The other day I heard that Bidden might be proposing a 15% “flat income tax” as a solution to something. I am not quite sure what that would solve, but it got me to wondering about income taxes in general. We seem to have gotten to a situation where the poor pay 10% in Federal income tax, the “middle” pay something like around 50% and the top pay next to nothing (less than 1%). If you break it at 50% of the population, the top 50% pay 97% and the bottom 50% pay 3%. That sounds pretty dramatic, and it sounds like the “rich” are paying for everyone else – except that isn’t how it works. The top 50% also owns far more than 97% of the wealth, and makes more than 90% of the “income” (discussed below).

These numbers are based upon “taxable” income. Sorting out what should be taxable is the key question. If “income” means an increase in net worth, then the very rich do very will. For example, Warren Buffett (worth about $128B) who is of the richest folks pays about 0.02% of his annual increase in wealth in income taxes. He is one of the generous ones. That compares to something like 10% at the bottom and perhaps 40% in the middle.

The reason that the “income” is so much lower than the increase in worth is that most increases are increases in value, but don’t get turned into money very often. If you own a $500,000 home as you main asset, then you are “worth” $500,000. However, if home prices raise 5% a year, then the value of your assets incomes by $25,000 a year – which is not “realized” so there are no taxes against that “income”. If you are lucky and happen to own that land in a prime location, it is possible for the value to double without creating a tax liability until you sell it. At that point in time, the income will be considered capital gains, not “income” – with a tax rate of around 20%, unless you reinvest that money in a way that it stays “hidden” as an investment and not an income. Then there is no tax.

A thing with “rich” people (those who have more than they spend) is that they can choose what “income” that would like – and therefore they can choose how much tax they want to pay. You can just keep the money invested and it just keeps growing without taxes. However, sometimes the income grows in ways that become taxable income even though it is not turned into cash. An example is with using a house as a rental creating income. The part of the rent that exceeds the expenses becomes “income” and is therefore taxable. However, instead of just owning a house for this purposes you create a business (such as a corporation). In that case the corporation would owe any taxes (at a considerably smaller tax rate), but can also do things such as purchase other rental properties – and the “excess” income goes away in business expense – along with income tax. This is a never ending cycle of needing to keep investing in more and more to keep from having taxable income show up. At a certain point that gets overwhelming so you have to start giving it away, of course giving it away to charitable organizations that generate a tax deduction (“write off”). Sometimes you can even give away stuff (perhaps art to an art museum) where you can take a deduction for the value, rather than the initial cost. If you are careful with your purchases you can buy low, give away high and make enough in the tax benefits to avoid paying any taxes – it is not really a donation, it is just another way to make money.

Considering things closer to home. Perhaps a person decides to buy a restaurant to make a living. They have a lot of business expenses such as rent, or a mortgage on the building, all of the equipment and furniture, utilities, labor, etc. Clearly all of those things are not “income”, in fact they are expenses. This person has a gross income based upon their sales receipts, but their net taxable income has very little to do with that number, the part that they can live off of is the difference. It seems reasonable for that difference to be the taxable part. However, if successful this same business starts to be worth much more than the initial value – but that extra part doesn’t get taxed until it is “realized”. It becomes an interesting exercise to determine which part of the money flow is “business expense” and which part is personal income. There are lots of rules about this, generally the smaller the business the easier it is for the IRS to figure out that you didn’t pay tax on the portion of the company car that you used for personal transportation. However, at a certain point the business expenses so overwhelm the personal spending that the “income tax” becomes negligible. That is what results in folks like Warren Buffet from paying any reasonable amount of income tax, he can only personally consume so much stuff – and that is all that he takes out of the business (which is his choice – it is not some sort of natural thing). So income tax becomes trivial. What about corporate taxes?

Corporate taxes are similar in that they only occur when realized, and there are many, many “incentives” that give huge tax breaks when they do become realized. The only reason that they would become realized is to allow the business to get into an entirely different line of business – in which case the new costs aren’t counted as on-going business expenses. One interesting thing in California is known as the “Prop 13” freeze on property tax. The deal is that property taxes are fixed (almost) at what they were when the property was purchased. That means that it increases to the new value when sold, but remains at the low rate compared to the actual value until that time. This is not a big deal with residential property because that “turns” on average about every 3.5 years – resulting in property taxes lagging inflation slightly, but not significantly. However, at the very last minutes (literally) before being voted into law the wording was changed to include business property. The thing with business property is that it seldom gets sold (because that would cause the value to be realized and therefore taxed). Since the property doesn’t get sold, the property tax remains frozen at very low rates relative to inflation. This in turn results in services, such as schools, that depend upon local property taxes go broke. That keeps teacher’s salaries extremely low, driving teachers out of the field. There are many bad results of this law, which was initially passed because people on fixed incomes were losing their homes because of property taxes that tracked the “appraised” value of their homes. The cure was a sensible one of giving them a break during their lives. But the cure brought a very negative impact by stopping the flow of business money to support local services.

So what it the solution? A flat rate won’t help unless it comes with a change in the definition of “income”. As long as people with a lot of money don’t have any income because it is all either eaten up as business expense, or “hidden” in unrealized gains, then they won’t have to pay a flat tax either. A flat tax will increase the taxes on the low income folks from 10% to 15%, won’t do anything for the upper income folks, but might help the middle income people (with their extra money coming from the low income folks). The solution isn’t in adjusting the nominal tax rates, it is in adjusting what gets taxed. What are normally called “loop holes”. It seems like the solution is in taxing based upon value – but even that is a bit questionable since much of what is owned is not actually “owned” it is borrowed. If I “own” a $500,000 home, the reality is that I probably only own $100,000 and owe $400,000. However, I am getting the use of the other $400,000. Would the bank then have to pay taxes on the part that they own? That would cause mortgage rates to skyrocket – forcing huge numbers of people to lose their homes. How about the increase portion? So if the house increases in value by 5% a year, who pays for the tax on the $25,000? Is that the homeowner who really only owns 20% of the property, or the bank? By the way, allowing taxes to follow property values like that puts us right back into the problems that created Prop 13 in the first place.

I don’t have an answer to this, and it appears that I am not alone. What is value? What is income? How do you pay for unrealized increases in value? For example, lets say that your retirement nest-egg is a $5,000,000 investment in securities (stocks and bonds). This should be able to generate about $125,000 a year in increased value at today’s rates (leaving enough in the fund to increase as inflation increases). After income taxes on the part that distributed results in an after tax income of around $70,000/yr. Enough for a nice retirement for most folks. But it also means that you were leaving $125,000 in the fund to grow – as unrealized income. This means that $125,000 of “income” (increase in worth) was tax free. Actually, even the initial tax was smaller than for someone that works for their money because comes out as capital gains (taxed at 20%) instead of regular income (taxed at 45%). All of a sudden your reasonable retirement nest egg that you saved and fought for during your working life puts you into the category of the “rich that abuse taxes”. You are now only paying 10% on your income – income that you did nothing to earn but buy some paper that you never even get to see. You are now paying less (as a percentage) than the poor kid selling hamburgers down the street.