Why Your Tax Cut Doesn't Add Up

Tax time isn't fun, unless you're an accountant keeping a running tab of how much you're billing clients as April 15 nears. But this year tax season's even more distressing than usual. You've been looking forward to cashing in your share of the $3 trillion or so in tax cuts President George W. Bush has pushed through in the past few years, those "real and immediate benefits to middle-income Americans" he's promised (most people consider themselves middle-income these days). But who can figure out this stuff? Even accountants now get Excedrin headaches from an ever-more-complex set of rules: financial publisher CCH says its Standard Federal Tax Reporter, the tax-biz bible, has grown by a third in the past three years, to more than 60,000 pages.

For millions of Americans who do their own taxes, the workload has vastly increased because so many of us have to fill out a second return, using a whole different set of calculations, to see if we've fallen prey to the alternative minimum tax. Feel confused? The tax-policy sound bites emanating from the presidential campaigns are certainly no help. They just add to the confusion and make you want to forget it all, write your check (or cash your refund), get on with your life and hide from taxes until next year. Even I feel this way sometimes, and I deal with numbers and taxes for a living.

But you can't afford to shrug off this stuff and go hide under your bed. Not only are taxes going to be a central issue of the presidential campaign, but there are huge stakes here--nothing less than the financial well-being of our government and your family, not to mention of generations to come. It's not just about how much money you send to Washington (or get from it). Taxes are really a policy statement that reflects our government's notion of fairness, including how it wants to give strivers a chance to move up the ladder.

Until now, the public debate over the Bush tax cuts has played out along predictable, partisan lines. You've heard it so often, you can probably say it along with me. Bush argues that cutting taxes for all Americans stimulates the economy and will make everyone more prosperous. His stated goal: "Lower income taxes for all, with the greatest help for those most in need." Meanwhile his opponents say the bulk of the tax cuts have gone to the well-off. Bush and his opponents are both being factual--but, as we'll soon see, they use convenient facts and ignore inconvenient ones.

The blather from both sides obscures the real, but largely hidden, agenda behind the Bush tax cuts. Bush has been open about each item he wants: lowering taxes on capital income, such as dividends and capital gains; creating two big new income-sheltering investment plans; eliminating the estate tax. But he's not been at all forthcoming about the ultimate effect of his program. If Bush gets what he wants, the income tax will become a misnomer--it will really be a salary tax. Almost all income taxes would come from paychecks--80 percent of income for most families, less than half for the top 1 percent. Meanwhile taxpayers receiving dividends, interest and capital gains, known collectively as investment income, would have a much lighter burden than salary earners--or maybe none at all. And here's the topper. In the name of preserving family farms and keeping small businesses in the family, Bush would eliminate the estate tax and create a new class of landed aristocrats who could inherit billions tax-free, invest the money, watch it compound tax-free and hand it down tax-free to their heirs.

By drastically favoring investment income over salary, fees and other "earned income," Bush would make it harder for people who start out with nothing to earn their way up the economic ladder, because they'd pay full taxes on almost everything they make, but he'd shower rewards on people who have already made it to the top rungs.

With the current rate of spending and tax-cutting, there's no way the government can even remotely balance its books without huge spending cutbacks, which are unlikely, or new sources of revenue. Bush people talk about growing our way out of budget problems, but that just doesn't seem possible--especially if Bush's two big new proposed tax cuts are adopted. Private whispering among experts from right to left is that some sort of national sales tax is inevitable if we continue current spending patterns, exempt investment income from taxation and try to fix the AMT. Who would be affected the most by such a "consumption tax"? People who live from paycheck to paycheck, spending virtually every dollar that comes in the door.

Greg Mankiw, chairman of Bush's Council of Economic Advisers, argues that lowering taxes on investment income doesn't reward just the well-off, even though they get the bulk of that income. "When you reduce the taxes [on capital], you get higher investment," says Mankiw, chosen by the White House as its spokesman for this article. "And when you get higher investment, workers are more productive and get higher wages." Over time, he argues, more and more of the benefit goes to workers. It sure sounds great--but it's not provable, at least not to me. This isn't trickle-down economics, it's seep-down economics. When I paid lower taxes on the dividends I got from Lee Enterprises, an Iowa-based newspaper chain, did Lee run out and give raises to reporters and buy more presses? I think not.

Lest you think that I'm picking only on Bush, bear with me. Sen. John Kerry's turn will come later--I'm dealing with Bush first because it's clear what his policy's about, but we don't really know much about Kerry's specific plans yet.

I do know, though, that a good part of the tax discussion is a misnomer. If we're going to talk about what Americans pay in income taxes, let's deal with the elephants in the room that are almost never mentioned--Social Security and Medicare. Now get this: about 75 percent of American families pay more in Social Security and Medicare taxes than in income tax. The total combined Social Security and Medicare tax is a whopping 15.3 percent on the first $87,900 of salary (or other earned income) and 2.9 percent on the rest. (I'm counting workers' total cost the way the Congressional Budget Office, Mankiw and virtually all other economists do, by assuming that workers foot the bill not only for the taxes they pay themselves but also for what their employers pay.) We sent about $550 billion of Social Security and Medicare tax payments to Washington last year, two thirds as much as we sent in income taxes, four times what corporations paid. (My numbers are from the Social Security Administration and the Council on Budget and Policy Priorities.)

Mankiw says it's wrong to combine Medicare and Social Security with income taxes when calculating families' tax burdens. Families get specific benefits in return for Social Security and Medicare taxes, he argues. But those benefits aren't guaranteed, and the benefit formulas are virtually certain to be cut sometime in the next decade. Meanwhile Social Security's cash surplus, about $75 billion this year, helps cover the federal deficit. So with all due respect to Mankiw, it seems only fair to take Social Security and Medicare into account when calculating income-tax burdens. These are, after all, taxes on income.

Now turn to our scenarios (facing page). They support Bush on one important count. He's repeated endlessly that the average American family--married, two incomes, two kids, $40,000 of income--gets a huge break from his tax cut. Sure enough, the tax mavens at CCH, who computed tax burdens based on income levels NEWSWEEK suggested, calculate that Bush has given this household a 98 percent cut on income taxes, but only a 24 percent cut in total taxes. Yeah, 24 percent's not chopped liver--but it's not 98 percent, either. And while $40,000 is close to the mean income of all tax filers, which means about half earn more and half earn less, fewer than a quarter of households consist of two parents and two kids. The four-person, $40K family is average--but it's sure not typical. Look at our other scenarios and you'll see something interesting. The farther up you go in income level, the more important lower taxes on investment income become. So higher-income people tend to get bigger percentage cuts in their total tax burden from Bush's cuts than lower-income people--the exact opposite of how a progressive tax system is supposed to work.

Wait, there's more. Dividends and capital gains have an extra bonus. First, they're taxed at a maximum of 15 percent rather than the 35 for salary income. Second, that preferential rate doesn't get whacked by the accursed alternative minimum tax. The short version of the AMT's origins: in 1968, the IRS revealed that 155 people with incomes of $200,000 and up hadn't paid a penny of income tax in 1966. Congress whipped up the AMT to force these folks to send at least a nominal check to Uncle Sam. Now, like a piranha that's escaped into the swimming pond, the AMT is biting everyone in sight. It's changed from a class tax to a mass tax. When you calculate your AMT income, you can't deduct things like state and local taxes that are itemized deductions for the regular tax. You apply the AMT brackets (26 and 28 percent) to your AMT income, and pray it's lower than your regular tax. If not, you lose. I wouldn't touch this without tax software, but you may be braver than I am.

About 2.3 million returns for 2003 got nipped by the AMT, and that could rise to more than 30 million by 2010. This year's new victims ranged from a two-person New Jersey family with big state- and local-tax deductions to a seven-person family in rural Kansas taking the standard deduction. In a tongue-in-cheek calculation in the July 7 issue of Tax Notes, tax mavens Leonard Burman, Bill Gale and Jeff Rohaly calculated that in 2008, the government would realize more revenue by abolishing the income tax and keeping the AMT intact than it would get by abolishing the AMT and leaving the income tax intact. It makes your head spin.

For fluky reasons, capital gains--the underpinnings of most tax shelters--haven't been AMT items since 1986. Dividends logically should have been added to the AMT last year when Bush cut the tax rate on them, but they weren't. So the AMT has become a hidden tax on--you guessed it--salaries. At the low end, you pay through the nose for Social Security and Medicare. In the middle and upper-middle levels, you're bitten by the AMT, or soon will be. The Tax Policy Center calculates that in 2010, the AMT will claw back $40 billion--some 34 percent of the income-tax cuts Bush pushed through in 2001. This means that when Bush showed us $100 of income-tax cuts for 2010, their cost for budget-projection purposes was only about 66 bucks. Slick. I wish I could pay my bills with that kind of math.

Taking the AMT out and shooting it is so expensive in terms of forgone tax revenues that both the Bush and the Kerry campaigns are ducking, talking about commissions to study the AMT rather than just ending it. The Kerry campaign won't say anything of substance on this topic. Mankiw, the Bush economist, says, "You might think of the AMT as an impetus for thinking about fundamental tax reform." But he won't say what "fundamental tax reform" means, and wouldn't rise to the bait when I told him it sounded like a code word for a national sales tax or value-added tax. Throw in a 1 percent VAT and, by my guesstimate, you can probably raise about $1 trillion over 10 years. Since the Bushies want to exempt investment income from taxation and are not about to raise income taxes or corporate taxes, pretty much the only way to get major bucks would be adopting something VAT-like.

Now, to show that I'm an equal-opportunity critic, it's time to take a look at Kerry and the Democrats, who shriek about Bush but whose hands aren't exactly clean. During their decades in power, they let injustices and problems in the tax code fester, disparaging "the rich" as if it were a crime to be successful. They never fixed the AMT--and that cost them. It let the Bushies promise tax cuts with a retail value of $1.6 trillion but with a cost, for budget purposes, of only $1.2 trillion. Taxpayers, on average, would lose about 25 cents of each gross tax-cut dollar to the AMT. The Bushies, obviously, knew that would happen, but chose not to highlight it.

The Democrats were also burned, badly, by not fixing the estate tax. They let it become a perceived threat to middle- and upper-middle-income households by refusing to raise the amount exempted from the tax to keep pace with the nation's growing wealth. The Democrats' sloth gave Bush an opening to seem like a populist by proposing to kill the tax. Only about 2 percent of estates send a check to Uncle Sam, but that fact's been obscured by Bush's successful campaign to demonize it as a "death tax" imperiling the well-being of the masses.

Kerry is proposing to reinstate pre-Bush tax brackets for households with $200,000 or more of adjusted gross income--2 to 3 percent of taxpayers. Kerry wants to keep an estate tax, but with an exemption of several million dollars rather than the old $1 million. The Kerry campaign says he'll propose making virtually all the Bush cuts permanent for taxpayers with adjusted gross incomes below $200,000. Those cuts are now slated to expire in stages through 2010, and Bush is pushing to have them made permanent.

Kerry wants to tweak the corporate income tax to curb job outsourcing, and would lower the corporate rate to 33.75 percent from 35. New York investment banker Roger Altman, a senior Kerry adviser, claims this would help a million small businesses that file corporate returns--a counter to Bush claims that Kerry's upper-bracket increases would hurt small businesses.

At first glance, however, Kerry's anti-outsourcing initiative and his plan to offer temporary tax credits to manufacturing firms and small businesses to boost employment seem vulnerable to being gamed. There's no way to tell until Corporate America's loophole-opening experts have had a crack at Kerry's detailed proposals, which haven't yet appeared. Kerry's plan for a commission to boost corporate-tax receipts by closing loopholes and ending so-called corporate welfare sounds wonderful, but who knows? The devil's in the details, and we haven't seen them. It's the old story: it takes about five years to close a tax loophole, about five minutes to create a new one.

One reason the federal budget has been under such pressure the past few years is that corporations are picking up a lot less of the tab than they used to--7.4 percent, down from 20.3 percent 40 years ago. A major reason corporate taxes are a smaller part of the pie is that companies have gotten far more aggressive about avoiding taxes. They prefer the risk of being exposed publicly as pigs to the certain wrath of their shareholders if profits don't keep climbing nicely. And tax avoidance is a dandy profit generator. Companies buy subway cars as tax shelters, or shift income to tax havens like the Cayman Islands, things they wouldn't have dared do in the past.

When you're dealing with Corporate America, beware the word "reform." Last year, when the Bushies pushed through their cut on dividend taxes, they said that shareholders would encourage corporations to pay income tax and avoid moving to tax havens. Why? Because stockholders were supposed to get the lower rate only on dividends paid by U.S. companies from profits on which corporate income tax had been paid. "Income should be taxed once and only once," Bush said. (And said.) But guess what? At the last minute both "reform" provisions disappeared from the legislation. What happened? "Congress was not as enamored of these provisions as we were," Mankiw says. At the time Treasury spokesmen claimed Bush had fought to keep these provisions, but they wouldn't provide details of what he'd done.

Tax discussions these days often feel like academic exercises, with dueling spreadsheets and carefully chosen--albeit misleading--examples. Bush has been a master at forcing the agenda. His cuts are due to expire in stages because that's the only way he could get the cuts he wanted to fit into the budget numbers that Congress adopted. So he proposes things, tortures the numbers, accepts "temporary" status for his cuts, then accuses anyone who's worried about budget deficits of trying to take money out of the pockets of hardworking Americans by not agreeing to make his "temporary" cuts permanent. He could have had smaller, permanent cuts, but he chose not to compromise. So now he needs to have the cuts made permanent. This means that if Kerry wins, much of Bush's tax-cut legacy--both the good and the bad--could disappear without Kerry's having to repeal it.

There is going to be a lot of noise over the next few months: talk of class warfare, promises of something for nothing, plenty of posturing. And maybe, just maybe, we'll have a debate consisting of more than sound bites and round-the-clock spinning. I sure hope so.

So welcome to tax season, which seems set for a good long run. Forget the April 15 deadline. This year, my friends, tax season won't end until Nov. 2.