The Myth of Progressive Taxes

Every few years, there's a little flurry of headlines about millionaires who don't pay any taxes. Last year's version included stories like that of Michael Dingman, chairman of the New Hampshire-based aerospace manufacturer Abex, who gave up his U.S. citizenship to become a Bahamian. Dingman told the New York Times that he was seeking "a gentle, thoughtful, pleasant place to raise our three children." Along the way he also eliminated his U.S. tax liability. His wife and children remained Americans; when Dingman dies, if it's at least 10 years from now, they will get their inheritance tax-free.

Dingman and people like him may have found the ultimate estate plan (as William Zabel, author of the cheerily titled The Rich Die Richer--And You Can, Too put it). But you don't really have to go to quite those lengths to avoid paying your share. J.P. Morgan had it figured out back in 1932, when his accountants figured out a way to cut his taxable income almost to zero. "Congress should know how to levy taxes," declared Morgan, "and if it doesn't know how to collect them, then a man is a fool to pay."

And that's assuming Congress, and the executive branch, want to collect more money from the rich. Every time the stories about tax-free millionaires surface, a lot of talk follows about closing "loopholes" (last year's remedy was an expatriation tax). But according to Philadelphia Inquirer reporters Donald Barlett and James Steele, authors of America: Who Really Pays the Taxes?, that very language is myth: It implies that unfairness in the tax code gets there by accident, only to be removed as soon as sharp-eyed politicians catch it. The record, they write, reads differently: "For over 30 years, members of Congress and Presidents--Democrats and Republicans alike--have enacted one law after another to create two separate and distinct tax systems: One for the rich and powerful--call it the Privileged Person's Tax Law--another for you and everyone else--call it the Common Person's Tax Law."

There are plenty of people who would quibble with Barlett and Steele's phrasing, but the raw numbers aren't in dispute. Liberal or conservative, academic or political, pretty much everyone who studies the tax code concludes that it offers plenty of good deals to those who can afford them. What follows are some examples; for reasons of space--and because "corporate welfare" has received a fair amount of attention lately anyway--we're only talking about taxes on individuals and families.

Start with the tax rates themselves, structured so that taxes go up dramatically as you move through the lower rungs of the middle class, but barely budge when you hit the six-figure set. For a single person getting a raise from $26,000 to $29,000, the rate nearly doubles on the additional money (going from 15 percent to 28 percent); by contrast, the rate stays exactly the same for someone whose income jumps from $300,000 to $3 million.

The differences are even more drastic with the portion of taxes devoted to Social Security. Everyone's been talking about how the retirement system is destined to implode as the boomers age; much less noted is the fact that, partly as a result of changes Congress made over the years, the burden has been shifted almost entirely onto the poor and the middle class. That's because the Social Security tax is only applied to the first $61,200 of a person's income; thus, a single person making $62,000 pays the tax on every paycheck while the person's boss, making $500,000, pays only on what he earns by mid-February.

(Incidentally, though Social Security has a reputation as a program for the poor, in 1989 some $5 billion in payments went to people with incomes over $100,000. Only 14 percent of retirees with that kind of money collect Social Security now, but that figure is rising.)

Much of the current rate system is a product of the Reagan years, and it's worth noting that the Gipper knew what he was talking about when he said "tax relief." When he first started out in Hollywood, the top tax rate was 71 percent; World War II brought it to 91 percent. The top rate was still at 50 percent in 1980; then, the tax reforms enacted by Reagan and the Democratic Congress's tax bills slashed it to 31 percent. By Barlett and Steele's calculation, the First Family alone thus saw their effective tax rate cut from 40 percent in 1981 to 25 percent in 1986. In 1992 Congress tweaked the rates, increasing them to 39.6 percent for income over $256,000--still one of the lowest rates in the industrialized world.

Now the hottest ticket in political circles is the flat tax, most versions of which would effectively slash the top rate in half again. According to the Treasury's analysis, the savings for people making more than $200,000 would come to at least $79 billion a year under a 17 percent flat tax.  

Of course, almost no one who can afford an accountant pays the full rate. Ever since the U.S. first got an income tax about a century ago, lobbyists have swarmed to the tax-writing committees for the same reason Willie Sutton said he robbed banks--it's where the money is. Federal "tax expenditures," as they're called, are estimated by the Joint Committee on Taxation to amount to $483 billion in 1996; by 1999 they're expected to come to as much as all federal "discretionary spending"--the Pentagon, social programs, foreign aid, everything--put together. In Minnesota, the list of tax expenditures put out by the Department of Revenue runs 19 pages and totals more than $7 billion; that includes everything from a beverage-tax exemption for sacramental wine to a sales-tax break for "Petroleum Products used in Passenger Snowmobiles."

The effect of a tax break is the same as any other kind of government expenditure--money out of the treasury, and in someone's pockets. But there's one difference: With tax-based subsidies, the government gives you more money the more you already have. Take the deduction for mortgage interest, worth $55 billion to homeowners in 1990. (The entire budget for subsidized rental housing that year, by way of contrast, was $8 billion.) In theory, it's the birthright of the middle class; in practice, the lion's share of the benefit accrues to the most affluent. Congress's Joint Committee on Taxation estimates that the wealthiest 5 percent of the population picked up more than one third of all the mortgage-interest tax benefit last year.

Here's how it works. Imagine a couple in south Minneapolis; he supervises telemarketers, she works at a downtown office, and together they make $35,000. They bought a house four years ago--your basic two-bedroom bungalow, nice woodwork, needs some fixing--for $75,000. If they don't bother to itemize deductions (only one in five Americans do), they don't get any benefit from the interest deduction. If they do, the subsidy, based on a 9 percent mortgage, is worth an average of 13 percent of their payments, or about $81 a month, for the first 10 years. (The subsidy declines in value as the years go on because interest makes up a smaller portion of the payment.)

By comparison, take a family making $500,000. Say they bought a comparatively inexpensive two-story in Eden Prairie. It has five bedrooms, a formal dining room, informal dining room, living room, family room, amusement room, two fireplaces, heated four-car garage, a porch overlooking the golf course, and a $360,000 price tag. In this case, the government picks up about 35 percent of the family's mort

gage payments during the first 10 years, for a total of $1,020 a month. Second homes qualify too, and if the family buys a new boat they may be able to write off that interest--provided the yacht has a bathroom.

From homes it's a short way to property taxes--probably the most unpopular of all taxes, because you get a bill for the full amount rather than having them dribbled out over time. In California, the tax revolt of the 1970s led to Proposition 13, which froze valuations for homeowners who stayed put, and sent taxes through the roof for the next generation of buyers. By the early 1990s, note Barlett and Steele, some homeowners in the Watts section of L.A. paid taxes at a higher rate than their counterparts in Beverly Hills. A single professional woman in West L.A., making $40,000, paid more property tax per square foot on her bungalow than convicted junk bond king Michael Milken did on his eight-bathroom estate.

In Minnesota the disparities aren't quite as drastic, in part because the state taxes the first $72,000 of a home's value at a reduced rate. Still, in our example, the family in Eden Prairie would pay $8,900 a year in property taxes, or about 1.8 percent of their income, while the south Minneapolis family would pay $1,152, or 3.3 percent of their income. According to a 1995 study by the state Department of Revenue, the top 1 percent of taxpayers (those with incomes over roughly $190,000) made 13.9 percent of all the income in the state, but paid only 10.5 percent of all the residential property taxes (not counting cabins); by contrast, people making between about $18,000 and $23,000 had 5.8 percent of the income, but paid 8 percent of the property taxes.

And the gap is likely to widen. For a long time, Minnesota was one of the few states taxing the most expensive homes at a higher rate. But in 1991, the Legislature brought the top rate down from 3 percent to 2 percent of market value. Since government spending didn't go down by a corresponding share, the result was a massive redistribution of the tax burden from the people in mansions to everyone else. In 1994, a study by the state chapter of Citizens for Tax Justice showed that local property taxes had gone up between 5 and 50 percent in almost every city and town, with a few exceptions: North Oaks (down 0.3 percent); Wayzata (down 9.6 percent); and Minnetonka Beach (minus 12 percent).  

This session, lawmakers passed a tax break for cabins, which should be worth $500 annually to most owners. And next year is likely to finally bring results from years of lobbying by business interests--a thorough property-tax reform that would feature a reduction in commercial and industrial rates at its center. All the proposals floated so far would shift a good part of the burden to poor and middle-income people; the only question is whether they'll pay through higher homeowner taxes or new sales taxes.

One more thing about property taxes: They, too, qualify for a tax deduction. For the Eden Prairie family, that means a savings of more than $3,500. The folks in south Minneapolis reap a mere $210.

There's a reason why people with higher incomes are far more likely to itemize deductions than those in the lower brackets: There are so many deals to take advantage of. Some write-offs are phased out as income rises, but the majority are not. Like the deduction for investment interest--money borrowed to, say, play the stock market. It was worth some $11.6 billion in 1990, according to the Joint Committee on Taxation; more than 80 percent of that was claimed by people who had incomes over $1 million each and collected an average write-off of $115,000, on top of any profits they made from their investments.

There are deductions for pension plans (with preferential treatment for Keogh plans, generally used by the affluent) to charitable donations (and we're not talking church collection here--Nancy Reagan got a $6,000 deduction for giving some designer clothing to a museum). Even owning thoroughbreds can save you money, since they qualify as livestock--making for racehorse names like My Deduction, Write Off, Tax Holiday, and Justa Shelter. Sometimes creative accounting gets a little ahead of itself: L.A. magnate William Wilkerson once claimed a deduction for maintaining his Bel Air home (including two maids, a cook, a chauffeur, a butler, and gardeners), arguing he had to have it so he could do "business at the dinner table." The U.S. Board of Tax Appeals eventually rejected that one.

With some kinds of income, you don't even need a deduction to reduce your taxes. State and local bonds--the kind governments issue for everything from stadiums to airline maintenance bases--offer a fantastic deal to people like Ross Perot, who, according to information he filed with the Federal Elections Commission, made upwards of $18 million in public bond interest in 1991, without having to pay a penny to the IRS.

The biggest investment-related break is probably the preferential treatment for capital gains--profits from the sale of stocks, real estate, and other assets that become more valuable as you hang on to them. Say a person--perhaps borrowing some money and using the interest deduction--buys some stock, or real estate, for $1 million; five years later it's worth $4 million. The profit is taxed at a top rate of 28 percent; by contrast, a couple whose annual taxable income is $95,000 pays 31 percent, simply because they got their money from paychecks rather than trading paper.

Again, in theory the deal is available to anyone; in practice, it benefits the affluent almost exclusively. According to Citizens for Tax Justice, people making more than $200,000 a year reaped 96.7 percent of all the capital-gains tax advantage in 1994; people making between $100,000 and $200,000 took care of most of what was left. And capital-gains taxes are due for another cut if politicians have their way. Under one proposal in the Contract with America, the rate would be cut to an effective 19.8 percent. The argument is that this would stimulate investment, though by most historical analyses that's never happened when the rate was cut before; instead, money simply flowed from investments that didn't get the break, like certain stocks, to those that did, like the office buildings that sprouted everywhere in the early 1980s. (This is true for many types of tax-based economic tinkering: As Michael Kinsley has pointed out, if you cut taxes in half for all the people named "Newt," you'd probably see a rise in income for Newts--not because everyone by that name suddenly got the urge to make money, but because rich people changed their name to Newt.)  

The list goes on, but the pattern stays pretty much the same. There are a few tax breaks designed specifically for people with low to moderate incomes, notably the earned-income credit, which actually gives you money back even if you made so little you don't owe taxes. But it's slated for cuts that could eliminate one fifth of the 14 million families currently using it, and reduce the benefits to those who remain covered. Instead, politicians from Bill Clinton to Rod Grams are championing a $500-per-child tax credit that would not be available to the poorest working families because it only applies to taxes actually paid.

And none of this even takes into account the additional tax breaks for large corporations; the details could (and do) fill books, but one figure tells much of the story. In 1954, corporations paid 75 cents in taxes for every dollar paid by individuals and families. In 1994, the figure was about 20 cents to the dollar. By Barlett and Steele's calculation, if corporations paid taxes in 1994 at the same rate they did in the 1950s, the U.S. Treasury would collect an extra $250 billion a year--enough to nearly eliminate the federal deficit, pay for a universal health care system, or cut taxes by more than half for everyone making less than $200,000.

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