uses for some of these credits; I just haven’t dealt with any small businesses lately where any of them would have made a difference. You may view a full list of the credits here. In my view, most are either obsolete, redundant, or serve only a narrow base of special interests. Anyone serious about tax reform has my permission to strike the entire list.

16. Limitations on penalties for errors in tax reporting that disproportionately affect small business

The bill would change the penalty for failing to report certain tax transactions from a fixed dollar amount – which was criticized for imposing a larger penalty on small businesses – to a percentage of the tax benefits from the transaction. There was a time that all tax penalties were based on a percentage of taxes owed, but that’s no longer the case. Unfortunately this new provision doesn’t limit the effect of the $195 per month penalty the IRS currently charges, per shareholder, for each part of a month that an S-Corporation or Partnership return is filed late. S-Corporations and Partnerships, which have no income tax liability, are currently assessed the penalty, even though the late filing typically affects only a limited number of owners, or sometimes just one. If the government was serious about helping small businesses, they would stick to the old percentage of tax benefit policy (i.e. no tax benefit, no penalty), and eliminate this unfair charge on small businesses immediately.

And from the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act

17. 100 percent expensing

Hey, didn’t we do this twice already? See numbers 3 and 11 (above). This provision only applies to qualified property placed in service after September 8, 2010 and before January 1, 2012. So for those who purchased qualifying equipment on or before September 7, 2010, too bad, you should have waited. This is a prime example of another wacky implementation date from Obama. It’s also the provision that allows up to 100% of the price of an SUV or Corporate Jet to be written off in the first year, a provision signed into law by Obama, who later railed against the same.

This might be a good thing for some, but so far we haven’t seen any great demand for purchasing new equipment, no matter the incentive. Most small businesses, within my scope, are trying to pay off the debt from yesteryears purchases, and not looking to expand, or to replace equipment unless it’s an emergency. In other words, it’s not just hiring that’s down, it’s the economy as a whole, and with that comes dealing with slow paying customers, managing debt, grappling with price competition, and cutting back on expenses - including the purchase of new equipment. Thus, upping bonus depreciation from 50% to 100% looks good on paper, but it’s another temporary measure which in my estimation will not provide the spark needed to boost the economy.

Conclusion

Overall, most of Obama’s so called tax “cuts”, listed above, may make good sound bites, but I haven’t found them to have much practical application in the real world. There was a time, not so long ago, that the term tax cut, meant exactly that. It meant that tax rates were reduced. None of the provisions above represent reductions to income tax rates or adjustments to tax brackets, so they are not technically tax cuts. They are merely temporary ploys, targeting special interest groups, requiring one to either borrow and spend money, or jump through unreasonable (often impossible) hoops simply to obtain an additional deduction or credit.

Meanwhile, on Main Street, a permanent reduction in personal and corporate income tax rates, from the get go, would probably have had a greater impact, even if it were done in stages, with super low rates for two years followed by modest increases over the next eight, or something. None of Obama’s 17 tax deductions, credits, or extensions have really mattered much to me or to most of my small business clients, and the stuff he’s talking about now won’t make much of a difference either. If it’s temporary, and if it requires jumping through hoops, borrowing money, or meeting time frames beginning in the middle of the year - or starting on some arbitrary date in some odd month, then just forget it. It would be a heck of a lot easier to just cut overall income tax rates for one year, and then provide fixed rate schedules for the next decade. Is that so difficult? Is it really? If JFK, Reagan, Clinton, and ‘W’ could do it, why couldn’t Obama?

It’s all over for Obama now, time to move on. He had his chance, and blew it. The era of temporary stimulus boondoggles is over. Instead of thinking targeted, timely and temporary, it's time to move towards a plan that’s broader based, strategic and permanent. Now it’s up to Congress and the 2012 presidential candidates to outline a long-term strategy and take it to every corner of the country.

Related:

Obama: The Era of Flimflam Economics, Part II - Untimely and Proven to Fail

Taxing the Rich – 1765 to 2011, Part III – War on Taxes: 1964 to 2011

References:

DNC Chair Wasserman Schultz says Obama has signed bills with 17 small business tax cuts

Sunday, September 4, 2011

Taxing the Rich – 1765 to 2011, Part III

– War on Taxes: 1964 to 2011

– By: Larry Walker, Jr. –

"The largest single barrier to full employment of our manpower and resources and to a higher rate of economic growth is the unrealistically heavy drag of federal income taxes on private purchasing power, initiative and incentive." ~John F. Kennedy, Jan. 24, 1963, special message to Congress on tax reduction and reform

From Taxing the Rich

Recap: 1776 to 1912

In 1765, Great Britain imposed a series of taxes upon the American Colonies, in order to pay for its lengthy French and Indian War (1754-1763). After the war, the British forced upon the Colonies, the Stamp Act of 1765, requiring the purchase of tax stamps for any printed documents including newspapers, legal documents, marriage licenses and more. This was followed by the Townshend Acts of 1767 which were passed: to raise revenue in order to pay the salaries of governors and judges so that they would be independent of colonial rule; to create a more effective means of enforcing compliance with trade regulations; to punish the province of New York for failing to comply with the 1765 Quartering Act; and to establish as precedent the British Parliament’s right to tax.

Just like the Tea Party Movement of today, our founding fathers resented insidious taxes and regulations imposed upon them without their consent. Then as now, it is simply a matter of ‘taxation without representation’, an act which early Americans likened to tyranny. By 1773, when the East India Company was granted a virtual monopoly on the importation of tea, it was the last straw. In protest, a group of Boston citizens disguised as Mohawk Indians boarded a ship and dumped 342 chests of tea into Boston harbor. The Revolutionary War ensued, and the United States of America was born. Today, the Affordable Care Act is only a symptom of the disease. The disease being: overregulation, overburdensome covert and overt taxes, unsustainable federal debt, and a small minority of ideologues, with socialist tendencies, forcing their will upon the people.

The first income tax proposed by the United States Government was intended to fund the American Civil War (1861). Prior to this, the government was funded strictly through customs duties, tariffs levied on imported goods. During the War of 1812, the government experimented briefly with excise taxes on certain goods, commodities, housing, slaves and land, but a tax on income was out of the question. What is significant is that prior to 1861, or for the first 86 years of American history, whether a citizen had an annual income of $800, $250,000, $1,000,000 or $10,000,000, every dime was considered to be private property of the individual, and not subject to any federal claim.

In 1862, the first Revenue Act was revised, before any tax was due, and the Revenue Act of 1862 launched the first progressive rate tax in U.S. history. The Act established the office of the Commissioner of Internal Revenue, and specified that the Federal income tax was a temporary measure that would terminate in the year 1866. Annual income of U.S. residents, to the extent it exceeded $600 ($13,400 in 2011 dollars), was taxed at a rate of 3.0%; those earning over $10,000 per year ($224,000 in 2011 dollars) were taxed at a 5.0% rate. Through 1912, the income tax only existed for 11 out of the first 137 years of American history, from 1862 to 1872, while no income tax was imposed upon private citizens for 126 years. The income tax was a temporary measure imposed to fund the American Civil War. During the era, the highest tax rate assessed on married couples occurred between 1865 and 1866, when those earning the equivalent of $250,000 (in 2011 dollars) paid a tax of 8.4%, those earning $1,000,000 paid 9.6%, and those earning $10,000,000 incurred a tax rate of just 10.0%.

In the midst of the Panic of 1893, an amendment to the Wilson-Gorman Tariff Act of 1894 was passed, establishing a flat 2.0% tax on all incomes above $4,000 per year (about $104,000 today). The amendment would have exempted from taxation the salaries of state and local officials, federal judges, and the president. Believing the tax to be unconstitutional, President Grover Cleveland refused to sign it. The Act became law in 1894 without his signature, but was ruled unconstitutional by the U.S. Supreme Court in the following year.

Thus America remained the land of the free, free of an income tax from 1873 through 1912. But behind the scenes, the Democratic Party was fast at work, conjuring legislation which would ultimately destroy the freedoms won by Americans in 1776. Democrats proposed a constitutional income tax amendment in their party platforms of 1896 and 1908. Theodore Roosevelt endorsed both an income tax and an inheritance tax, and in 1908, became the first President of the United States to openly propose that the political power of government be used to redistribute wealth.

In 1909, the income tax amendment passed overwhelmingly in the Congress and was sent off to the states. The last state ratified the amendment on February 13, 1913. The Sixteenth Amendment owes its existence mainly to the West and South, where individual incomes of $5,000 or more were comparatively few. Sold to the public as a tax on the rich, the income tax initially applied to less than 1.0% of the population, but that would be short lived. The aspirations of power hungry, greedy and wasteful politicians would soon change the federal government into the conundrum it is today.

From Taxing the Rich

Recap: 1913 to 1963

In April of 1913, President Woodrow Wilson summoned a special session of Congress to confront the perennial tariff question. He was the first president since John Adams to make an appeal directly to Congress. Under the guise of reducing tariffs, the Act turned out to be nothing more than a means of reinstituting a federal income tax. The argument followed that since a reduction in tariff duties would lead to lost revenue, an income tax would be required to makeup the shortfall. We should be mindful of this deception as Barack Obama attempts to twist arms during his upcoming special session.

World War I commenced on July 28, 1914 and lasted until November 11, 1918. Since the income tax was initially imposed as a means of funding war (1861), its original intent now combined with an element of wealth redistribution, lead to one of the most convoluted tax rate schedules of all time. The War Revenue Act of 1917 expanded the tax rate schedule from 7 to 56 tiers. Rates were hiked to a range of 6.0% to 77.0% in 1918. The 1918 tax rate schedule was so convoluted that taxpayers were thrown into a higher bracket with every $1,000 to $2,000 of additional income.

Although the war ended in 1918, income taxes were not significantly reduced until 1924. In 1919 the top rate was gradually lowered to 73.0%, then to 58.0% in 1922, and to 46.0% under the Mellon Tax Bill of 1924. By 1924, the tax rate schedule contained just 43 tiers compared to 56 in 1918. The bottom rate also gradually declined from 6.0% in 1918 to 2.0% in 1924. Then in 1925, under the leadership of President Calvin Coolidge, the bottom rate was reduced to 1.5%, the top rate slashed to 25.0% with a reduced top bracket, and the tax rate schedule was simplified to 23 tiers from 43.

In the midst of the Great Depression, President Herbert Hoover relapsed, imposing higher tax rates and expanding the number of tax brackets from 23 to 55. In 1932, the bottom rate was increased from 1.5% to 4.0%, and the top rate was hiked from 25.0% to 63.0%. Franklin Roosevelt would later increase the top rate to 79.0%, in 1936, where it remained through 1940. Hoover had in effect reinstated wartime tax rates during a time of peace. Errantly believing that higher taxes would increase government revenue, Hoover was the first president to prove that raising taxes during a recession only prolongs the downturn.

Thanks to Hoover, and his successor Franklin Roosevelt, the Great Depression wouldn’t end until America entered the 2nd World War. After Hoover opened the door, FDR removed the hinges, gradually raising rates from the bottom up. President Franklin Roosevelt believed and stated that, “Taxes, after all, are dues that we pay for the privileges of membership in an organized society.” This would mark a critical turning point in American history, as the purpose of the income tax had shifted from a temporary means to fund the Civil War, to a measure reinforcing lower tariff duties, to a tool for redistributing wealth, and ultimately to the price of living under the rule of a tyrannical dictator.

Following suit, bottom tax rates were raised from 4.0% in 1932, to 10.0% in 1941, to 19.0% in 1942, and to a record high of 23.0% in 1944. His successor, Harry Truman, would continue the tradition. After initially lowering the bottom rate to 20.0% in 1949, Truman raised it to 20.4% in 1951 and to 22.2% in 1952. The bottom rate was then locked in at 20.0%, by President Dwight Eisenhower, where it remained from 1954 through 1963. The top rate was likewise increased by FDR, climbing from 63.0% in 1932, to 79.0% in 1936, 81.0% in 1941, 88.0% in 1942, and to a record high of 94.0% in 1944 -- during the height of the 2nd World War. Truman later lowered the top bar to 91.0% in 1946, and then raised it yet again to 92.0% in 1952. Eisenhower would fix the top tier at 91.0%, where it would remain from 1954 through 1963.

During the first 51 years after reinstatement of the income tax (1913 – 1963), the bottom rate commenced at 1.0%, peaked at 23.0%, and settled at 20.0%. Meanwhile, the top rate was nudged in at 7.0%, peaked at 94.0%, and ended the period at 91.0%. Imagine being in the top tax bracket with an opportunity to make an extra $1 million, and facing the prospect of handing over $910,000 of it to the government, while clutching to a paltry $90,000. Was that fair? Does it sound like a plan for economic prosperity and jobs growth? As we shall see, neither John F. Kennedy nor Ronald Reagan thought so.

From Taxing the Rich

The Tax Reduction Act of 1964

"Our tax system still siphons out of the private economy too large a share of personal and business purchasing power and reduces the incentive for risk, investment and effort – thereby aborting our recoveries and stifling our national growth rate." – John F. Kennedy, Jan. 24, 1963, message to Congress on tax reduction and reform, House Doc. 43, 88th Congress, 1st Session

Finally in 1963, President John F. Kennedy was able to restore a measure of common sense to the overburdening income tax system. However, shortly after rebuking the “tax the rich” intelligentsia, JFK was assassinated in November 1963. He was succeeded by Lyndon Johnson who signed his vision into law. Under the Tax Reduction Act of 1964, the bottom rate was lowered from 20.0% in 1963, to 16.0% in 1964, and then to 14.0% from 1965 through 1976, and then later reduced to 0.0% in 1977 where it remained until 1986. The top rate was likewise reduced from 91.0% in 1963, to 77.0% in 1964, and then cut to 70.0% in 1965 where it remained until 1981.

Note: It was also during this era, that the Earned Income Credit (EIC) was signed into law by President Gerald Ford in 1975. The function of the EIC was to offset the burden Social Security taxes placed on low-income filers with children, and to motivate them to work.

From Taxing the Rich

In 1965 married couples with taxable income equivalent to $250,000 today paid a tax of 28.6%; those earning $1,000,000 paid 50.3%; and those earning $10,000,000 forked over 67.9% of taxable income (see table below).

From Taxing the Rich

During the entire 18 year period marking JFK’s tax reform legacy, married couples with taxable income equivalent to $250,000 today would have faced an average tax rate of 31.0%; those earning $1,000,000 would have paid an average rate of 52.8%; and those earning $10,000,000 would have forked over an average of 68.6% of their taxable income.

The Economic Recovery Tax Act of 1981

“We don't have a trillion-dollar debt because we haven't taxed enough; we have a trillion-dollar debt because we spend too much” ~Ronald Reagan - 40th US President (1981-1989)

In 1981, President Ronald Reagan, in the Jeffersonian spirit, with the wisdom of Lincoln, and the knowledge of Coolidge, took over where Kennedy left off. Summing up the folly of big government, he declared that, “The government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.” The Economic Recovery Tax Act, which went into effect in 1982, would maintain the bottom rate of 0.0%, and slash the top rate from 70.0% to 50.0%, but this was only the beginning.

In 1982 married couples with taxable income equivalent to $250,000 today paid a tax of 38.3%; those earning $1,000,000 paid 47.1%; and those earning $10,000,000 forked over 49.7% of taxable income (see table below).

From Taxing the Rich

The Tax Reform Act of 1986

The Economic Recovery Tax Act of 1981 was only a prelude to Reagan’s ultimate goal, tax reform. His objective was to simplify the income tax code, broaden the tax base and eliminate many tax shelters and other tax preferences. Under the Tax Reform Act of 1986 the bottom rate was raised from 0.0% to 11.0%, and the top rate slashed from 50.0% to 38.5%. As of 2011, the Act is the most recent major simplification of the tax code, drastically reducing the number of deductions and the number of tax brackets.

From Taxing the Rich

In 1987 a married couple with taxable income equivalent to $250,000 today paid a tax of 30.5%; those earning $1,000,000 paid 36.5%; and those earning $10,000,000 forked over 38.3% of taxable income (see table below).

From Taxing the Rich

The Tax Reform Act of 1986 culminated in the most simplified rate schedule since the days of Abraham Lincoln. Between 1988 and 1990, the tax rate schedule contained only two tiers, with a bottom rate of 15.0% for couples making under $56,504, and a top rate of 28.0% for those making $56,504 or more.

Between 1988 and 1990, married couples with taxable income equivalent to $250,000 today paid a tax of 25.1%; those earning $1,000,000 paid 27.3%; and those earning $10,000,000 had a tax liability of 27.9% of taxable income (see table below).

From Taxing the Rich

Although George H. W. Bush would ultimately raise taxes by adding a new top bracket of 31.0%, in 1991 through 1992, during the entire 11 year period, married couples with taxable income equivalent to $250,000 today would have faced an average tax rate of 30.5%; those earning $1,000,000 paid an average of 37.2%; and those earning $10,000,000 would have incurred an average tax liability of 39.3% of taxable income.

The Deficit Reduction Act of 1993

"I'll tell you the whole story about that budget. Probably there are people in this room still mad at me at that budget because you think I raised your taxes too much. It might surprise you to know that I think I raised them too much, too" ~Bill Clinton - 1995

Bill Clinton’s Deficit Reduction Act of 1993 was nothing more than a tax hike. It was far from stellar, simply adding two new brackets above George H. W. Bush’s, but one positive aspect was that it represented a permanent change. The tax rates and brackets remained constant from 1993 through 2000, with an annual adjustment for inflation. The Act kept Reagan’s 15.0% and 28.0% brackets, and Bush’s 31.0% bracket in tact, and merely added two new brackets to the mix -- 36.0% and 39.6%.

Note: Clinton is also responsible for implementing the Child Tax Credit, as part of the Taxpayer Relief Act of 1997. The credit was designed to provide tax relief to lower-income families. Initially, for tax year 1998, families with qualifying children were allowed a credit against their federal income tax of $400 for each qualifying child. For tax years after 1998, the credit increased to $500 per qualifying child, and for families with three or more children, the child tax credit was refundable.

From Taxing the Rich

During the 8 year period, 1993 through 2000, married couples with taxable income equivalent to $250,000 today enjoyed an average tax rate of 27.1%; those earning $1,000,000 incurred an average rate of 36.0%; and those earning $10,000,000 gave up an average of 39.2% of taxable income (see table below).

From Taxing the Rich

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)

“He said, tax the rich. You've heard that before haven't you? You know what that means. The rich dodge and you pay.” ~George W. Bush - 2004

In 2001, George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act. The Act maintained the 15.0% bracket, and modestly reduced Reagan’s 28.0% bracket, Bush’s 31.0% bracket, and Clinton’s 36.0% and 39.6% brackets, to 27.5%, 30.5%, 35.5% and 39.1% in 2001. Then in 2002, the Act added a new 10.0% bracket (making it an authentic across the board tax cut), maintained a 15% bracket, and further reduced the remaining brackets to 27.0%, 30.0%, 35.0% and 38.6%.

Note: EGTRRA also enacted a stair-step schedule that raised the Child Tax Credit from $500 to $1,000 over a 10 year period. It also made a portion of the credit, known as the additional child tax credit, refundable.

The following year, Bush would sign the Jobs and Growth Tax Relief Reconciliation Act of 2003 which provided the rates in force today. The Act maintained the 10.0% and 15.0% brackets, and reduced the remaining brackets to 25.0%, 28.0%, 33.0%, and 35.0%. As of today, although Barack Obama has delivered numerous speeches and proposed various temporary tax relief measures, such as a 2.0% cut on the employees’ portion of Social Security taxes (which threatens to accelerate the programs demise), he has offered nothing in the order of permanent tax reductions or reforms.

From Taxing the Rich

Between 2003 and 2011, married couples with taxable income equivalent to $250,000 today are accustomed to an average rate of 24.0%; those earning $1,000,000 have incurred an average of 32.0%; and those earning $10,000,000 are accustomed to paying an average tax of 34.7% of taxable income (see table below).

From Taxing the Rich

Pressing On

“Nothing in this world can take the place of persistence. Talent will not; nothing is more common than unsuccessful people with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan ‘press on’ has solved and always will solve the problems of the human race.” ~Calvin Coolidge

When a taxpayer has enough deductions and credits to not owe any income tax, that should be the end of the matter, but that’s not the case today. No. Ever since enactment of the Earned Income Credit in 1975, followed by the Child Tax Credit in 1997, the federal income tax has become one of the government’s primary tools for the redistribution of wealth. Today, billions of dollars are transferred from one taxpayer to another before the funds ever reach federal coffers. Nowadays, a family with no tax liability at all may receive a “tax refund” of as much as $8,000 per year. This is most outrageous, and a matter which should be on the table for Congressional reform today, not tomorrow. In fact, on September 2, 2011, the Treasury Department’s Inspector General for Tax Administration reported that, in 2010, $4.2 billion in refundable credits were paid to individuals not even authorized to work in the United States. The federal government’s days of sitting around begging for more tax revenue, while recklessly giving away the dollars we currently pay are over.

When we examine the tax rates levied on upper incomes since the Revenue Act of 1913, we find that the average rate paid by married couples with taxable income equivalent to $250,000 today is 23.3%, while those earning $1,000,000 have paid an average tax of 38.6%; and those earning $10,000,000 have paid an average rate of 55.7%. The weighted averages are essentially the same, at 23.3%, 38.6%, and 55.8%, respectively (see table below).

From Taxing the Rich

But of course, if we take into account the first 137 years of American history prior to 1913, when the income tax was for the most part nonexistent, the historically weighted averages are actually significantly lower. We must never forget that out of 236 years of American history, the United States has only put up with an income tax for 110. That’s why many American’s are pressing towards a return to the low rates of Coolidge, while some long for the rates promised in 1913, and still others for repeal of the 16th Amendment.

Today we have Barack Obama, a man who seems curiously decoupled from any sense of American history. By repeatedly delivering the same broken record speech about raising taxes on millionaires and billionaires, while simultaneously proposing to apply the top tax rate to those earning $250,000, Obama has made himself the laughing stock of POTUS’. What gives? Did he miss the 1960’s, 1970’s, or 1980’s? Perhaps Obama was living outside of the country during a key decade, missing a segment of history that most Americans my age remember. I would suggest to Obama or anyone else proposing a radical change in U.S. tax policy, to first learn something about American tax history, and then proceed with caution. We must never forget that it was ‘taxation without representation’, an act of tyranny, which led to the first American Revolution.

Since 1913, the highest average tax rate assessed on taxable incomes of $250,000 has been 32.2%, during precarious times, the lowest 1.3%, and the historical weighted average 23.3%. So with that in mind, one can only imagine where Barack Obama is coming from as he delivers speech after speech hinting at raising taxes on millionaires and billionaires, a feat he portends to accomplish through ushering those making $250,000 into the top tax bracket. If we can learn anything from the past, it should be clear that tax rates on incomes of $1,000,000, $10,000,000 or more are lagging behind their historical weighted averages, while rates on those making $250,000 are within tolerance. So where’s the legislation spelling out the addition of upper brackets on those making millions and billions per year? Obama should either place a proposal in line with his rhetoric on the table, or simply step aside.

From Taxing the Rich

References / Related:

Taxing the Rich, Part I

Taxing the Rich, Part II

Spreadsheets: Historical Income Tax Data

Images: Tax Tables and Charts

Tax Foundation - Income Tax Tables: 1913 to 2011

Tax Acts of the United State, 1861 through 2010

The Origin of the Income Tax

Quick Revolutionary War Tour 1765-1777

Natural Born Conservative on Taxes

CPI Adjusted Dollars:

http://www.measuringworth.com/uscompare/

http://www.dollartimes.com/calculators/inflation.htm

Saturday, September 3, 2011

Taxing the Rich – 1765 to 2011, Part II

– War and Taxes: 1873 to 1963

– By: Larry Walker, Jr. –

“A wise and frugal government, which shall leave men free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned - this is the sum of good government.“ ~Thomas Jefferson

From Taxing the Rich

In the post-Civil War years, a booming economy produced tariff surpluses for decades. However, Democratic members of Congress, not wanting to give up on the pursuit of legalized theft, introduced sixty-eight income tax bills between the years of 1874 and 1894. It was in the midst of the Panic of 1893 that an amendment to the Wilson-Gorman Tariff Act of 1894 was passed, establishing a 2.0% tax on all incomes above $4,000 per year (about $104,000 today). The amendment would have exempted from taxation the salaries of state and local officials, federal judges, and the president.

Believing the income tax to be unconstitutional, President Grover Cleveland refused to sign it. The Act became law in 1894 without his signature, but was ruled to be unconstitutional in the following year. In 1895, the Supreme Court ruled 5-4 against the income tax, stating that its provisions amounted to a direct tax, which was prohibited by the U.S. Constitution. Prior to the 16th Amendment, a direct tax could only be levied if apportioned among the states according to the census, a concept that America could easily restore through its repeal.

Article I, Section 8: The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States.

Article I, Section 9: No capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken. [This section was changed in 1913 by passage of the 16th Amendment.]

Thus America remained the land of the free, free of income taxes from 1873 through 1912. But behind the scenes, the Democratic Party was fast at work, conjuring legislation which would ultimately destroy the freedoms won by Americans in 1776. Democrats proposed a constitutional income tax amendment in their party platforms of 1896 and 1908. Theodore Roosevelt endorsed both an income tax and an inheritance tax, and in 1908, became the first President of the United States to openly propose that the political power of government be used to redistribute wealth.

In 1909, the income tax amendment passed overwhelmingly in the Congress and was sent off to the states. The last state ratified the amendment on February 13, 1913. The Sixteenth Amendment owes its existence mainly to the West and South, where individual incomes of $5,000 or more were comparatively few. Sold to the public as mainly a tax on the rich, the income tax initially applied to less than 1.0% of the population, but that would be short lived. The aspirations of power hungry, greedy and wasteful politicians would soon change the federal government into the conundrum it is today.

“Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.” ~Ronald Reagan

Those hornswoggled by today’s Democratic Party, having been indoctrinated in the tired old “tax the rich” mantra of the early 20th Century, will eventually find themselves mired in an infinite array of new taxes: energy taxes, excise taxes, higher Social Security and Medicare taxes, mandated health care taxes, consumption taxes, value added taxes, and every imaginable form of regressive fine and fee. From 1776 to the present, a battle has been waged to determine the government’s fair share of a private citizen’s earnings, and it will continue until government is finally restored to its Constitutional limitations.

The Revenue Act of 1913

In April of 1913, President Woodrow Wilson summoned a special session of Congress to confront the perennial tariff question. He was the first president since John Adams to make an appeal directly to Congress. Under the guise of reducing tariffs, the Act turned out to be nothing more than a means of reinstituting a federal income tax. The argument followed that since a reduction in tariff duties would lead to lost revenue, an income tax would be required to makeup the shortfall. We should be mindful of this as Barack Obama attempts to twist arms during his upcoming special session.

The 1913 Act appealed to those of the “tax the rich” mentality. Its progressive rates were similar to our modern day model, with the exception that it contained 7 tiers and a top rate of 7.0%, versus the present 6 tiers with a top rate of 35.0%. Marginal tax rates, under the 1913 Act, ranged from just 1.0% up to 7.0%. And since a married couple was allowed an exemption of $4,000, which was more than most people earned, most of the population was exempt. At the time, less than 1.0% of the population was subject to the tax, which helps to explain how the 16th Amendment achieved ratification: i.e. “It won’t affect me, so why should I care?” The largest proportion of the tax was targeted to those with incomes higher than anyone could imagine, as at the time, the top bracket of $500,000 was the equivalent of more than $10,000,000 today.

From Taxing the Rich

In 1913, a married couple with taxable income equivalent to $250,000 today would have paid a tax of just 1.0%; those earning $1,000,000 would have paid a tax of 1.6%; and those earning $10,000,000 would have incurred a tax rate of just 4.9% (see table below).

From Taxing the Rich

The War Revenue Act of 1917

World War I commenced on July 28, 1914 and lasted until November 11, 1918. Since the income tax was initially imposed as a means to fund war (1861), its original intent, now combined with an element of wealth redistribution, lead to one of the most convoluted tax rate schedules of all time. The War Revenue Act of 1917 expanded the tax rate schedule from 7 to 56 tiers. Rates were hiked to a range of 6.0% to 77.0% in 1918. The 1918 tax rate schedule was so convoluted that taxpayers were thrown into a higher bracket with every $1,000 to $2,000 of additional income.

From Taxing the Rich

Under the 1918 Act, a married couple with taxable income equivalent to $250,000 today would have paid a tax of 12.9%; those earning $1,000,000 would have paid a tax of 25.7%; and those earning $10,000,000 would have incurred a tax rate of 66.9% (see table below).

From Taxing the Rich

The Mellon Tax Bill (1924 – 1931)

Although the war ended in 1918, income taxes were not significantly reduced until 1924. In 1919 the top rate was gradually lowered to 73.0%, then to 58.0% in 1922, and to 46.0% under the Mellon Bill of 1924. By 1924, the tax rate schedule contained just 43 tiers compared to 56 in 1918. The bottom rate also gradually declined from 6.0% in 1918 to 2.0% in 1924. Then in 1925, under the leadership of President Calvin Coolidge, the bottom rate was reduced to 1.5%, the top rate slashed to 25.0% with a reduced top bracket, and the tax rate schedule was simplified to 23 tiers from 43.

Finally, common sense had returned. It was peacetime, and with taxes greatly reduced, the “Roaring Twenties” ensued. Although Coolidge didn’t cut top rates back to 7.0%, the lower rates he put in place, lasting from 1925 through 1931, have never been matched since. Coolidge had it right when he proclaimed that, “Collecting more taxes than is absolutely necessary is legalized robbery.”

From Taxing the Rich

Even before being elected President of the United States, the former Governor of Massachusetts understood and opined that, “There is a limit to the taxing power of a State beyond which increased rates produce decreased revenue. If that be exceeded intangible securities and other personal property become driven out of its jurisdiction, industry cannot meet its less burdened competitors, and no capital will be found for enlarging old or starting new enterprises. Such a condition means first stagnation, then decay and dissolution. There is before us a danger that our resources may be taxed out of existence and our prosperity destroyed.” ~Calvin Coolidge (Address to the General Court beginning the 2nd year as Governor of Massachusetts January 8, 1920)

By 1925, a married couple with taxable income equivalent to $250,000 today would have paid a tax of just 4.9%; those earning $1,000,000 would have paid a tax of 14.4%; and those earning $10,000,000 would have incurred a tax rate of 23.9% (see table below).

From Taxing the Rich

Revenue Acts of 1932 to 1940

In the midst of the Great Depression, President Herbert Hoover relapsed, imposing higher tax rates and expanding the number of tax brackets from 23 to 55. In 1932, the bottom rate was increased from 1.5% to 4.0%, and the top rate was hiked from 25.0% to 63.0%. The tax rate on upper brackets was later increased to 79.0%, by FDR, in 1936, where it would remain through 1940. Hoover had in effect reinstated wartime tax rates during a time of peace. Errantly believing that higher taxes would increase government revenue, Hoover was the first president to prove that raising taxes during a recession only prolongs the downturn. Thanks to Hoover, and his successor Franklin Roosevelt, the Great Depression wouldn’t end until America entered the 2nd World War.

From Taxing the Rich

In 1932, a married couple with taxable income equivalent to $250,000 today would have paid a tax of 8.6%; those earning $1,000,000 would have paid a tax of 21.8%; and those earning $10,000,000 would have forked over 54.8% of their taxable income (see table below).

From Taxing the Rich

Revenue Acts of 1941 to 1963

The next major tax hike would occur in 1941, with rates remaining at accelerated levels through 1963. After Hoover opened the door, FDR removed the hinges, gradually raising rates from the bottom up. President Franklin Roosevelt believed and stated that, “Taxes, after all, are dues that we pay for the privileges of membership in an organized society.” This would mark a critical turning point in American history, as the purpose of the income tax had shifted from a temporary means to fund the Civil War, to a measure reinforcing lower tariff duties, to the price of living under the rule of a tyrannical dictator.

Following suit, bottom tax rates were raised from 4.0% in 1932, to 10.0% in 1941, to 19.0% in 1942, and to a record high of 23.0% in 1944. His successor, Harry Truman, would continue the tradition. After initially lowering the bottom rate to 20.0% in 1949, Truman raised it to 20.4% in 1951 and to 22.2% in 1952. The bottom rate was then locked in at 20.0%, by President Dwight Eisenhower, where it remained from 1954 through 1963.

The top rate was likewise increased by FDR, climbing from 63.0% in 1932, to 79.0% in 1936, 81.0% in 1941, 88.0% in 1942, and to a record high of 94.0% in 1944 during the 2nd World War. Truman later lowered the top bar to 91.0% in 1946, and then raised it yet again to 92.0% in 1952. Eisenhower would fix the top tier at 91.0%, where it would remain from 1954 through 1963.

From Taxing the Rich

In 1941, a married couple with taxable income equivalent to $250,000 today would have paid a tax of 23.1%; those earning $1,000,000 would have paid 46.9%; and those earning $10,000,000 would have forked over 71.0% of their taxable income (see table below).

From Taxing the Rich

During the entire 23 year period, a married couple with taxable income equivalent to $250,000 today would have faced an average tax rate of 32.2%; those earning $1,000,000 paid an average tax of 57.6%; and those earning $10,000,000 would have forked over a whopping 85.5% of their taxable income (see table below).

Summary

"The government should create, issue, and circulate all the currency and credits needed to satisfy the spending power of the government and the buying power of consumers. By adoption of these principles, the taxpayers will be saved immense sums of interest. Money will cease to be master and become the servant of humanity." ~Abraham Lincoln, 16th US President (1809-1865)

From Taxing the Rich

During the first 51 years after reinstatement of the income tax, from 1913 to 1963, the bottom rate commenced at 1.0%, peaked at 23.0%, and settled at 20.0%. Meanwhile, the top rate was nudged in at 7.0%, peaked at 94.0%, and ended the period at 91.0%. Imagine being in the top tax bracket with an opportunity to make an extra $1 million, and facing the prospect of handing over $910,000 of it to the government, while clutching to a paltry $90,000. Was that fair? Does it sound like a plan for economic prosperity and jobs growth? As we shall see, neither John F. Kennedy nor Ronald Reagan thought so.

The average rates on the wealthy during each significant wave between 1913 and 1963 are shown above. It is important to understand that a small imposition, upon the rich, blossomed into grand theft taxation. That’s what happens when citizens allow a government to act without restraint. Those seeking to usher couples with taxable income of $250,000 into the upper echelons of taxation should recognize that the highest tax rates ever assessed at this level, when wartime taxes were at a peak, averages out to 32.2%, while pre-1941 averages were below double digits.

It’s time for America to return to her roots. We cannot and will never again allow our government to lead us, as blind men, into the abyss. To raise taxes on one is to raise them on all. Those who believed they would always be exempt from taxes, in 1913, would soon find themselves paying nearly three times the rate initially assessed on the wealthy. Today, every worker is subject to Social Security and Medicare taxes totaling 15.3% (temporarily 13.3%), a rate which is more than double that paid by the wealthiest Americans under the Revenue Act of 1913. There is no escape; you’re either for higher taxes, or lower taxes. Don’t believe the lie. Those advocating higher taxes on the rich have always and will always ultimately raise them on every soul, from the bottom up.

To be continued… Taxing the Rich – 1765 to 2011, Part III

References / Related:

Taxing the Rich – 1765 to 2011, Part I

Spreadsheets: Historical Income Tax Data

Images: Tax Tables and Charts

Tax Foundation - Income Tax Tables: 1913 to 2011

Tax Acts of the United State, 1861 through 2010

The Origin of the Income Tax

Quick Revolutionary War Tour 1765-1777

Natural Born Conservative on Taxes

CPI Adjusted Dollars:

http://www.measuringworth.com/uscompare/

http://www.dollartimes.com/calculators/inflation.htm