ataxingmatter

Measuring Ancient (and modern) Inequality

Braqnko Milanovic, Peter Lindert and Jeffrey Williamson have an interesting new paper on the measures of inequality in ancient and modern societies.  Measuring Ancient Inequality, The World Bank Development Research Group Poverty Team, Nov. 2007 (available at the World Bank website at this link).

Working with sparse date such as social tables and tax census or monthly census of expenditures, the three economists try to determine whether inequality in ancient pre-industrial societies was greater or less than inequality in today's undeveloped countires or even today's modern countries, given that the convergence of incomes within industrial countries that impressed Kuznets in the 1950s has reversed itself, with gaps widening again.

Under their approach, the creation of economic surpluses beyond the resources needed for  subsistence creates an opportunity for the elite to exploit the surpluses and capture an increasing share of growth, leading to greater economic inequality.  This requires the introduction of two concepts:  the "inequality possibility frontier" (IPF) and the "Inequality extraction ratio" (IER).  The IPF assumes that each society must provide a subsistence minimum for its poorest classes but the surplus is shared among the richer classes.  As average incomes increase, the surplus increases and the maximum possible inequality compatible witht that higher income also increases.  A chart of the maximum possible Gini coefficients against mean income levels gives the IPF.  The IPF therefore represents the "maximum inequalityh that is dynamically sustainable."  (Sometimes I suspect that the "there's no time that a tax cut isn't the right answer to fiscal questions" group are aiming for that kind of a society--one in which the rich are allowed to exploit the surplus, and let the rest of the population just get by. )

The authors conclude that "inequality differences within the ancient and modern samples is many times greater than the difference between them."  In other words, contemporary pre-industrial societies show about the same inequality as ancient ones, though there are some in each group that are much more unequal than others, the average Gini for the fourteen ancient societies investigated was 45.7 while the average Gini from the nine modern comparators was just a little less--43.3. 

The second factor the authors assess is how countries' inequality measures compare with the maximum feasible Ginis for their income levels.  I.e., as income increases, there is more of a surplus beyond subsistence, if this surplus is captured by the elite few, then the Gini coefficient will be much higher, indicating a less equal society. For any income level, there is a maximum Gini possible (related to the amount of surplus there to be extracted).  The authors define an "inequality extraction ratio" as the ratio between the actual Gini inequality and the maximum feasible inequality for that society.  The higher the IER, the more unequal the society.   By this measure, ancient societies are more unequal--the elite were more successful at extracting the surplus than today's elite are.

They note that this additional inequality measure may provide a better understanding of the relationship between wealth and power.  Tanzania, for example, has a relatively low Gini of 35, suggesting it is about as egalitarian as most of today's societies.  But its Gini is very near the maximum possible for its mean income level--i.e., measured inequality lies very close to the inequality possibility frontier.

They find another interesting correlation (or rather lack thereof) between ancient and modern socieites.  IN today's socieites, the change in the top 1 percent's share of the wealth provides a good approximation of the changes in overall income distribution.  By that measure of course, the US is plummeting towards a highly unequal society, as the "creme de la creme" at the very top--the top one-half of one percent--are amassing huge fortunes and leaving the "just rich" behind. 

the study looks at two key factors--the top 1 percent's share of the country's income and the cut-off point where the top 1 percent begins.  They find that the change within the top 1 percent doesn't reflect what's going on in the ancient societies like it does for contemporary societies.  Instead, they find that "the gap between poor landless labor and the landed elite, whose incomes raise the average considerably, drives the Gini, not conditions at the top."

The authors then turn to survival inequality.  If the rich enjoy longer lives, then lifetime inequality is much greater.  In ancient times this was a major factor, since the rich had such better resources and health that they lived much longer than the poor.  It is less of a factor now, as the "global spread of better health care and public victories over many pathogens and parasites in the twentieth century created a dramatic life expectancy convergence between nations."  Yet, the authors note that they haven't yet found a century where the poor outlive the rich, but lots of examples where the rich outlive the poor. 

The authors summarize their insights as the following: (i) income inequality in preindustrial countires today is not very different from inequality in ancient times, (ii) the extraction ratio, however, was significantly bigger then than now, (iii) differences in lifetime survival rates between the rich and the poor were much higher 200 years ago, causing greater lifetime inequality in the past, and (iv) there was no correlation between the income share of the top 1% and inequality in ancient societies like there is in today's societies.

Left out of the paper was discussion of the social structures underpinning inequality.  But the authors speculate that (i) initial resource endowments matter, (ii) the role as a colonized country matters because colonial powers tend to reward indigenous elites rather than mollify the mases; (iii) economic inequality is correlated with extreme concentration of political power that is then used to further widen income gaps through rent-seeking and rent-keeping, which in turn retard broad economic growth.

The paper is helpful in coming to terms with the relationship between economic development and inequality.   I take from it some comfort that while modern socieites are about as unequal as ancient societies, the elites have extracted less of the feasible inequality surplus than the elites of ancient societies.  Perhaps this means that as economic development takes place and a broader middle class with education develops, they are more likely to demand a share of the surplus rather than allowing it to be concentrated wholly at the very top.  Yet the trend in the US over the last few years is worrisome in this regard--from tax cuts to executive compensation, the powers that be seem to be awarding more to those in the  top 1 percentile.  that's the real class warfare--a system that let's one class accumulate most of the surplus created by the productivity of the masses of ordinary wageearners.  Ultimately, that policy will retard broad economic growth (see Glaeser, Scheinkman & Shleifer (2003), referenced in the article) and will impact the sustainability of democracy.  I suspect that is why progressive populism has increasingly caught on with ordinary Americans--people are beginning to ask why the deck should be stacked in favor of the few at the top instead of working to the benefit of everyone.  (The hedge fund managers with the preferentially favorable treatment of their compensation income are a good example--continuing that treatment which singles them out and lets them accumulate without the same tax burden that ordinary workers pay is a problem.) 

Bruce Bartlett on the "Fair" Tax Proposals

Bruce Bartlett has a well-written piece on the so-called "Fair Tax" proposal.  Bruce Bartlett, Why the Fair Tax Won't Work, 117 Tax Notes 1241 (Dec. 24, 2007).  The arguments he makes aren't really new, since various people (myself included) have criticized the Fair Tax proponents for trying to have their pie and eat it too.

The Fair Tax proposal calls for elimination of the income and payroll taxes (and the withholding and IRS audit and enforcement machinery that stands behind them) and replacement with a national sales tax.  The sales tax would purportedly apply to every purchase, without exception, including state and local government purchases.  The proponents claim it would be able to generate sufficient revenues at a flat (tax-inclusive) rate of 23%.  They also make various claims that people will be able to keep all their paychecks and that prices won't rise, there will be no compliance failures, and life will be hunky-dory ever after. 

Bartlett effectively debunks these exaggerated and downright misleading (and often contradictory) claims.  Here are a few of the points he makes.

First, the fair tax would be highly regressive, resulting in a huge tax break for those in the top quintile of the income distribution (roughly, those earning $200,000 and up annually) and crushing burdens for those at the bottom.  This is because the poor consume all of their income, and the wealthy do not.  Consumption decreases with wealth. 

In order to make the "fair tax" even somewhat palatable, there'd have to be a mechanism for relief for those at the bottom.  The Fair Tax proposal provides for a monthly government check to every person in the US.  But single parents with children will be discriminated against compared to married couples without children, getting a much smaller rebate.  The rebate isn't based on income or amount of consumption or the cost of living or the cost of raising children; it is not even a rough justice measure of who merits it. It's based at most on an arbitrary back-of-the-envelope calculation from the 1960s determining the poverty level.   Bill Gates will get the same check that the beggar on the corner gets.  This is an immense new governmental entitlement program, that will require reams of disclosure (number of people residing in the household each year, ages, social security numbers).    Nothing "fair" about any of that.  And nothing simple either.  Maybe there's no IRS (more on that later) but there's certainly a lot of big brother mechanism just to figure out the rebate for each household.

Bartlett notes that this is just the kind of situation that brings out the political negotiator in every politician.  One will press for extra help for single parents with multiple children, and another will think of another group needing extra care and attention.  Pretty soon the "fair" and "flat rate" tax will be riddled with different rates because of special exemptions for all those special interest groups.  And it won't stop there.  Some goods just aren't meant to be taxed--many states don't tax groceries, for example.  And services--look at the debacle in Michigan when the legislature tried to initiate a services tax.

The Fair Tax would tend to penalize the young--who need to "over consume" by borrowing to begin to build up assets (homes and cares and all the things required to start a family).   It would also penalize the old-o-who saved for retirement under an income tax and now will be taxed harshly when they spend that savings, instead of being able to spend it freely without further tax.  (Politicians would of course create more exemptions and exceptions to try to deal with this.)

Proponents of the Fair Tax also make all kinds of misleading and simply erroneous claims.  Bartlett calls it a "double free lunch" claim--claiming that prices will fall once the income taxes currently embedded in them are gone, but acting as though wages will not fall as well.  In fact, as Bartlett notes, either prices will stay up or wages must fall.  Neither gives the ordinary guy the windfall that proponents appear to promise.  Of course, if prices really fell, no rebate would be needed so long as everybody is satisfied with a large pay cut while prices steady themselves down lower.  That, Bartlett notes, simply will not happen.  So there will be no windfall gain compared to the income tax.

Oh, about that 23% rate.  It's not really 23%--at least, not if you calculate it the way we ordinarily calculate sales taxes.  We think of the price without taxes ($100) and the  tax that must be added on as a percentage of that price( a 23% tax-exclusive rate yields a $23 tax), giving a total cost of $123.  But that's not what proponents of the Fair Tax are talking about.  They are looking at a $30 add-on tax on a $100 price.  30/130 = 23%.  So we can describe the rate as a 23% "tax inclusive" rate or a 30% "tax exclusive" rate.  We ordinarily talk about sales taxes as tax exclusive rates.  We pay $10 for the item, we pay a 7% sales tax which will be 70 cents on the $10 price.  Most Americans would not be very happy with a sales tax of 30% on every item purchased (and every service purchased), especially when applied to doctors' and hospitals' bills, health and car insurance, and other big ticket items (like large appliances, cars, even houses).  So FairTaxers disguise the negative impact of their proposal by using a tax-inclusive rate.

As for taxing government to raise government revenues, this is no benefit.  It may mean states have to increase their taxes to pay the taxes to the federal government, which won't provide relief to ordinary taxpayers.  Bartlett estimates that states that pay for their increased costs due to the FairTax by raising sales tax rates would tend to increase the average rate from about 6.5% to 11%.

The FairTax assumes about 80% of the GDP would be taxed.  But no country currently succeeds with that kind of a sales tax.  In small countries where cheating is harder, maybe 48% can be covered by a VAT, but in the EU, only about 38% can be covered by VAT.  The sales tax is less efficient and more prone to abuse than the VAT, so even less than that would be realistic.  That's a lot of slippage compared to the sales pitch from FairTax proponents.   No state taxes anywhere near as broad a base as the proposed FairTax base--services are hardly taxed at all (partly because taxes on them are easier to evade) and of course states don't currently tax imputed rent to homeowners, as the Fair Tax would require (else homeowners would be sitting pretty compared to renters). 

Barlett concludes that "[m]assive evasion is inevitable with the FairTax because all revenue would be collected at just one point in the entire economic system."  And since the states would be doing the collecting for the federal government, the collectors' incentives to engage in the extra administrative hassle would be minimal.  States would have complicated jobs to do, since their sales taxes are not very similar to the proposed FairTax.  With no backup to the collection the retailer on the front line is required to do, no withholding, and  no other points of tax collection, the tax collection process will be "fragile", says Bartlett.  (A wreck might be a more apt description.)  Fake Social Security numbers such as those used by illegal immigrants (I was the one that first informed Barlett about this problem) would magnify noncompliance--invent a Social Security number for your invented dependent, and claim an additional rebate amount.   Tax evasion would probably necessitate a much higher rate--at least 35% or 40% on a tax-exclusive basis, quite possibly as high as 65%, according to one Brookings Institution study.  Id. at 1252 n.55.  (See also this 2005 Urban Institute study by William Gale on the topic.)   In fact, once politicians do their thing to start creating exemptions and special provisions for the most needy (or the loudest special interest groups), it is quite likely that the higher end forecasts would be the more accurate ones.

And remember that problem with the states doing the collecting?  Their sales tax doesn't match the FairTax, so they have two likely options--make it match or get rid of their sales tax and institute a bigger income tax now that the federal income tax is out of the way.  Bartlett is betting on the second choice, and I think that is highly probable.  Most states already have both sales and income taxes, so expanding the income base would be relatively easy.   Most states with income taxes don't exactly copy the federal income tax, so it appears they wouldn't be likely to do so for the sales tax either, especially since their sales taxes have been in place for some time, and they won't be eager to go through the bruising local political battles to make changes that increase the sales tax base.

Complexity will vanish, you say?  Not likely.  As long as states retain an income tax, taxpayers will have to retain their records and face potential audits, etc.   As politicos make changes to make the FairTax more palatable, there are likely to be further recordkeeping requirements.

Are Americans beginning to get more sophisticated on these tax issues, or will they continue to be gullible about these proposals being pushed by groups with ulterior motives about the desired shape of the tax and spending system?  Here's hoping that the 2008 campaign will help focus attention on the issues.  As candidates like Huckabee hawk the FairTax, perhaps the other candidates will start making some of these obvious points about its problems.  I think if ordinary taxpayers get enough information about it, they will soundly reject the idea.

If we want to do something with the tax system, let's have a deliberative consideration of how to improve the income tax system that we are already well familiar with, that an overwhelming majority of Americans complies with, and that satisfies most Americans concept of fairness by providing for a progressive rate structure.

For more on Barlett's criticisms of the FairTax proposal (especially comments from FairTax proponents), see the following:

FairTAx, Flawed Tax, Bruce Bartlett Op-Ed in the Wall St. J. (Aug., 2007)

FairTax.org (organization pushing the FairTax proposal, and responding quickly on any blog that posts Bartlett's criticisms with reiterations of the "double free lunch" claims--see comments on "Freedom Talks" blog, below)

Cato.org (an early 1997 piece praising the FairTax proposal and setting forth various of the flawed arguments highlighted by Bartlett, such as the claim that states can readily administer the system in spite of having different sales tax bases, and the failure to account for the funding needed to provide a payment to the states for so doing).

FreedomTalks (a blog that argues for lower taxes no matter what, but still ran an article on the problems wih the FairTax; the comments are from dyed-in-the-wool FairTaxers who continue to make the same "double free lunch" claims about their pet project that Bartlett debunks--that prices will go down, workers will still keep all their income, and the economy will soar in spite of the need for a high rate of tax on all transactions)

TaxProf Blog's gathering of responses to Bartlett's Wall Street Journal Op-Ed.

Jade Trading Decision: Economic Substance Reinvigorated

The Federal Claims Court December 21, 2007 decision in Jade Tradeing LLC vs United States Download jade_trading. 122107.pdf will likely reverberate across the tax shelter/economic substance debate.

Jade Trading was a purported partnership set up to make it possible for clients of BDO Seidman  to generate an artificially high basis in a low value asset that would create a loss on exit from the partnership, which loss could be used against other, unrelated gains.  The "Son of BOSS" shelter required the clients to purchase offsetting currency options, ostensibly priced at about $15 million.  The clients only paid the difference, a scant $150,000 or so.  The option counterparty, AIG, took care to be sure that the options wouldn't be separated (if they were, AIG would be under considerably different and substantial counterparty risk, among other things).   Each client's (there were three brothers in this deal) total upside potential (ignoring the fees paid for the transaction) was about $140,000, and  total loss potential was only the actual investment of $150,000.  But each client paid consulting and legal fees of more than $934,000 (not including the fees to set up LLCS and other transaction costs).  So there was a negative 80% rate of return on their "investment", which existed to generate tax losses and really added nothing to their ability to trade in options.  In fact, one expert quoted in the case sounds almost bemused as he notes that there simply was no reason for contributing the options to a partnership.

The Court does a superb job of separating the grain from the chaff.  It notes that the partnership scheme relied on an anomaly in the tax law--the fact that a pair of purchased and sold options might create an artificially high partnership interest basis because the law, at the time of the deal based on the 1975 Helmer case, disregarded contingent liabilities for purposes of section 752 (the provision that ulimately results in basis adjustments in respect of liabilities of a partner assumed by a partnership).   But the court moves right on to economic substance, giving short shrift to the partnership's argument that no shelter could be found if it was in literal compliance with the tax code.  The court specifically states that the economic substance doctrine disregards transactions despite their literal compliance with tax laws, if the particular transaction that generates the tax benefit lacks objective economic substance.

And the court minces no words in pointing out the ways that the Jade Trading deals lacked economic substance.  Citing Coltec, it looks to objective evidence and finds a long list, including fictional losses, huge fees that make a reasonable profit expectation impossible, minimal investments that are parked in a partnership that has no business purpose, all according to the structure of a deal that was marketed as a tax avoidance transaction by the BDO Seidman "wolf pack" tax shelter team.  In discussing the appropriate penalties, the court notes that this was "an elaborate fictional construct with no economic consequences other than tax benefits."

This is a good decision, well written, and supported by ample evidence from depositions, tax opinion letters, and marketing materials.  It will likely be quoted frequently as the courts continue to use economic substance to hold taxpayers accountable for their tax evasion schemes.

AMT: more borrowing, but from whom?

When the Republicans in the Senate held out against any revenue raisers to pay for the AMT "relief" for all those upper-middle class taxpayers making mostly above $200,000 who would have been caught by the alternative system without the one-year patch, they acted like it didn't matter that it would cost the government billions in revenue.  We're spending billions in occupying Iraq, billions more in arms, and in the meantime Congress sees fit to enact another tax cut without paying for it.  That means, of course, that the US federal debt will have to increase even more, and it will be the next generations that will pay for it. 

But will there always be somebody interested in buying that debt?  With the dollar's value sinking and the economy looking like it might slip into recession, maybe those who've been our piggy bank--China, Japan, the island nations, and the UK-- will decide they've had enough and would prefer euros to dollars.   China seems to be heading that way.  Floyd Norris, China Less Willing to be America's Piggy Bank, NY Times, Dec. 22, 2007, notes that China bought one fifth of the Treasury securities issued in 2004, 30% of the issuance in 2005 and 36% in 2006.  But this year, China reversed course and has become a net seller of Treasury securities.  Even so foreigners continued to be the financiers for the American government's needs beyond its fundraising through taxes--$197.4 billion in the first ten months of 2007. 

Makes no sense, does it--we cut taxes for the rich, and we borrow from foreigners (individuals and sovereign nations) to pay for our needs.  If those foreigners reach a point where they quit buying, the Treasury securities will still need to be sold.  So what will happen?  Interest rates will have to increase to attract buyers, making our debt burden a higher share of GDP and pushing down on the U.S. economy even further.  That's a likely scenario, though it will depend on the fate of the dollar and the view abroad of the likely future of the American economy.

Taxes, Corporate America, and Sustainable Democracy

There seems to be a growing awareness lately about the harm of the now common "anything goes that makes me wealthier" creed that has been adopted by large, wealthy corporations and the ravelling of the social fabric related to their ability to act on their greed without any concern for the harms caused small investors or consumers along the way.

For example, look at Ben Stein's "everybody's business" column in the 12/23/07 New York Times at 6BU, "Tattered Standard of Duty on Wall Street."    By "tattered standard" he refers to one of the underlying principles necessary to make capitalistic markets work as they should--the possibility of clients trusting those in whom they invest their money.  Stein says that necessary trust started breaking down in the junk bond scandals of the 1980s, the savings and loan scandals that followed soon after, amd the explosion of fraudulent accounting from big firms like Enron and others in the late 1990s.  The collateralized mortgage obligations and subprime mortgage mess is just the latest example.  And the worst culprits are the big financial institutions that packaged these deals so that they made lots of money, sold them to investors big and small, and led many, sometimes themselves included, to huge losses.  Goldman Sachs has been touted as a great bank because it managed to deal in this toxic waste without suffering losses--in fact, it made lots of money (and paid its traders and executives record bonuses this year) because it shorted the same securities that it peddled to clients.  Stein hits the nail on the head when he notes that this is "extremely hard to reconcile with basic fairness."  If Goldman knew the securities were so risky that it needed to short them, then how could it sell them to its clients with a straight face talking about the wonderful ratings the credit agencies had given them.  Goldman says its actions were fine, Stein notes, and that most of its buyers were sophisticated big guys who can make their own decisions.  Of course, some of them were also little guys, and Stein wasn't able to get Goldman to give him a list. 

What the CMO debacle shows is that we've let the Reagan push for deregulation get to a point where big guys get by with anything and little people suffer.  From the investors in those "golden" securities that turned out to be not so risk free as they were said to be to the purchasers of homes who were pushed into risky mortgage deals that they couldn't sustain, so that realtors and brokers could make their big commissions and fees.  Stein says we're not much of a nation if there is "no meaningful restraint on what people can do with an offering statement and a computer screen."  In other words, we need to increase regulation to protect little guys.  Markets don't work on their own: they require appropriate infrastructure to keep the "titans of commerce" from using every hook and crook to amass fortunes for themselves at whatever cost to society.

Meanwhile, Robert Kuttner has come out with a book that also looks at the signs of the times and what they portend--the increasing chasm between the 1% who get incredibly richer every year while the rest of the population faces higher costs for the basic necessities of life and stagnating wages and even declining prospects for pensions in old age.  In"The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity", Knopf (2007), Robert Kuttner criticizes the laissez-faire "free market" orthodoxy of the neoconservative revolution and talks about the ijmportance of realizing that financial speculation is threatening the long-term prosperity of our society.  His book is reviewed in the Times by Harry Hurt III, A Grim Diagnosis for the U.S., and a Prescription, (12/16/07).  Kuttner looks at the statistics that I have often noted in this blog--the "staggeringly disproportionate distribution of wealth in America" as Hurt describes it.  The median income of working famimlies has fallen 5.4%, adjusted for inflation, over 7 years, while the very richest one-tenth of 1 percent have seen their income increase by 550% from 1970 (about $3.6 million then to about $24 million now).

The cause of this gross inequality?  Kuttner attributes it to the dismantling of the regulated economy established under FDR in the post-war era.  The Reagan deregulation has resulted in what he calls a "casino economy":  labor unions have no power, pension funds become speculative vehicles and not protection for the workers who earned them, and financial elites get rich with hedge funds and private equity funds that take advantage of lack of accountability to rip off society.  The culprit?  Kuttner blames big business and corproate excecutives who boost stock prices tied to benefits and bonuses for themselves.  In this casino economy, corporate executives and other capitalizes "effectively manage--and limit--government for their own ends".  Id.

This is the challenge for any new administration and new Congress.  To get beyond their being beholden to the businessmen whose money helps assure their election and to get about the task of restoring restraints on the power of business to rip assets away from the communities in which they are located, to break promises made to workers so that managers can make even bigger profits.  The fact is, businesses are making big profits but they are sharing much less of them with their ordinary workers.  And the "free market" creed that has been pushed since Reagan has justified that as just fine--the people at the top, we are supposed to believe, are only getting their just desserts for the value they add to the enterprise.  Ordinary Americans have to realize how they have been exploited and used, all in the name of free markets, and make themselves heard again.  It's time for a "pocket-book populism", Kuttner says.  I heartily agree with that sentiment.

AMT Legislation for 2007

Dear Readers:  I am finally over the lung infection that made it impossible for me to blog over the last month.  Of course, now the holidays are upon us, and likely there is little interest in the musings of a tax prof about the vagaries of congressional action (and inaction) and administrative laissez-faire.  But I will perservere, nonetheless.

So Congress finally acted on the AMT before the holidays.  After some heated debate about the pay-go rules, the House Democrats on December 19 went along with the wimpy Senate Democrats and passed a one-year AMT patch--H.R. 3996, the Tax Increase Prevention Act of 2007-- that does not raise the lost revenue, with a vote of 352 to 64.  Good for those 64 in the House who voted against the bill in order to raise adequate revenues to compensate for whatever AMT patch was really necessary.  The Republicans did what the Democrats just can't seem to find the guts to do--held firm on their stated view that an AMT patch should raise the deficit rather than be paid for with reasonable provisions, because, they claim, it was never intended to reach the group it now reaches.

What is most disturbing about this is that Congress has now explicitly recognized that the hedge fund managers and other partners who get "profits" interests for their services are essentially scamming the government and ordinary taxpayers by converting compensation income in many cases to capital gains income.  Their use of offshore accounts to defer the inclusion of income is another device that gives results in less taxation for these wealthy managers, since the deferral in many cases means almost not tax.  That was the provision that the House attempted to include in its last vote before the decision to go with no revenue raisers.  See this story on the Dec 13 House vote.  As Rangel notes, "No one has the guts to defend the offshore deferred compensation. ... We know that it is indecent and immoral."  Id. 

Once Congress recognized these inequities, its failure to act speaks volumes about the way Congress is captured by special interests--especially the Republican party that used their close minority status in the Senate to protect those wealthy hedge fund managers who would have been subject to tax on their compensation like ordinary taxpayers are under the two House proposals (one regarding "carried interests" and the other eliminating deferral of offshore compensation income).  The hedge funds and equity funds flooded Congress with lobbyists, arguing to protect their special interests, to a degree not seen before.   Remember their claims that equity fund managers wouldn't have any incentive to manage without getting their cushy capital gains rates?  That of course is pure baloney.  Sixty-five percent of millions is still a lot of money to incentivize adequate management and entrepreneurial activity.  Of course, most of these money managers are not really entrepreneurs--they are merely making money using other people's money.  As Mike Ross (D-Ark) put it, the "Senate and House Republicans have decided to side with tax cheats and their offshore accounts."  See this Dow Jones Newswire story by Michael Crittenden.

And of course the Republicans' other argument about the AMT is simply nonsensical--that it was intended to be a tax on rich folks and so therefore there should be no tax increase when Congress changes it to protect the upper strata of the income classes from its impact.  That is simply wrong as a historical matter.  The AMT long ago became something quite different--an alternative system aimed at ensuring that those taxpayers who enjoyed a number of special benefits built into the tax code (like the mortgage interest deduction which provides by far the greatest benefit to those with expensive homes and high incomes) weren't able to get too much of a free ride from accumulating different benefits.  And the Republican-controlled Congress was well aware that the AMT would "clawback" the Bush 2001-2003 tax cuts for a sizeable group of the upper middle class when those tax cuts were passed.  They intentionally left the AMT, to pretent that the tax cuts were not as devastating as they actually are in terms of increasing deficits and requiring additional billions of borrowing.

It's actually quite sensible to have a system that takes back various of the special deductions that can pile up for some taxpayers.  Else the rich will continue to get richer at the expense of the ordinary guys, as has been the case particularly over the last few years.  There was simply no need for an AMT patch for those making $200,000 or more, the majority of the group that would be subject to AMT taxation to any significant extent.

And as for that other recurring theme, the complexity of having an alternative system, this patch has nothing to do with relieving that.  The dual system continues.  The complications of the current AMT could be relieved, of course, as I have suggested, by setting the exemption levels so that ordinary taxpayers who are truly in the middle class or lower income distribution--those earning less than $150,000 a year, maybe--do not have to bother with the AMT.  And the AMT could better target the upper middle class and upper class by making the capital gains preferential rate a special AMT adjustment item.

It is discouraging to see how easily the wealthy can twist Congress to their bidding.    Congress should focus on those who merit tax assistance--ordinary taxpayers who are in the lower distribution quintiles and should stop allowing those with money to speak so loudly in its hallowed halls. 

Mortgage debt relief

RIA announced just a few minutes ago that the House will approve the Senate-passed version of HR 3648, the Mortgage Debt Relief Forgiveness Act of 2007.

According to RIA, the House will definitely pass the bill tomorrow.  Once passed by the House, the bill will go to the President for signature.  No veto is expected.

The bill includes several tax reductions, such as the following (among others):

1. a three-year exclusion (ending 12/31/09) for mortgage debt forgiveness income on a principal residence, up to $2 million;
2. a three-year exclusion (2008-2010) for certain state and local property tax rebates and reimbursements to qualified voluntary emergency response organization members; and
3. extension of the $500,000 exclusion on sales of principal residences to people whose spouses die within two years of the sale, if the spouses would have been qualified for the $500,000 exclusion at the time of the death.

Revenue raisers include an increased per-partner and per-S corp shareholder penalty for failures to file returns and an increase in the estimated payments due by corporations in 2012.

On the whole, the Senate bill is better than the House bill, because of the temporary three-year nature of the mortgage debt relief provision.  The $2 million ceiling for the relief is exorbitantly high--the relief should have been limited to low-income or at least middle-income taxpayers with house values at or below the regional median.   

Liberty University and Huckabee

Barry Lynn, the head of Americans United for Separation of Church and State, has written the IRS calling attention to the recent endorsement of conservative Mike Huckabee by Jerry Falwell, Jr., the President of Liberty University.  Lynn's letter is available in the BNA database. 

The Falwell endorsement was on Liberty University letterhead, and accompanied by a very favorable piece in the university's journal about Huckabee's visit to the campus.  Apparently, when Falwell introduced Huckabee for his presentation at the University, he announced  that the success of Huckabee's candidacy " would be a God thing."  See this statement in the Liberty Journal at the University journal's website.  the Journal claims that "The University as a whole stopped short of endorsing Huckabee" even though he received Falwell's "personal" endorsement. 

Lynn argues that this clearly violates the ban on candidate endorsements by organizations that have section 501(c)(3) tax exempt status.  This case comes very close to the paradigmatic problem of endorsement, when a person who holds an office is so closely associated with the exempt organization that the person's endorsement is seen as an official endorsement.  Falwell's use of university letterhead makes the case very strong that he has violated the rules on candidate endorsements.

The US Budget: up, down, where?

The news these days is a roller-coaster.  One day Wall Street is feeling more positive, and stocks go up.  Oil prices are so high that some people are almost treating them as irrelevant--it's strange when it is good news that oil is just under $90 a barrel.  Another day, worries about the subprime crisis expansion among big banks gets everybody down.  Today, the New York Times notes the impact of higher unemployment figures than analysts expected, leading more to predict a US recession is either in the offing or already begun.  The Fed may cut rates, or not, but people are less sure than before that the Fed can solve the deep fiscal problems.

At the same time, Congress has to make some decisions fairly soon about a number of significant tax issues.  One of those is the AMT.  Republicans appear to want to continue to provide a one-year patch, at least, without finding new revenues to cover it.  It's part of the pretense that the Bush 2001-2003 revenue reductions were really almost costless and the further pretense that the Republicans care as much about ordinary taxpayers as they do about people at the top of the income and wealth distribution.  So they are insisting on an AMT patch, but just as insistently refusing to support reasonable revenue raisers, like taxing the compensation of wealthy hedge and equity fund managers the same way we tax the compensation of truck drivers and waitresses--i.e., as ordinary income.  See this discussion at OMB Watch.

Into the mix should be added the Congressional Research Service report, Would a Housing Crash Cause a Recession? Nov. 7, 2007.Download crs_report. Housing Crisis. RL34244_20071107.pdf .  The summary is enough to dampen holiday spirits, becasue the CRS answers its question with a resoundingly strong maybe, listing four channels whereby declines in house prices could result in aggregate declines in spending:

1. builders reduce residential investment because of lower prices
2. since mortgages are tied to house values, declines in housing lead to financial instability, which we have been witnessing in terms of a liquidity crunch caused by subprime mortgage-backed security problems
3. lower house pricess leads to less consumer spending, since homeowners don't think of their homes as provided increasing wealth to back up their spending
4. impending mortgage resets to higher payments cause significant financial distress for a growing number of homeowners who will be forced to reduce consumption spending

The report concludes that the government can take some actions to forestall recession, and that housing prices alone are likely not enough to cause a recession but could well "tip an already tepid economy into recession."

Paul Krugman: Innovating to Crisis

Paul Krugman, Innovating our way to Financial Crisis, New York Times, Dec. 3, 2007, suggests that things are considerably worse than they may appear.  Big banks have developed securitization techniques that they have used to "spread the risk" to many large and small investors--from small towns in Norway to grannies with everything they own tied up in one small package.  The assumption behind Collateralized Debt Obligations (CDOs) and other fancy derivatives was that even risky stuff could be sliced and diced to provide a "super-senior" slice for those wanting a secure investment and a riskier residual for those bottom feeding for high returns no matter the risk.

The problem, according to Krugman, is that the slicing and dicing didn't really spread the risk--it merely confused investors about just how risky were the items they were buying, leading them to take on more risk than they realized.  The complexity of financial innovation is obvious from several perspectives--the "alphabet soup of acronyms" denominating the various deals and the fact that the income chair of the Federal Reserve needed a refresher course in hedging.

Krugman suggests the problem was lack of regulation--banks were free to innovate and make deals, come what may.  They did so.  Some of the banks were smarter than others--realizing the toxicity of the stuff they were creating, they made sure they steered clear of too much of it.  Goldman Sachs appears to be in that camp, having kept very little of the securitizations of subprime mortgages on its books, although it was busy creating lots of them for sales to its clients.  Others maybe bought their own pitch about diversification curing all evils and failed to realize that too many mortgage defaults could cause a liquidity crunch with repercussive effects on the credit markets that would reverberate all the way through the CDOs, REMICs and other deals meant to separate out nice, safe tranches of debt.

More regulation of banks and financial products would be a good thing.   Consider the latest financial accounting development--the trend towards adoption of the IFSR rather than US Gaap.  Banks will likely treat this as one more playing field for manipulating their bottom lines (and, of course, their income tax due).  Congress should get the message, and start taking a harder look at financial innovation and a less appreciative glance at tax-book conformity arguments.  Unless, of course, we don't mind if the banks set their own rules for everything, including taxes.

Dear Readers:  I apologize for the unexpected absence of postings on the blog--I have been quite sick (and still am).