Friday, December 3, 2010

Our Ever-Changing Permanent Tax Rates

Here's a great column by Larry Elkin explaining the history of tax rates. Please forgive him for thinking taxes somehow benefit society.-RW

By Larry M. Elkin, CPA, CFP®

Every news outlet in the country says the big battle in the lame-duck Congress is over whether, and for whom, to permanently extend the Bush-era tax rates.

This requires us to ask: What exactly is a “permanent” tax rate?

A history compiled by the Tax Foundation shows that we have had 26 top rates for married couples since the modern income tax was enacted in 1913. On average, a “permanent” tax rate lasts less than four years. This has held true during my working lifetime. I have seen nine separate top rates since I joined the work force 34 years ago, in 1976.

But this focus on the official top tax rates makes “permanent” sound more permanent than it really is. We should also consider occasional surtaxes, like the 10 percent Vietnam-era levy that brought the real top rate from 70 percent to 77 percent in 1969. The surtax itself fluctuated. It was 7.5 percent in 1968 and 2.5 percent in 1970. Yet the “permanent” 70 percent rate stayed fixed at 70 percent.

There also have been other complexities, like the imposition of a minimum tax (now extinct) and an alternative minimum tax (definitely not extinct), as well as inflation adjustments and income-related phase-outs of deductions and credits. Many of these items change every year.

So when the White House and Congress talk about a “permanent” tax provision, they actually mean “for the next 12 months, unless we decide to change it sooner.”

You probably know the general outlines of the current debate. President Obama and most Democrats want to permanently (try not to laugh) extend the tax rates enacted under President George W. Bush for most Americans, but not for individuals earning more than $200,000 or couples earning more than $250,000. Democrats want to raise their rates back to the pre-Bush level of 39.6 percent, from the current 35 percent.

Republicans want to permanently (stop snickering) extend current rates for everyone. Republicans also want to bring the federal budget deficit under control, which inevitably means that someone’s taxes are going to go up. This year’s version of “permanent” comes with a self-destruct button labeled “deficit reduction.”

Clearly, the argument is not about permanent tax changes, because permanent tax laws do not exist. This is really about trying to separate the rates paid by upper-income households from those paid by everyone else. Democrats seem prepared to extend the upper-income rates for a year or two, with a provision to automatically revert to higher rates thereafter, while leaving the rest of the rates in place without an automatic future increase. Unlike the current situation, in which everyone’s rates are set to rise next year, the Democrats’ approach would shield most voters from the impact of the future rate rise, which might translate into better election results for Democrats.

By keeping all the tax rates tightly linked, Republicans would ensure that Democrats who want to raise high-income taxes in the future will have to run on that tax increase platform, rather than letting an automatic adjustment occur while they shield most voters from it.

It’s actually not surprising, nor is it necessarily a bad thing, that tax rates change frequently. Circumstances change, and our tax laws have to change with them. If we want more services, we eventually have to pay for them. If the economy tanks and we don’t trim government, the burden of supporting that government falls on fewer able shoulders. Most communities in this country run primarily on property taxes, which typically change every year according to mill levies and property values. There’s nothing wrong with it.

But there is something wrong with a soak-the-rich philosophy of income taxation: It doesn’t work for long. Sudden and sharp increases can raise significant revenue for a little while, until business and tax planning structures adapt. But in the end, we have always cycled back toward lower rates at the top end and a more even distribution of tax burdens, because the bottom line is that most of us, not just the rich, are going to have to contribute to the costs of running the country.

If you don’t believe me, let’s stroll down tax-memory lane.

The 1913 version of the tax included a top rate of 7 percent, which applied to incomes above $500,000. That’s more than $11 million in today’s dollars, according to the Bureau of Labor Statistics. The first $20,000 of 1913 income (that’s $441,000 today) was completely exempt. The income tax was sold as a modest way to get families named Rockefeller and Vanderbilt to fund the government.

But within five years, as the country fought World War I, a 6 percent rate applied to taxable incomes between zero and $4,000, while incomes above $1 million (about $15 million today) had a 77 percent tax. When the war was over, the top rate dropped to 25 percent in the 1920s, but President Franklin D. Roosevelt helped boost it back to 79 percent in 1936, on incomes above $5 million. That $5 million threshold equals about $75 million today. I’m not sure exactly whom FDR was trying to tax, but he certainly didn’t like that person.

World War II brought the highest income tax rate in our history, 94 percent, to incomes above $200,000 (about $2.5 million today) in 1944. Even the lowest-income taxpayers paid 23 percent that year. Then again, there was nothing much to buy anyway. After the war the rate dropped, but only by a sliver, to 91 percent, where it more or less stood until the 1960s. That’s about as close as we’ve come to a “permanent rate.” But the code was so riddled with deductions and credits, such as a deduction for credit card interest (at a time when only a wealthy few people had credit cards) that the effective tax rate was much lower.

A series of tax reforms produced a much lower and flatter rate structure. This culminated in the landmark 1986 tax law, which did away with many of those deductions, including credit card interest, in exchange for a permanent maximum rate of 28 percent that was phased in by 1988. That permanent rate lasted three years. Since then we have seen permanent increases to 31 percent and 39.6 percent, followed by the Bush-era laws that, for budget reasons, were designed to expire this year.

Maybe we can get some lawmakers to push for a “truth in political speech” act. That way, when someone in office talks about a “permanent” tax cut, we can throw the book at him. I suggest we toss a copy of the Internal Revenue Code with all its amendments. It’s a really thick book.

For more articles on financial, business, and other topics by Larry Elkin, view the Palisades Hudson newsletter, Sentinel, or subscribe to my daily opinion column, Current Commentary.

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