Who Gets More from the Federal Government, The Rich or the Poor?

So long as we use the Internal Revenue Code to influence behavior we have to acknowledge that social policy will dictate the result.  If we can’t get to a flat tax on the top line (e.g. gross income) unreduced by the deductions we hold so near and dear, then the true beneficiaries will be the wealthy.  Not President’s Obama’s definition of wealth (anyone who earns $250,000) but everyone who wants to protect his or her own little corner of the world.

There are numerous examples of this principle most of which have to do with itemized deductions.  Let us examine a few:

Homeowners deduct interest on the homes they live in and, through creative financing, even on second homes.

The regular mortgage interest deduction is a major federal subsidy for home purchases.  The interest deduction on home equity loans is an exception to the general denial of deductions of personal interest and the higher a person’s income (and tax bracket), the larger the share of mortgage interest that the government subsidizes.

The CTJ Journal (Canadian Tax Journal) reported in an article titled “The Hidden Entitlements” which analyzed tax systems around the world that if a family making $45,000 borrows $75,000 to buy a home, the federal government will offset about 13% of its total mortgage payments, a subsidy worth about $81 per month. But if a family making $500,000 takes out a $360,000 mortgage to buy a house, the government will subsidize about 35% of its mortgage payments, worth $1,020 a month.

Renters, however, get no such direct help from the mortgage interest subsidy. On average, mortgage interest deductions are worth almost $5,000 a year each to taxpayers making more than $200,000, but only $333 a year to families earning between $30,000 and $75,000.

It seems obvious that a $43 billion a year direct government housing subsidy program with such bizarre effects would have no chance at all of being enacted. Nevertheless, the mortgage deduction has been on the books so long and is relied on by so many people that curtailing it would have to be done slowly and gradually to avoid serious unfairness during the transition. Some reformers have suggested eliminating the home equity loan loophole and the deduction for second homes and also lowering the cap on regular mortgage loans eligible for the deduction from the current $1 million. These are all excellent ideas, although lowering the cap on regular mortgages too much too quickly could create significant regional disparities (due to the wide range of housing costs).

Itemizers also get to deduct state and local taxes.

The rationale for the tax deduction for state and local taxes is that people shouldn’t be taxed on income when the proceeds from that tax do not directly benefit them personally, but are, instead, required to serve the general good. Put another way, a New Yorker making $50,000 is thought to have a lower ability to pay federal taxes than a Texan with the same gross income, because the New Yorker’s state and local taxes are higher.

The same CTJ Journal quoted above provides data on the controversial issue of charitable deductions.  Although the data covers a period ending in 2002, the rationale could only make more current data even more lopsided.

Contributions to charitable, religious, and certain other nonprofit organizations are allowed as itemized deductions for individuals, generally up to 50% of adjusted gross income.  Taxpayers who donate assets to charitable or educational organizations can deduct the assets’ full value without any tax on appreciation. Corporations can also deduct charitable contributions, up to 10% of their pretax income.

The basic principle behind the tax deduction for charitable donations is a defensible one: people shouldn’t be taxed on income that doesn’t benefit them personally, but that they instead give away for the public good. (This is the same as the rationale for the deduction for state and local taxes.) In other words, if someone earns $1,000 and gives it away to charity, it’s reasonable not to tax him on that $1,000 in earnings. The normal way it works in the case of cash gifts is that the donor includes the $1,000 in his gross income and deducts the $1,000 gift in computing taxable income. Net result: no tax on the income given to charity.

But there are major problems with charitable deductions, most notably in the case of donations of property rather than cash. In 1986 (the last year before the 1986 Tax Reform Act took effect), the IRS says that one out of every ten people making more than $200,000 who paid no federal income tax at all reported giving more than 30% of total income to charity. A few of these no‑tax rich people said they donated all of their income to charity. If this looks a little fishy to you, you’re right. Almost certainly, much of this apparent largesse reflected a loophole in the law that allowed these wealthy people to deduct the appreciated value of donated property, even though the increase in value was never counted as part of their gross income.

Take someone who has $1,000 worth of stock that she originally bought for $100. If she sells the stock and gives the $1,000 to charity, she’ll include the $900 gain in her gross income and get a deduction for the donation. The net tax on the income given to charity will be zero. Fair enough.

Suppose, however, that instead our taxpayer gives the stock itself directly to charity. That shouldn’t end up with a different bottom‑line tax result.  After all, there’s no real distinction.  But under the regular income tax rules, there’s a huge difference. Not only will she get a deduction for the $100 in earnings originally used to buy the stock, but she’ll also get a deduction for the $900 in appreciation that is not included in her adjusted gross income. As a result, she won’t have to pay taxes on $900 of her other income that she did not give to charity.

The point we are making doesn’t end with itemized personal deductions.  Staff writers, Dan Morgan, Gilbert Gaul and Sarah Cohen of The Washington Post have noted that millionaire landowners and absentee landlords receive billions of dollars not to grow crops on their land.

The essential point is that if you ask most people a simple question:  Who gets more support from the government . . . the rich or the poor, they would guess it is the poor.  But the evidence supports the opposite conclusion.  Hence, the point we made in last week’s essay, “there is something terribly wrong with a governing philosophy that (provides) more for the unneedy than for the needy.”

Willie Sutton, who robbed many people and places at gunpoint when asked why he robs banks, famously said, “That’s where the money is.”

What is the fix?  Obviously it is a flat tax with two or three brackets based on taxing the top line and not the bottom.  Only then can we achieve tax fairness and raise the revenues needed for our social infrastructure and provide a robust national defense in troubled times.