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Last night, I heard a group of pundits claiming that the US tax system is regressive when payroll taxes (for Medicare and Social Security) are considered.  Huh?

This encore was originally posted on Aug.3, 2008.

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OK, I’m officially confused. Is the current U.S. tax system “regressive” – the more you make, the lower your effective rate – or is it  “progressive” – the more you make, the higher your effective rate. 

The politicos and pundits – even the smart ones – seem split on the question.  So, which is it?

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Summary

Practically everyone agrees that the U.S. federal income tax structure is progressive (i.e. high earners pay a higher tax rate).  But, the Reagan and Bush tax code changes did make it less progressive than it was in the 1960s; there are some isolated anomalies ( e.g. Warren Buffett and his secretary); and it may be less progressive than some folks want.

The estate tax (a.k.a, “death tax”) is – by definition —  progressive since only the wealthiest 1% of folks who die pay it.

• Note: there’s a difference between “income” and “wealth” – while high income usually correlates with high wealth, income is a “flow” variable and wealth is a “stock”.

So, any dispute must arise from so-called  “payroll taxes” – the paycheck deductions that fund Social Security and Medicare. 

There is a single rate for Medicare (1.45%) that is applied to all wages; and.there is a single rate for Social Security(6.2%) that is applied to at most $102,000 in wages.  Employers match their employees’ contributions dollar-for-dollar.

• Note: most economists argue that, in the final analysis, employees bear the full burden of their employer’s matching amounts since employers most likelycover the tax by reducing wages.

Since the same rates are applied to all taxpayers , and since Social Security’s“base earnings” are capped at  $102,000, then payroll taxes are regressive with respect to current earnings.  But – as I’ll demonstrate is future analytical posts – Medicare benefits are the same, regardless of how much a taxpayer contributes (and high earners contribute more than low earners); and Social Security benefits are “coupled” to earnings via a very progressive formula – i.e. high-earners get disproportionately less in benefits.  So, taking into account the benefits received as well as the contributions made, both programs are very progressive.

The bottom line: all of the components are progressive:  federal income taxes, estate taxes, payroll taxes.  So, it logically follows that the combined program is progressive.

In this post, I’ll set-up the issue and provide some references.  In subsequent posts, I’ll provide some numbers and analysis that support the above conclusions..

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The Details

The question: Is the current U.S. tax system “regressive” – the more you make, the lower your effective tax rate – or is it  “progressive” – the more you make, the higher your effective tax rate.

Let’s look at the pieces that make up the U.S. tax system..

There’s the estate tax (a.k.a. “death tax”).  It’s clearly progressive since only the richest 1% of folks who die pay it.  As the exclusion levels increase under the Bush plan, fewer dead people have to pay it – making it even more progressive.  When it gets eliminated entirely in 2010, it stops being progressive, but it doesn’t start being regressive.  It just stops.

The estate tax in small potatoes in the overall  tax mix.  The big behemoth is the federalincome tax.  The aggregate statistics  (i.e. looking at the broad population , and not just Warren Buffett and his secretary) are – in my opinion – incontrovertible.  Higher income folks – say the top 50% — pay a higher effective income tax rate and shoulder over 97%l of the federal income tax burden. The federal income tax is progressive.  Period..

Why then, do many really smart, well-intended people say the tax system is regressive and that high earners aren’t paying their fair share?

• Note: though some people use the terms interchangeably, “regressive” and “fair share” are not synonymous.

First, what some of them are really saying is that the income tax code isn’t as progressive as it used to be (true, but so what?),  or that it isn’t as progressive as the tax code in other countries, say France (true, but — for sure — so what?),  or that it’s not progressive enough based on higher order socio-ethical criteria (very important, but also, quite debatable).

• Note: for a recent, left-leaning, comprehensive recap, see “How Progressive is the U.S. Federal Tax System?”, Journal of Economic Politics, http://elsa.berkeley.edu/~saez/piketty-saezJEP07taxprog.pdf

A more structural argument posed by many people is that so-called “payroll taxes” that fund Social Security and Medicare are regressive and tilt the balance of the tax system..

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For example, Robert Reich, Bill Clinton’s former Secretary of Labor says:

The fact that “84.6% of all federal taxes are paid by the top 25% of income earners, and over a third are paid by the top 1%, advances a specious argument.

Most Americans pay more in payroll taxes than in income taxes … payroll taxes take a much bigger portion of the paychecks of lower-income Americans than of higher-income.

Viewed as a whole, the current tax system is quite regressive.”

http://economistsview.typepad.com/economistsview/2007/10/robert-reichs-p.html

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OK, so parsing Reich’s argument, if the overall system is regressive, and if major parts of the system —  income and estate taxes are progressive – then it logically follow that payroll taxes are both substantial (especially to low-earners) and very regressive.  The culprit is payroll taxes.

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The Tax Policy Center—  a joint venture of the Urban Institute and Brookings Institution and self-proclaimed non-partisan organization   – explains:

“Taken as a whole, the federal tax system is progressive: on average, households with higher incomes pay a larger share of their income in federal tax than do those with lower incomes. In other words, the overall average effective tax rate-total tax paid as a percentage of income-rises as income rises.

But not all taxes within the federal system are equally progressive. The estate tax is the most progressive federal tax. The individual (and corporate) income taxes are also progressive. In contrast, payroll taxes for Social Security and Medicare are regressive, claiming a larger share of income from lower-income than from higher-income households.

For 2008 average effective payroll tax rates are estimated at 8.4 percent for the bottom fifth of income earners, and 10.4 percent for the next fifth, but only 5.7 percent for the top fifth. Households in the top 1 percent will pay an estimated average of only 1.5 percent of their income in payroll taxes.

This regressivity of payroll taxes stems from two factors. First, the Social Security portion of payroll taxes is subject to a cap: in 2008, individuals pay Social Security tax on only their first $102,000 in earnings. Second, higher-income households tend to receive more of their income from sources other than wages, such as capital gains and dividends, which are not subject to the payroll tax.”

http://www.taxpolicycenter.org/briefing-book/background/distribution/progressive-taxes.cfm

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The underlying logic of the regressive claim is simple. Take Social Security: A worker gets docked 6.2% on wages up to $102,000.  The rate drops to zero for any wages over $102,000.  So, somebody earning $50,000 has $3,100 deducted from their paycheck [6.2% times $50,000];  somebody earning $102,000 has $6,324 deducted —  a greater amount, but the same 6.2%;  somebody earning $200,000 has $6,324 deducted — the same as the worker earning $102,000, but representing a lower effective rate (3.2%).  The more that somebody earns over the $102,000 maximum, the lower the effective rate. By definition, that’s a regressive tax since the rate declines as income gets higher.  Case closed. Right?

Not so fast.

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The Urban Institute gets to the real core of the question:

The payroll tax is very regressive with respect to current income: The average tax rate falls as income rises …  (But) the regressivity of the payroll tax is mitigated to a substantial extent when Social Security and Medicare benefits are considered as well..

http://www.urban.org/publications/1001065.html

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In other words, the single payroll tax rate and the cap on taxable earnings combine to make payroll taxes appear regressive when analyzed solely based on current payroll deductions but, the benefits the taxes buy (retirement income and health insurance) are so progressive – i.e. highearners get muchlowerbenefitsperdollarthanlowearners — .that the net effect on tax payers is progressive – very progressive.

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A Congressional Joint Economic Committee states the case more directly:

The rapid growth in payroll taxes over the past 40 years has imposed a large burden on working Americans. This burden has fallen disproportionately on low-income workers. However, in the context of a comprehensive tax policy, it is misleading to focus on the short-term burden imposed by payroll taxes without accounting for the future benefits (since) the progressivity of the benefit formulae outweigh the disproportionate burden imposed by the taxes.

As a result, low-wage workers can expect to receive benefits that exceed the sum of their and their employers’ payroll tax contributions. Middle- and high-wage workers, on the other hand, can expect to pay substantially more into the system than they will receive in benefits.

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>>> Read more

One thing is definitely bipartisan: all politicians take liberties with economic data and use it selectively to make their cases.

Most recently, Senator Obama has been stumping that median real household income grew under President Clinton, and fell by over $1,000 because of President Bush’s policies. 

Taken literally, that’s true.  Reported median real household income declined from $49,163 in 2000 (Clinton’s last year in office) to $48,201 in 2006 (the most recently available data).

http://www.heritage.org/research/features/BudgetChartBook/index.html

Now, some folks (i.e. Republicans) might argue that the Clinton years’ gains were more attributable to the harvesting of the Reagan tax cuts and a coincidental internet-technology boom.  And, some folks (again, Republicans) might point out that Clinton handed Bush an economy that was, by generally accepted measures, in a the early stages of a recession that was subsequently deepened by the 9/11 crisis and its aftermath.  So, some of Clinton’s apparent gains may have been windfalls, and Bush may have been dealt a bad opening hand.  So be it.  That’s life in the oval office.

 
http://www.heritage.org/research/features/BudgetChartBook/index.html

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Putting aside the debatable qualitative aspects of the change in median real household income, what does the underlying hard data say ?

Starting from the very top, aggregate real income — the total income across all households, adjusted for inflation — grew 6.7%  from 2000 to 2006 — going from $7.2 trillion to $7.7 trillion. During that same period, the U.S. population grew 6.4%  — from  281.4 million  in 2000 to 299.4 million in 2006.  So, doing some simple arithmetic, real income per capita was flat from 2000 to 2006 — $25,722 to $25,795.  In other words, real income kept pace with population growth.

During that same period, the number of households grew 7.2%  — faster than population — going from 108.2 million in 2000 to 116.0 million in 2006.  Households got slightly smaller  — 2.58  people per household in 2006, versus 2.60 in 2000.  Why?  Some couples had fewer children, and some households split-up with multiple wage earners forming separate household units.

So, despite an increase in aggregate real income, the average —  mean real household income — declined slightly , going from $66,895 to $66,570. 

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Importantly, for several reasons, mean real household income isn’t a particularly good criteria.  It is an incomplete and misleading measure of families’ economic well-being.

First, most analysts would agree that when statistical distributions are highly skewed (such as income data with many folks at the bottom and relatively few at the very top), the median  — the 50th percentile mark that splits the population into a top  and a bottom halves —  is a more representative measure than the mean, which is a simple average of all folks. 

So, from a strictly statistical perspective, it makes sense that Obama is touting a median.  The criteria he selects is median real household income — which  dropped from $49,163 in 2000 to $48,201 in 2006.

But, that narrow metric has some glaring flaws: It doesn’t include some items that contribute to household income and, most important, it is pre-tax.  It doesn’t account for  the taxes that the government takes out.

More specifically, median real household income isn’t all inclusive.  The commonly reported measure of household income — the one Obama cites —  is what’s called  “money income” — i.e., wages and transfer payments.  Money income doesn’t include common income items such as capital gains.  By just including capital gains, the median real household income gap between 2000 and 2006 narrows by a third.

 
Note: Capital gains data is from Tax Foundation estimates:
http://www.taxfoundation.org/blog/show/23411.html

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And, even more important, the median real household income metric is pre-tax. 

Since families can only spend after-tax income,  it is somewhere between disingenuous and intellectually dishonest to ignore tax benefits inyear-to-year comparisons.  This is particularly true in this case since the core of the Bush economic program is lower taxes. 

While the Bush tax plan is often demonized as being just for the rich, it also includes substantial benefits for folks in the lowest tax brackets.  For example,  the low bracket marginal income tax rate was cut from 15% to 10% , the personal exemption allowance has been increased from $2,900 in 2000  to $3,300 in 2006, and  the standard deduction has been increased from $10,200 in 2000 to $13,000 in 2006 (for joint filing married couples).

Median after-tax real household income isn’t commonly reported.  But, it can be estimated by simply running the reported median real household income through each year’s tax tables. 

In 2000, nominal median household money income — unadjusted for inflation — was $41,990.  Estimated nominal household capital gains were $680, so nominal median household income (including capital gains) was $42,670.

Since there were an average of 2.6 people per household in 2000, the estimated allowance for personal exemptions would be $7,540 — 2.6 times the $2,900 allowance per personal exemption in 2000.

The standard deduction for married couples filing jointly in 2000 was $10,200. Subtracting the personal exemptions allowance ($7,540) and the standard deduction ($10,200) from the median nominal household income ($42,670),  nets to a taxable income of $24,930. 

Since $24,930 was within the 15% marginal tax bracket in 2000, income taxes — ignoring, for simplicity, any child or earned income tax credits –would be $3,740  and median nominal after tax income would be $38,931.

Adjusting for inflation — that is, expressing the answer in 2006 dollars —  estimated median real household after-tax median income would be $45,581.

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How does 2006’s median real household after-tax median income rack-up against 2000’s ?

Well, taking into account Bush’s higher personal exemption allowance, the higher standard deduction, and the lower marginal tax rate — 10% versus 15% — the answer reverses !   Median real after-tax household income went up 2%  — about 2% or $1,000 per household — from the end of the Clinton administration in 2000 to the latest reported data (2006). 

For sure, that puts a different paint job on the picture.

Note: An excellent  analysis by Gerald Prante of the  Tax Foundation — “Has Real Median Household Income Fallen Since 2000?”  —  traces through the inclusion or exclusion of other income adjustments.  For example, including the imputed value of employer paid health insurance increases the 2006 real advantage by over $700 per household; payroll taxes on the higher income reduces the 2006 advantage by about $200.
 http://www.taxfoundation.org/blog/show/23411.html

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Now, some folks  (Democrats) might say that 2006 isn’t relevant since the economy has been in a slump since then. True, but the effect probably isn’t enough to re-reverse the answer.  We’ll see when the data comes out. 

Until then the most reasonable fact-based conclusion is that median real after-tax household income went up between 2000 and 2006, and Senator Obama’s claims are, in their best light, misleading.

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I think that both candidates gave pretty good answers to Rick Warren’s question at Saddleback.

McCain is getting hammered for his $5 million joke (which Paul Krugman of the NY Times acknowledges was a joke).

Going beyond the sound bites and reading the transcript (below), it turns out that it was McCain, not Obama, who gave the more nuanced answer.  Hmmm.

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Obama’s  Answer:

REV. WARREN: Okay. Taxes — this is a real simple question. Define “rich.” (Laughter.) I mean, give me a number. Is it 50,000 (dollars)? One hundred thousand (dollars)? Two hundred thousand (dollars)? Everybody keeps talking about who we’re going to tax. How do you define that?

SEN. OBAMA: You know, if you’ve got book sales of 25 million, then you qualify. (Applause.)

REV. WARREN: (Laughs.) I’m not asking about me. (Laughter.)

SEN. OBAMA: Look, here’s how I think about it. Here’s how I think about it, and this is reflected in my tax plan. If you are making $150,000 a year or less as a family, then you’re middle class, or you may be poor. But 150 (thousand dollars) down, you’re basically middle class. Obviously, it depends on region and where you’re living.

REV. WARREN: In this region, you’re poor. (Laughter and applause.)

SEN. OBAMA: I don’t know what housing prices are doing lately. (Applause.) I would argue that if you’re making more than 250,000 (dollars) then you’re in the top 3, 4 percent of this country. You’re doing well. Now, these things are all relative, and I’m not suggesting that everybody who is making over 250,000 (dollars) is living on Easy Street.

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McCain’s  Answer:

REV. WARREN: Okay, on taxes, define “rich.” Everybody talks about, you know, taxing the rich but not the poor, the middle class. At what point — give me a number. Give me a specific number. Where do you move from middle class to rich? Is it $100,000? Is it $50,000? Is it $200,000? How does anybody know if we don’t know what the standards are?

SEN. MCCAIN: Some of the richest people I’ve ever known in my life are the most unhappy. I think that rich should be defined by a home, a good job, an education, and the ability to hand to our children a more prosperous and safer world than the one that we inherited.

I don’t want to take any money from the rich. I want everybody to get rich. (Laughter.) I don’t believe in class warfare or redistribution of wealth. But I can tell you, for example, there are small businessmen and women who are working 16 hours a day, seven days a week, that some people would classify as, quote, “rich,” my friends, and want to raise their taxes and want to raise their payroll taxes.

Let’s have — keep taxes low. Let’s give every family in America a $7,000 tax credit for every child they have. Let’s give them a $5,000 refundable tax credit to go out and get the health insurance of their choice. Let’s not have the government take over the health care system in America. (Applause.)

So I think if you’re just talking about income, how about $5 million? (Laughter.) So, no, but seriously, I don’t think you can — I don’t think, seriously, that — the point is that I’m trying to make here, seriously — and I’m sure that comment will be distorted — (laughter) — but the point is, the point is, the point is that we want to keep people’s taxes low and increase revenues.

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Technical note: Obama’s 25 million books line (also a joke) is getting a free pass — even though, at $5 per copy, they represent $125 million in income — which is equivalent to $5 million amortized over 25 years.  Hmmm.  Did the candidates jokingly say the same thing ?

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Full debate transcript:
http://www.clipsandcomment.com/2008/08/17/full-transcript-saddleback-presidential-forum-sen-barack-obama-john-mccain-moderated-by-rick-warren/

Video:
http://trevinwax.com/2008/08/17/obama-mccain-with-rick-warren-at-saddleback-forum-video/

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I never agree with ultra-liberal NY Times ranter Paul Krugman. Well, I guess I should never say never.

While I disagree with his conclusions, I think he provides some interesting perspective in this op-ed.

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Excerpted from NY Time’s Op-Ed,  “Now That’s Rich”, Paul Krugman, August 22, 2008

Last weekend, Pastor Rick Warren asked both presidential candidates to define the income at which “you move from middle class to rich.”

Mr. Obama answered the question seriously, defining middle class as meaning an income below $150,000.

Mr. McCain, at first, made it into a joke, saying “how about $5 million?” .

The real problem, however, was with the question itself.

When we think about the middle class, we tend to think of Americans whose lives are decent but not luxurious: they have houses, cars and health insurance, but they still worry about making ends meet, especially when the time comes to send the kids to college.

Meanwhile, when we think about the rich, we tend to think about the handful of people who are really, really rich — people with servants, people with so much money that, like Mr. McCain, they don’t know how many houses they own.

The trouble with Mr. Warren’s question was that it seemed to imply that everyone except the poor belongs to one of these two categories: either you’re clearly rich, or you’re an ordinary member of the middle class. And that’s just wrong.

In his entertaining book “Richistan,” Robert Frank of The Wall Street Journal declares … that country is divided into levels, and only the inhabitants of upper Richistan live like aristocrats; the inhabitants of middle Richistan lead ample but not gilded lives; and lower Richistanis live in McMansions, drive around in S.U.V.’s, and are likely to think of themselves as “affluent” rather than rich.

Even these arguably not-rich, however, live in a different financial universe from that inhabited by ordinary members of the middle class: they have lots of disposable income after paying for the essentials, and they don’t lose sleep over expenses, like insurance co-pays and tuition bills, that can seem daunting to many working American families.

Which brings us to the dispute about tax policy.

According to estimates prepared by the nonpartisan Tax Policy Center, those Obama tax increases would fall overwhelmingly on people with incomes of more than $200,000 a year. Are such people rich? Well, maybe not: some of those Mr. Obama proposes taxing are only denizens of lower Richistan, although the really big tax increases would fall on upper Richistan.

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Full op-ed:
http://www.nytimes.com/2008/08/22/opinion/22krugman.html?_r=1&oref=slogin&pagewanted=print

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Excerpted from WSJ, “We Can’t Tax Our Way Out of the Entitlement Crisis”, by R. Glenn Hubbard, August 21, 2008

The spending shortfalls in Social Security and Medicare are large.

According to the Congressional Budget Office, Social Security and Medicare spending left unchecked would, after a generation, consume about 10 percentage points more of GDP than it does today.

Simple arithmetic suggests that with this much more of GDP eaten up by the two programs, all federal taxes on average would have to be raised by more than 50% to make up the shortfall … such a tax increase would reduce long-term GDP growth by about a full percentage point … reversing all of the gains in our long-term growth rate from the productivity boom of the past 15 years.

Large entitlement budgets … cannot be financed with growth-chilling taxes alone. Spending on other areas, including defense but also education, research, etc., must also be adversely affected.

Mr. Obama’s fiscal …  vision is plain enough: a larger welfare state paid for by higher taxes …  leaving open the question of what tax increases are next.

If Mr. Obama is going to increase spending, will he raise the money by higher business taxes instead? He has already distanced himself from John McCain’s call to reduce America’s corporate tax rate, and he is committed to raising tax rates on successful small business owners who pay individual as opposed to corporate income taxes. Does this mean he will raise tax burdens on individuals with annual incomes less than $250,000?

In a June 26 interview  … Mr. Obama said he wanted to roll back the Bush tax cuts for those in the top 5% of incomes — that is, about $145,000 per year. He also voted for the Democrats’ fiscal year 2009 Budget Resolution, which would raise taxes on individuals earning $42,000 or more.

Balancing the federal budget without a tax increase is possible, but will require strong fiscal restraint.

Three actions are essential: (1) reduce entitlement spending growth through some form of means testing; (2) eliminate all nonessential spending in the rest of the budget; and (3) adopt policies that promote economic growth.

This 180-degree difference from Mr. Obama’s fiscal plan forms the basis of Sen. McCain’s priorities for spending, taxes and health care.

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Mr. Hubbard, dean of Columbia University Business School, was chairman of the Council of Economic Advisers under President George W. Bush.

Full op-ed:
http://online.wsj.com/article/SB121927694295558513.html?mod=opinion_main_commentaries

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 OTP = Obama Tax Plan

An irony of Senator Obama’s tax plan is that folks in Democratic-leaning Blue electoral states will take the brunt of  proposed tax hikes. 

High-earners are concentrated   in big Democratic strongholds: DC, New Jersey, Maryland, Massachusetts, Connecticut, New York, California, and Illinois. 

Here are a couple of indicators of the level of concentration:

First, the average income of tax filers falling into the top 5% in each state.  As a rough measure, if the average is higher than Obama’s $200,000 – $250,000 income thresholds, then most (or all) of the state’s top 5% will be hit by the Senator’s increased tax rates.

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A second view is the proportion of top 5% income represented by each state’s top 5%.  The top 10 states — 7 of which are Blue states –account for over 55% of the total.

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Bottom line:  More Blue state filers than Red state filers will get hit by Obama’s tax increases.  And, there’s nothing they can do about it since their states are unwaveringly Democratic states.

Maybe there is justice in the world.

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Source : http://www.electoral-vote.com/

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Excerpted from Bloomberg, “Misleading on Taxes”,  Kevin Hassett, Aug. 18, 2008

Last week, the Government Accountability Office released a report … that led to an Associated Press story with the startling headline, “Most Companies in U.S. Avoid Federal Income Taxes’

House Speaker Nancy Pelosi piled on, arguing that the data revealed a fundamental unfairness in the U.S. system, and called for reform. “When two-thirds of corporations pay no taxes… American workers are forced to pay too much in taxes even as they cope with rising prices and falling wages.”

The problem is, the study showed no such thing.

First, while it is true that 60 percent to 70 percent of companies in the study paid no tax in a given year, there was a big qualification. The study focused on an Internal Revenue Service tax database that included millions and millions of companies. The vast majority of firms in the study were tiny mom- and-pop enterprises.

Why did the tiny mom-and-pop enterprises pay no taxes? Because they didn’t make any money! The study reported that was the reason about 80 percent of the firms in the sample avoided taxes in a given year. How terrible of them.

How can it be that so many small businesses made no money? Companies tended to have no profits because they had large deductions including wages. Hot dog vendors can pay themselves a wage, in which case they have no profits but pay wage taxes, or they can take their money in profits, in which case they pay profits tax. The data suggest they tend to do the former.

Most of them do this for a simple reason: we still have double taxation of dividends. If you are a hot dog vendor in the top tax bracket and you pay yourself $100, then you pay $35 in taxes. If you keep it as profit and then pay it to yourself as a dividend, you pay a $35 corporate tax, and then a 15 percent dividend tax on top of it. Why would anyone choose the latter? To do so would be to pay more taxes voluntarily.

For big corporations, the story is different. The study found that … almost no companies went through the sample period without paying taxes. 

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For full column:
http://bloomberg.com/apps/news?pid=20601039&sid=aJHKNW1lro9Y&refer=columnist_hassett

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Obama frequently rants that Warren Buffett’s tax rate is a bit under 18% — while Buffett’s $60,000 per year secretary has to pay 30%.

Among the ironies of the Obama plan –  as “clarified” by Forman and Goolsbee –  is that Buffett will still be paying a lower rate than his secretary. 

By my math, Buffett’s effective  rate will go up to about 22% (mostly due to the 5% bump in the capital gains rate) and his secretary’s rate will come down to 29% (courtesy of the $500 tax credit). 

The gap closes, but the much ballyhooed injustice is still there.

Apparently the plan’s architects fired but missed one of their most conspicuous, self-declared targets.

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Summary: Tell your rich relatives to check out in 2010. 

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Under the Bush Tax Plan, estate taxes were cleverly rebranded “death taxes” and have been phasing towards full repeal (zero federal estate taxes) in 2010. 

But after 2010, estate taxes get automatically reset to 2000-2001 levels ($675,000 exclusion, 55% rate) unless Congress extends the provisions.

click table to make it bigger

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Some Numbers

Based on 2004 IRS data (the latest available, full table below):

2.34 million adults died (a remarkably constant number over the past decade)

19,294 taxable estate returns were filed (less than 1% of adult deaths)

$5.3 million average taxable estate

22% average tax rate on taxable estates

$22.2 billion aggregate estate taxes collected (down from $24 billion in 2000)

click table to make it bigger

Source: http://www.irs.gov/pub/irs-soi/08es01hi.xls

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Candidates’ Plans

Obama proposes a $3.5 million exclusion ($7 million for a married couple) with a top rate at 45%.

McCain proposes raising the exclusion to $5 million per person (which is thought by many to be the appropriate size to help small-business owners avoid cash-flow difficulties upon the death of a family member). and cutting the top federal estate-tax rate to 15% (linking the death tax with the current capital-gains tax rate … so that ” Americans will not be forced to pay more in death than they would if they had sold property prior to their death)”

Both Obama & McCain support retaining the current system for valuing stocks, mutual-fund shares and other inherited property whose value has increased over the years. at the time of the death (versus the original cost basis). This “stepped-up basis”  is important to many heirs because it can affect how much they eventually owe in capital-gains tax, if anything at all, when they sell inherited property.

Source: http://online.wsj.com/article_print/SB121495543483521281.html

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Observations

1. Under either plan, very few estates — less than 1 in a hundred — would pay Federal Estate taxes. 

2. I’m surprised that the stepped-up cost basis doesn’t get more attention.  Strikes me that eliminating it makes more sense than raising capital gains rates across the board.

3. These are only FEDERAL estate taxes.  States impose their own estate taxes  — and they vary widely (e.g. NY and NJ are high; FL and NV are low). For state rates check out  http://www.finance.cch.com/text/c50s15d170.asp

4. Charities will benefit (versus complete repeal).  The super-rich can direct mega-gifts to charities and foundations to at least keep the money out of the government’s hands.

5.  Heirs may benefit by getting an early distribution of estates via gifts … which are limited to $12,000 per giftor / giftee combo … meaning that a married couple can give $24,000 to an individual, tax free, each year

6. Bottom line, for all but the uber-rich, this doesn’t seem like a big issue — as long as the candidates follow through on their promises (ok, call me cynical).

7. I say, since Warren Buffet is parading his tax guilt so publicly these days, set up a separate provision to tax all of his estate 100%.  (Note: Buffet announced plans to give much of his estate  to the Gates Foundation.  That’s a worthy cause, but diverts money from the government coffers — where he wants everybody else’s money to go. Gotta ask: huh?)  

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Summary: In prior posts, I set-up the following issue …

Some policy analysts (typically left-leaning) such as  Robert Reich, Bill Clinton’s former Secretary of Labor argue that “Most Americans pay more in payroll taxes than in income taxes … payroll taxes take a much bigger portion of the paychecks of lower-income Americans than of higher-income … Viewed as a whole, the current tax system is quite regressive.”
http://economistsview.typepad.com/economistsview/2007/10/robert-reichs-p.html

Other analysts such as the Urban Institute clarify  “The payroll tax is very regressive with respect to current income: The average tax rate falls as income rises …  (But) the regressivity of the payroll tax is mitigated to a substantial extent when Social Security and Medicare benefits are considered as well.
http://www.urban.org/publications/1001065.html

But analysts generally “punt” the question “what is the effect when both payroll taxes and their benefits are considered ? ”  Why ? In part, I suspect, because they know the  answer doesn’t fit their politics … and, in part, because the analysis is challenging — with many nuances and moving parts.

In this post, I take a shot at the “combined effect” question by applying some fundamental financial analysis tools. 

Specifically, I treat Social Security benefits as an annuity stream to individual retiring workers and I treat annual  payroll taxes over a worker’s career as periodic “premiums” that get applied to the “purchase” of the annuity.”contract”.  After adjusting for inflation, the difference between the present value of the expected benefits stream and the present value of the “premiums” paid over the years is, in essence, the real tax that a plan participant pays.

The answer: low wage earners pay practically nothing for their benefits — their contributions are simply a forced saving for their retirement benefits.  High earners get relatively little of their contributions back —  in effect, paying a tax rate over 60%

* * * * *

Analytical Details

Regarding Social Security, a Congressional Joint Economic Committee reports:

“The rapid growth in payroll taxes over the past 40 years has imposed a large burden on working Americans. This burden has fallen disproportionately on low-income workers.

However, in the context of a comprehensive tax policy, it is misleading to focus on the short-term burden imposed by payroll taxes without accounting for the future benefits they provide through the Social Security program.

Social Security benefits are paid according to a progressive formula that gives low-wage workers a better rate of return on their contributions than it gives high-wage workers. The progressivity of the benefit formula outweighs the disproportionate burden imposed by the tax.

As a result, low-wage workers can expect to receive benefits that exceed the sum of their and their employers’ payroll tax contributions. Middle- and high-wage workers, on the other hand, can expect to pay substantially more into the system than they will receive in benefits.

Overall, middle- and high-wage workers subsidize the income and payroll tax liabilities of low-wage workers, leaving most low-wage workers with net negative tax liabilities throughout their lifetimes.”
http://www.house.gov/jec/fiscal/tx-grwth/payroll/payroll.htm

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Here’s what the Joint Economic Committee is talking about:

The amount employees have deducted from their paychecks is determined by the Social Security tax rate and annual income “caps” – the maximum amount of wages subject to the tax.  The Social Security tax rate has been flat for almost 20 years; and the income cap has consistently increased over the years.

Currently. an employee’s Social Security tax rate is 6.2% on annual wages up to $102,000.  For high earners, the rate drops to zero for any wages over $102,000 in a given year.

For example, somebody earning $50,000 has $3,100 deducted from their paychecks [6.2% times $50,000].  Somebody earning $102,000 has $6,324 deducted [the same 6.2% times $102,000].  Somebody earning $200,000 has $6,324 deducted [6.2% times the $102,000 income “cap”; 0% on wages over $102,000] — so their effective rate drops to 3.2%.  The more somebody earns over the $102,000 income cap, the lower their effective rate.. By definition, that’s a regressive tax, right?

* * * * *

Not so fast.  There’s more to the story.

First, the 6.2% tax rate is literally only half of the story.  Employer’s are legally obligated to pay a matching amount to the Social Security fund (similar to a company matching 401-K contributions — but certainly not voluntary).  So, the applicable rate is really 12.4% (2 times 6.2%) — up to $102,000 in earnings. 

• Note: Most economists argue that, in the final analysis, employees bears the full burden of the employer’s matching amounts since employers probably cover the tax by reducing wages – or viewed conversely, employers would raise wages if they weren’t stuck paying the Social Security taxes.  That conclusion is debatable, but we’ll accept it and treat the full.12.4% as a charge incurred by the employee).  
• Note: Employers can deduct their share of the contribution for income tax purposes, but workers’ shares are not tax deductible.  For simplicity, we’ll ignore that taxing distinction. 

Obviously, doubling the rate ups the ante, but it doesn’t make this payroll tax any more (or less) regressive or progressive.

Second, while Social Security payroll deductions fit the technical definition of a tax  —  i.e.  a “levy” imposed on an individual or a legal entity by a government — they don’t act like most taxes. 

Most taxes are collected to fund a common interest (say, defending the country or building a bridge).  The amount that a taxpayer gets charged, is de-coupled from the benefits they (the tax payers) may receive. That is, the taxpayer may or may not actually receive a direct (or indirect) benefit, and any benefits that they do receive are almost always non-monetary (e.g. riding on a freshly paved highway, calling for an EMT crew)..

Social Security is different – it is both monetary and coupled. With Social Security, the benefits are strictly monetary – monthly retirement income checks – and are based on a  formula that is explicitly coupled to the beneficiary’s career income and corresponding contributions to the Social Security fund.

* * * * *

Let’s illustrate Social Security math using a hypothetical retiree.  We’ll call him Harry the High-earner — for shorthand referencing, just plain old Harry. 

Assume that Harry – an unmarried guy — turns 66 on January 1, 2008 and decides to retire — claiming his full Social Security benefits.

• Note: if Harry had retired at an earlier age, say 62, he would have started receiving scaled down benefits a few years earlier. 

Also assume that Harry has been working since age 25, that he earned precisely the maximum taxable base earnings each year (i.e. the year-by-year equivalent of 2008’s $102,000 wage cap), and that he and his employer both paid the applicable Social Security rates each year on those earnings. 

Applying historical Social Security rates and income caps, during the 41 year period (since age 25), Harry would have had $190,595 deducted from his paychecks.  His employer would have matched that amount  dollar-for-dollar.   

Again, economists usually argue that employee’s bear the burden of their employer’s contributions since they are  simply a diversion of higher  wages that might have been paid to the employee.  So, Harry’s total contributions – including his employers’ portions — are $381,189. 

The $381,189 is a “nominal” amount since it doesn’t reflect the impact of inflation over the years.  Using government-provided inflation indexing factors, the $381,189 has a “real” worth — in 2008 dollars – equal to $872,096.  That’s how much Harry and his employer paid into the Social Security fund, adjusted for inflation.

http://www.ssa.gov/pubs/10070.html#a

Conceptually, when he retires and starts drawing benefits, Harry is taking the $872,096 in accumulated contributions (stated in 2008 dollars) and investing the whole amount in an annuity —  a steam of checks that he’ll be receiving from the government.

How much is the annuity worth to Harry?  That is, what’s Harry getting for his $872,096 ?

The annuity valuation has two main components: the amount of the periodic payments and the duration of the payment stream.

Social Security benefits are based  on a relatively complex formula that factors historical earnings against a sharply dropping scale of payouts. 

Specifically, the Social Security  formula “looks back” over an employee’s career, picking the 35 years in which the employee earned the highest taxable wages (up to each year’s income cap).   The employee’s top 35 years of taxed earnings are then indexed to reflect inflation – i.e. “inflated” to current day dollars — and then averaged. .

Then, the qualified earnings (i.e. the 35 year average) are plugged into the sliding scale formula to determine the initial annual amount to be received in Social Security benefits.  90% of the first $8,532 counts; 32% of the next $42,924 (up to $51,456) counts; and only 15% of any excess over $51,456 counts.

Since we’re assuming that Harry earned the maximum taxable income in each year, his top 35 years are the last 35 years (since the income cap has been consistently going up).  His inflation adjusted average income over that period is $87,114.

Plugging the $87,114 into the Social Security benefits formula, Harry’s initial annual Social Security benefit will be $26,763 — 31% of his inflation adjusted average annual wages for his highest 35 years’ earnings.

How long will Harry  be getting the payments?

That’s conceptually easy to answer: Until he dies.  

• Note: If Harry had been married, payments would come until both Harry and his wife die  — since she would have survivor rights to his benefits).  

Currently, the average life expectancy in the U.S. is 78 years.  For simplicity assume that Harry is actuarially average, so he will get the $26,763 in annual benefits for 13 years — until age 78.  

Harry’s total  “annuity benefits” are $347,922 — 13 years times $26,763.  Assuming that the $26,763 gets inflation adjusted in future years (i.e. the Social Security Administration boosts the benefit each year to relect inflation), then the  $347,922 is — by definition — expressed in real 2008 dollars.

Pulling the parts together: stated in 2008 dollars,  Harry (and his employer) paid $872,096 to get annuity benefits worth $347,922. 

The $524,174 difference is the real Social Security tax that Harry paid — a whopping 60%

For comparison, let’s apply the same analytical logic and run the numbers for two other retirees who have  exactly the same profiles as Harry (the high-earner), except that they earned less during their best 35 years.

Low-earning Louie earned an inflation adjusted average of $30,000 and mid-earning Milt earned an inflation adjusted average of $50,000.   So, their respective calculated initial annual benefits are $14,549 (which works out to be 48% of $30,000) and $20,949 (42% of $50,000). High-earning Harry only got 31% of his inflation adjusted average wages in annual benefits.

For analytical simplicity, let’s assume that Louie and Milt earned a constant percentage of the Social Security income cap each year.  Applying that assumption, their $30,000 and $50,000 wage bases translate to 34% and 57% of each year’s income cap.  (Trust me and Excel Solver on the percentages).

Let’s assume that  Louie and Milt – like Harry — have been working and contributing to Social Security since age 25.  Then, we can multiply Louie and Milt’s income  cap percentages (34%, and 57%) times each year’s income cap (keeping in mind that it has increased in most years) — multiply that number (annual taxable wages) times the Social Security tax rate in each year (the total of the employees’ and employers’ contributions) – and then sum across the years (from age 25 to age 65).

The answer: Louie and Milt kicked in a total of $131,272 and $218,276, respectively.  Again, those are “nominal” totals, unadjusted for inflations. 

Applying the Social Security Administration’s inflation  factors –  the same ones used for the benefits calculation —   the nominal totals “inflate”  to $300,328 and $500,547 in 2008 dollars.

The rest of the analysis  is simply arithmetic: Louie kicked in $300,328 to secure an annuity with a present value (at retirement) of  $189,131.  The difference ($111,197) is, in essence, the implicit  net Social Security tax that Louie paid —  37% of his inflation adjusted contributions. 

Milt put in $500,547 to get $272,331 in benefits – an implicit tax of $228,215 – 46% of Milt’s inflation adjusted contributions. And trust me, below Louie’s qualifying income level, the rate drops further —  very quickly.

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The Bottom Line:

Social Security “payroll taxes” are fundamentally different from other types of taxes because they represent a future payment back to the contributor. 

Thus. payroll taxes cannot be viewed in isolation, but must instead be viewed in the lifetime context of tax payments and retirement benefits. http://www.house.gov/jec/fiscal/tx-grwth/payroll/payroll.htm

When both the taxes on current wages and the eventual benefits realized are both considered, real tax rates increase with income and Social Security is then – by definition – a  very progressive plan. 

Case closed !

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Some politicos and pundits say that payroll taxes — the paycheck deductions that fund Medicare and Social Security are regressive taxes — with high earners paying lower rates than low earners. 

For Medicare, they point out that that the same tax rate is applied to both high and low wages — the definition of a regressive tax. 

First, no it isn’t.  It’s a neutral of proportional tax.  A regressive tax rate goes down as income increases.  This one stays the same.

More important, though, the benefits eventually received are identical — whether a taxpayer contributed a little or a lot. 

When the Medicare program is considered in its totality — contributions and benefits — it’s clearly progressive — with high earners paying way more for the same benefits that low earners get.

* * * * *

The Details

The Medicare Program was introduced in 1966.  It is  primarily “our country’s health insurance program for people age 65 or older” — “helping” to pay (i.e. not paying all) for hospital services & stays, doctors, medical supplies, and prescription drugs.  The latter is courtesy of the Bush administration.

Generally, people who qualify for Social Security benefits qualify for Medicare.  Importantly, everyone who’s on Medicare gets exactly the same benefits package — regardless of how much they paid into the program over the years through payroll deductions.

Medicare isn’t a free program. 

First, plan participants (i.e. retirees)  have to pay monthly premiums.  Most folks pay about $100 per month ($1,200 annually), but higher income participants pay more, scaled to their retirement incomes.  Folks with super-sized retirement benefits pay $2,860 per year — 2.4 times the low-earners premium.  That’s progressive, not regressive — but since about 95% of plan participants pay the minimum monthly benefit, it’s not a big deal.

click table to make it bigger

What are a big deal are the contibutions that people pay during their working years.

The bulk of Medicare funding (roughly 75%) comes from paycheck deductions over a wage earners career.  While these are deductions are popularly referred to as “payroll taxes”, they are called “contributions” on the Social Security web site — indicating that they are more akin to prepaid insurance premiums that general taxes.

The contribution rates have increased over the years (see chart below).  These days, employees have 1.45% of their wages deducted from their paychecks — with  no income limits.  So, a person earning $25,000 pays $362.50 to the government dor safe-keeping; a person earning $150,000 pays $2,175.  Though the amounts are way different, the rate is the same — 1.45%.  Some people consider the constant rate to be regressive.  In fact, : it’s neither regressive nor progressive — it’s proportional and, thus, income neutral. 

Employers are obligated to match employees’ Medicare contributions dollar-for-dollar.  So, the combined Medicare contribution is 2.9% — half paid by employees and half paid by employers.  Since self-employed folks are both employers and employees, that get docked for the full 2.9%

• Note: Most economists say that the employer contribution is an employee burden.  They argue that if employers didn’t have to make the matching contribution, then employee wages would be higher by that amount. 

The big deal is that the cumulative “insurance premiums” paid by a high earner are SUBSTANTIALLY higher than low-earners’ contributions.

For example, take 5 individuals who have been earning wages since 1966 (the uear Medicare was introduced).  A relatively low-earner — with average earnings of about $20,000 over the period 1966 to 2007 — would have paid about $10,700  in Medicare premiums during that period.  Inflation indexing each year’s “current year” dollars (i.e. the “nominal amounts”), the premium are worth over $23,000 in 2007 dollars (i.e. “real amounts”).  A relatively high-earner — raking in average wages of about $80,000  — would have contibuted about $43,000 in current year dollars — inflated up to about $92,000 in 2007 dollars.  Middle-earners pay between those low and high amounts; uber-earners pay, and pay, and pay.

click table to make it bigger

• Note: The employer contributions don’t impact the degree to which the Medicare program is regressive or progressive — but, when conbined with the employee contributions and inflated up to 2007 dollars, might raise some questions about the program’s fundamental economics.

Again, keep in mind that Medicare benefits are identical for all — regardless of how much was paid into the program over the course of a wage earner’s career. 

So, high-earners pay substantially more than low-earners for exactly the same benefits.  And, high-earners who get high pension benefits or IRA payouts — a very likely correlation —  get even less in program benefits since their premiums are higher (than low-earning retirees).

* * * * *

The bottom line:

Curent year Medicare paycheck deductions are income neutral since the same rate applies to all wage earners, with no cap on the income level.

The premiums paid by high-earners are literally multiplles of the premiums paid by low-earners.

Benefits are identical, regardless of whether a person is a high- or low- wage earner.  Arguably, the benefits are slightly progressive since high retirement earners have to pay higher Medicare premiums.

There’s no way that anybody can say with a straight face that the Medicare portion of “payroll taxes” is regressive?  It’s progressive — in fact, very progressive.  PERIOD ! 

 * * * * * 

Next up: So, what about Social Security — regressive or progressive ?

* * * * *

More re: Medicare from the goverbment web site:
http://www.ssa.gov/pubs/10043.html#part2

Medicare is our country’s health insurance program for people age 65 or older. Certain people younger than age 65 can qualify for Medicare, too, including those who have disabilities and those who have permanent kidney failure or amyotrophic lateral sclerosis (Lou Gehrig’s disease). The program helps with the cost of health care, but it does not cover all medical expenses or the cost of most long-term care.

Medicare has four parts

• Hospital insurance (Part A) that helps pay for inpatient care in a hospital or skilled nursing facility (following a hospital stay), some home health care and hospice care.
• Medical insurance (Part B) that helps pay for doctors’ services and many other medical services and supplies that are not covered by hospital insurance.
• Medicare Advantage (Part C) plans are available in many areas. People with Medicare Parts A and B can choose to receive all of their health care services through one of these provider organizations under Part C.
• Prescription drug coverage (Part D) that helps pay for medications doctors prescribe for treatment.

For most beneficiaries, the government pays a substantial portion—75 percent—of the Part B standard premium and the beneficiary pays the remaining 25 percent.

Beginning in 2007, the government portion was reduced for higher income beneficiaries who began paying a larger percentage of the premium based on income …  In 2008, higher income beneficiaries will be responsible for 67 percent of their income-related adjustment. By 2009, the end of the transition period, these higher income beneficiaries will pay a monthly premium equal to 35, 50, 65, or 80 percent of the total Part B cost, depending on their income level.   However, the law is expected to affect only about 4 to 5 percent of Medicare beneficiaries, so most people will continue to pay the standard premium, without an income-related adjustment.

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In a prior post, I hypothesized that Warren Buffett’s guilt-ridden 17.7% effective Federal tax rate is most likely a consequence (unintended ?)  of the capital gains tax rate cut and  the functional failure of the AMT to do its job.

Another group of low capital gains tax rate benificiaries shows no Buffett-like remorse: private equity partnerships, and their close cousins, the hedge funds.

* * * * *

In brief, hedge funds are partnerships and are legally positioned to benefit from favorable capital gains tax treatment.  But, hedge funds cavalierly push the law to the limits with some contested schemes.

Specifically, hedge funds have made an art form of “carried interest” — a claim that current operating income should be classified as returns on their invested capital and then taxed at capital gains rates (which are, of course, much lower than regular income rates.

Many (most? all?) disinterested observers smell a rat — a Enron-like loophole that you can drive a truck through.

Why doesn’t the loophole get closed?  Simple politics.  Sen. Shumer (NY) keeps blocking action because he fears hedgers will head off-shore, and — some cynics reckon — stop their super-sized contributions to the Democratoric Senatorial Re-election Committee — which, coincidentally, Shumer runs.

The likely fix: raising everybody’s capital gains rates — to avoid the appearance of singling out a prized political support group. 

* * * * *

For details re: carried interest, below are summaries and links to a couple of good sources.

* * * * *

Carried Interest – The Issue

From : Senate Testimony: “The Taxation of Carried Interest”
by Peter R. Orszag, CBO Director
July 11, 2007

“A growing amount of financial intermediation is occurring through private equity and hedge funds, which are typically organized as partnerships or limited liability companies and … are growing rapidly for many reasons, including their tax advantages over traditional financial services corporations.

A general partner of a private equity or hedge fund typically receives two types of compensation: a management fee tied to some percentage of assets under management and “carried interest” tied to some percentage of the profits generated by those assets.

The management fee is taxed as ordinary income to the general partner. Taxation on the carried interest is deferred until profits are realized on the fund’s underlying assets, and any resulting profits to the general partner are taxed at the capital gains tax rate …

Most economists, however, would view at least part and perhaps all of the carried interest as performance-based compensation for management services provided by the general partner rather than a return on financial capital invested by that partner … and suggest taxing at least some component of the carried interest as ordinary income, as most other performance-based compensation is currently treated …

Much of the complexity associated with the taxation of carried interest arises because of the differential between the capital gains tax rate and the ordinary income tax rate, which creates an incentive to shift income into a form classified as capital gains. Further widening of the differential between the taxation of ordinary income and of capital gains would create even stronger incentives to shift income into the tax-preferred capital form.

Full testimony (worth reading):
http://www.cbo.gov/ftpdocs/83xx/doc8306/07-11-CarriedInterest_Testimony.pdf

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Carried Interest – The Politics

According to Bloomberg:

Democratic Senator Charles Schumer of New York is fighting a plan to raise taxes on hedge funds and buyout firms with his own legislative poison pill …  saying that he would agree to the proposals only if taxes were also raised on oil-and-gas, venture-capital and real-estate partnerships.

Schumer may be trying to shield both his Wall Street constituents [i.e. keeping jobs in NYC] and his party’s electoral war chest … based on federal filings, contributions from employees of private-equity firms and hedge funds to the Democratic Senatorial Campaign Committee, which Schumer heads ,,, far exceed the industry’s contributions to the Republican Senate committee.

http://www.bloomberg.com/apps/news?pid=20601103&sid=a9DpYagBpVIo&refer=us

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