Symposium | Unfinished Business

Taxes: Fund the IRS!

By David Cay Johnston

Tagged internal revenue serviceObama AdministrationTaxes

Will anyone remember the dramatic turnabout in tax policy that began when Barack Obama took office? Considering the awful economic conditions that prevailed, and the announced intention of Republican Congressional leaders to make his presidency fail, Obama’s successes in tax policy are nothing short of astonishing. They are also little known because of the generally poor quality of mainstream news coverage about his actions as well as Obama’s failure to toot his own horn.

President Obama’s first priority was to use the income tax system to get cash flowing to Americans, especially those on the bottom half of the income ladder. Ever the practical politician, he was willing to throw in tax breaks for business to placate congressional Republicans so his proposal would become law.

The warnings that Obama’s tax policies, including those related to the ACA, would sink the economy turned out to be utterly wrong.

Seven-plus years later, as Obama’s second term comes to an end, those on the highest rungs of the income ladder are paying a significantly larger share of their incomes in taxes, while decades-old loopholes and rules that made the corporate income tax a profit center for multinationals were tightened somewhat.

All the dire warnings that Obama’s tax policies, including those related to the Affordable Care Act, would sink the economy turned out to be utterly wrong. By the spring of 2016 the economy had a record 73 straight months of private-sector job growth and 14.4 million jobs added, more than all of Europe combined in the same period. As a result, total government revenues when adjusted for inflation rose on Obama’s watch by 57 percent, while the annual budget deficit fell by two-thirds. Revenues from individual income taxes were up 78 percent and especially robust corporate profits resulted in a 175 percent increase in corporate income tax revenues.

However, Social Security and Medicare taxes revenue rose a mere 16 percent. Since that money comes of course from payroll taxes, that comparatively small increase reflects pay stagnation, as the median wage has remained stuck since 1998 at less than $550 a week when measured in today’s dollars. Of all the wage growth in America from 2000 to 2012, when inflation raised prices by exactly a third, an astonishing 77 percent of that growth went to the 7 percent of workers making $100,000 to $400,000. The fact that the Social Security tax is capped not far above $100,000 means most of those gains were not taxed to support retirees, widows, and orphans.

Obama’s legacy is in showing that while government can be a problem, when a wise leader who understands the algebra of economics and is not just driven by hatred of government, the power to tax and spend can be harnessed to make the economy grow, especially the private sector.

Obama did not run for office on tax reform, beyond promises to restore some fairness to the system. Thanks to superficial news coverage during the 2008 campaign, covered by politics reporters rather than policy reporters, many people saw him as a soak the middle-class candidate. Obama’s encounter on a Toledo, Ohio Street with a fellow who soon after marketed himself as Joe the Plumber was broadcast in snippets that aided this impression. The full seven-minute exchange shows Obama trying to explain to Joe that he would pay lower taxes and could save more money toward starting his own plumbing business if the Obama tax plan were law. Obama’s comments track closely with lines in my tax policy book Perfectly Legal, which John Kerry had cited repeatedly in his 2004 presidential campaign. Throughout Obama’s presidency, White House reporters and editorial page writers greeted his tax proposals with only slightly less skepticism than Joe the Plumber did.

Obama’s actions on tax policy stand in sharp contrast to those of his predecessor, whose first campaign was built almost entirely on promises that tax cuts would spur the economy and make everyone prosper. When the details became public after President Bush took office, they showed his plan was heavily tilted to the rich. The best-off .1 percent of Americans, households with incomes greater than about $2 million a year, enjoyed 12.5 percent of the tax savings. Instead of broad prosperity, however, job growth failed to keep up with population growth. The total income reported on tax returns, adjusted for inflation and the number of taxpayers, fell during the Bush years by $2.9 trillion. That’s $100 a month less income per American, with most losses suffered by those toward the bottom, who received only miniscule tax savings under the Bush plan.

With the country losing 20,000 jobs or more per day as Obama was taking office, the steady flow of dollars that keeps the economy humming was shriveling, with those on the edges left high and cash dry. At the worst point, every 52nd person in America, statistically, had no income except food stamps.

The centerpiece of Obama’s first foray into taxes was the Making Work Pay tax credit, designed to get a little bit of help to those who needed it the most in the worst economic downturn since the Great Depression. That tax credit, available even to those too poor to file an income tax return, was fully available only to the bottom 80 percent, with the credit phasing out until those making $190,000 or more (roughly the top 3 percent) got nothing, on the theory that they didn’t need the government’s help.

Obama proposed a refundable $500 per-person tax credit ($1,000 for a married couple) for those making less than $75,000, roughly the bottom 80 percent. Congress gave him only $400.

One of the most important features of this credit was that even if you did not owe income taxes, you were eligible to get it as a refund, prompting a spike in tax-return filings. Later studies showed the poor promptly spent the windfall or paid overdue bills, both of which helped stimulate economic recovery, while those up the income ladder added to their savings.

The Making Work Pay plan suffered only from being much smaller than what economic algebra showed was necessary to counteract the devastation left by Bush policies on taxes; increased war spending; reduced government investment in education, infrastructure, and science; and, worst of all, an utter failure to police mortgage banking and the sale of mortgage-backed securities created by Wall Street.

Obama called the Making Work Pay Act “the biggest middle-class tax cut ever.” It was, but only for two years. Once Republicans won control of Congress in 2010 they killed this tax credit and replaced it with one that excluded the very poor. While Obama’s plan gave up to $400 ($800 for married couples) each year to those at the bottom, the GOP plan that Obama acquiesced to gave a tax cut of $2,136 ($4,272 for married couples) for each of two years to the highest-paid workers.

In 2011, when the Republican-sponsored tax cut took effect, 61 million workers, or 40 percent of those with any paid labor, made less than $20,000. In all, 51 million taxpayers, more than a third, had their taxes raised, and all of them made less than $30,000 per taxpayer household, analysis by the nonprofit, nonpartisan Tax Policy Center computer model showed.

Obama went along, as he did with more tax cuts for “small” business, because the stimulative effect would expand the economy even if it left the poor behind. (Small is in quotation marks because in the tax world, that term applies not so much to the size of a business as to how it is legally organized; many companies that qualify as “small” are owned by the Koch brothers, the Marriott family, and Donald Trump.)

Making Work Pay helped a lot of people through tough times in his first two years in office, but Obama’s single biggest effect on individual income taxes took effect at the start of his second term. Obama signed a law making the Bush tax cuts permanent except for a fraction of the top 1 percent, whose taxable income above $425,000 ($450,000 for married couples) became subject to a 39.6 rate, up from the Bush-era 35 percent levy. Adding on taxes for capital income (dividends and capital gains) above $250,000 a year and other changes raised the maximum possible tax rate to 43.4 percent.

These changes had an effect. In 2012, the last year the Bush tax cuts were in full effect, the effective tax rate on the 400 highest-income tax returns was just 16.7 percent. That’s about the tax rate that a single worker who does not itemize would pay on $80,000 of wages. In 2013, with Obama tax policy finally in place, the top 400 paid at a 22.9 rate.

Looking at the best-off one-in-1,000 taxpayer households, who report more than $1.8 million on their income tax returns, we also see a startling shift. From 1980—the last year of the New Deal economy—up through 2012, this group tripled its share of national income from 3.4 percent to 10.3 percent, as its tax burdens plummeted, enabling more saving and reinvestment.

This group’s annual tax bill, for the next ten years, will rise by an average of $500,000 per family, the Treasury Department estimates, with that burden borne heavily by those making more than $30 million per year. Average income in this group in 2014 was more than $6 million, up from $1.6 million in 1980 inflation-adjusted dollars. To put that in context, the average income of the bottom 90 percent of taxpayers was smaller in 2014 than in 1980, down $953 to an average of $33,068 (in adjusted dollars).

With regard to corporate taxes, Obama has not proposed raising them, even though a higher tax would encourage companies to reinvest in the business to avoid that tax and thus spur more job creation. Instead, he signed into law a reduction for domestic production companies—manufacturing and mining primarily—from 35 percent to 32 percent. That gave a huge boost to companies such as General Electric, still engaged in significant domestic manufacturing. And Obama has indicated support for lowering the corporate tax rate, on paper the world’s highest.

Where Obama has made a difference is in aggressively going after corporate loopholes. The costliest is available only to multinational companies thanks to Section 532(b)(3) and related lines of the tax code that encourage converting profits earned in the United States into tax-deductible expenses paid to corporate subsidiaries in the Cayman Islands and other tax havens. This effectively converts the burden of taxes into a zero-interest loan. A company that invests the loan proceeds, netting just 4 percent annually, and lets the gains compound for 30 years, can then pay the tax and keep more than twice as much money as the tax itself.

Many multinationals invest in the safest security the world has ever seen, Treasury bonds. That means the interest these multinational companies collect because they are allowed to defer paying their taxes comes from the rest of us, who have to pay our taxes before we get our pay, and from domestic companies that generally must pay their taxes on an annual basis.

Using his power to regulate by implementing the laws Congress has passed, Obama took an important step in spring 2016 to discourage companies from shifting profits offshore. One of the many technical aspects of his new regulations will largely block multinational companies from borrowing against their untaxed offshore profits to finance domestic operations. Since American multinationals have stashed at least $2.1 trillion of untaxed profits offshore, they are beneficiaries of zero-interest loans worth more than $700 billion, money that would spur economic growth if it were taxed immediately and used to rebuild our crumbling infrastructure, improve education, and, most importantly for long-term economic growth, finance basic scientific research.

Business damages itself when we do not use tax dollars to expand roads, bridges, and other infrastructure and maintain what we already own.

Along the way Obama has taken a variety of steps that did little to help the economy but instead mollified those business owners and ideologues who see taxes not as a tool to build a vibrant economy and ensure the liberties of people, but as evil. Business damages itself when we do not use tax dollars to expand roads, bridges, and other infrastructure and maintain what we already own, as well as when college graduates are so burdened by debt that years after joining the workforce they cannot buy homes, furnish them, or invest.

During the two terms he was in the White House, President Obama largely reversed the disastrous George W. Bush policies that resulted in a doubling of national debt, population growing five times faster than jobs, and total incomes declining until the tax favors for the best-off Americans ended on December 31, 2012. It’s a remarkable achievement, especially given the determined efforts by congressional Republicans to make Obama a failed president. The question is whether historians will see the strengths, compromises, mistakes, and the net impact of President Obama’s largely quiet efforts to create a tax system that fosters economic growth.

More work awaits the next President if we are to have a tax system that makes the United States prosper and endure.The biggest long-term problem is that America has a superb federal tax system—for 1960. The industrial economy tax system that was created in stages between 1909 and 1924 needs to be scrapped in favor of a new system that flows out of the twenty-first-century economy. Wealth once owned in the form of factories and other hard assets is being supplanted by intangible copyrights, patents, and formulas for making pharmaceuticals and exotic materials. The wealth of such intellectual property can be reduced to paper, and that paper, unlike a factory, can be hidden offshore.

A second major problem is the damage done by continuing the World War II-era practice of financing health care as a tax-free fringe benefit using insurance companies. The system is so inefficient that if America were to adopt the French or German systems, regarded as among the best in the world, we would not only have universal coverage with no out-of-pocket costs, we would save the equivalent of all the income taxes paid in 2015 by 99.3 percent of Americans. While often described as an issue of insurance, health care is really a tax issue; financing is mostly done through tax-deductible spending by companies and individuals or via direct tax spending on behalf of government employees, government contractors, and the poor.

A third problem is the definition of income that must be reported annually. Billionaires can legally live tax-free by borrowing against the assets. Imagine two billionaires, both invested in a stock that pays no dividend, its price growing 5 percent per year—$50 million—who each spend $10 million on very lavish lifestyles. One billionaire sells $12.5 million of stock, pays a 20 percent capital gains tax, and spends $10 million. The other borrows $10 million and pays 2 percent interest, or $20,000, to her banker. The borrowing billionaire files no income tax return because she has no income as defined by Congress, and she is now $2.3 million better off than the billionaire who sold stock. Even with the interest continuing year after year, and a new $10 million loan each year, the borrowing billionaire will over time become much richer than the one who pays taxes.

Those are among many fundamental reforms that await the next President. But the most pressing problem to deal with is an Internal Revenue Service (IRS) that is so starved for revenue it cannot chase most tax cheats and is barely able to process the tax returns of compliant taxpayers. Adjusted for inflation and the size of the economy, the IRS has about half the resources per capita that it had in 2000. While the IRS needs massive computer technology to collect trillions of dollars each year, its budget for new software and hardware is virtually zero.

We are heading toward a system where we tax not incomes, but just wages, pensions, interest on savings, and the dividends and capital gains from stocks. (Because taxes on those forms of income are withheld and the income is independently verified in an automated computerized system.) Taxation of landlords, business owners, and many others is neither automated nor verified. Without audits to check that total incomes are fully reported, lawyers to enforce audit findings, and revenue officers to collect the money, these Americans can pay little or nothing of what the law says they should pay.

Failing that, our nation will not just burden the honest while rewarding the corrupt. It will lack the resources to finance the government that makes possible our liberties and our prosperity.

From the Symposium

Unfinished Business

The economy's made halting progress, but the recovery's leaving too many behind. A series of contributors take stock of where we've come in one part of the economy, and what's left to be done. E.J. Dionne Jr. introduces the symposiumDavid Cay Johnston on TaxesMehrsa Baradaran on Banks Caroline Fredrickson on Families Lenny Mendonca & Laura Tyson on Entrepreneurs Adam Zurofsky on Corporations Amy B. Dean on Workers


Corporations: The “Positive Discipline” Model

By Adam Zurofsky


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Read more about internal revenue serviceObama AdministrationTaxes

David Cay Johnston is a Pulitzer Prize-winning investigative reporter who has been called the “de facto chief tax enforcement officer of the United States.” He teaches at Syracuse University College of Law.

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