Tax deconstruction: Who pays the most taxes? April 9, 2004

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Wall $treet Week with FORTUNE co-anchor Karen Gibbs recently had a talk on taxes with author David Cay Johnston and economist Bruce Bartlett. Johnston is a Pulitzer Prize-winning journalist and author of Perfectly Legal: The Covert Campaign to Rig our Tax System to Benefit the Super Rich -- and Cheat Everybody Else. Bruce Bartlett, an economist and a senior fellow at the National Center for Policy Analysis, worked in the administration of President Ronald Reagan in the 1980s.

Some of their 30-minute conversation will appear on our April 9, 2004 broadcast -- but most of it won't. Below are excerpts that didn't make it onto the air:

JOHNSTON: Most rich people pay a lot of taxes. I'm not disputing that one bit. But the IRS' new data out this week on 2001 tax returns shows that people who make $400,000 to $10 million a year pay a higher percentage of their income to the federal government than people who make more than $10 million a year. And that top group's average income is $25.6 million a year.

Now $400,000 is a lot of money, but compared to $25.6 million? That's one week's income. And most Americans I think believe that people whose income is higher than theirs pay a smaller amount, pay a larger amount in taxes than they do. That's not what's happening in our system. It is progressive up to a point, and then it falls off, and the people it falls off for are not that small in numbers. There are 7,000 households that make more than $10 million a year.

GIBBS: Bruce, what about it? What happened? Is it Congress' fault? Whose fault is this?

BARTLETT: Oh, it's primarily Congress' fault, although a lot of the complicated factors in the tax law are court, involve court decisions and things of that sort. But just to clarify something David talked about, the Bush administration did not put in the alternative minimum tax. In fact there was a fix put into the legislation that prevented the AMT from increasing, which it would under normal circumstances, and that fix runs out at the end of this year. So there will be a problem next year that will have to be taken care of. And also the rate reductions for the wealthy mostly yet haven't taken effect. They'll take effect in the future. In the short run, in the first three years of this administration, most of the tax cuts, such as the child credit, have primarily benefited people at the low and the middle income levels. And we do have a steeply progressive tax. Generally speaking, the more you make, the more you pay. So I think focusing on a few people at the highest end who perhaps overly use tax savings provisions of the tax code I think is a bit of a false impression. Most rich people pay a lot of taxes and they pay the overwhelming majority of all the taxes in fact.

GIBBS: Should tax records become public so I can find out how much my neighbors pay?

JOHNSTON: Well, you know tax returns, the entire return was public back in the 1920s, and up until the Nixon years, whether you filed a tax return was public. One of the recommendations that I make in the book for reforming our tax system is that we ought to have a public register of whether you filed a tax return. Because in the book I name two billionaires in New York City who run a business who've admitted under oath they never filed a tax return for 30years. Nothing's happened to them. I name lots of business owners who run businesses who do not pay taxes and don't file tax returns. Now in the economy they're a relatively small number of people. We're talking about thousands of people who are doing this. Nonetheless, their competitors are being disadvantaged because there's no enforcement of the law. If you're competing against a guy who doesn't pay taxes, he's cleaning your clock and making money because he can under-bid you. And the government should be out there enforcing the law and arresting people who publicly brag that they run businesses and don't pay taxes.

GIBBS: Bruce, what do you say to that? Because Congress specifically gave money to the IRS to go after the working poor, pretty much leaving significantly fewer resources to go after wealthy cheaters.

BARTLETT: Well, one reason they went after the so-called poor is that there is a lot of cheating that goes on with something called the earned income tax credit. Normally speaking, you want not to disclose that you have made income on your taxes. That's one way of cheating. But with the earned income tax credit, you have an incentive to declare income that you didn't actually have. So there is something, a very high percentage of the EITC, which is a $30 or $40 billion program, is by all accounts going to people who don't deserve it. So there is some need for some enforcement efforts there. Why these billionaires that David talks about haven't been gone after I haven't the faintest idea. But I think the central point of David's book is that we've gotten away from something economists call horizontal equity. If you and I make the same income, we ought to pay roughly the same taxes, and that's less and less true than it used to be.

GIBBS: Why is that?

BARTLETT: Part of it is that we've made explicit decisions in the tax code to favor certain types of families. We give enormous tax benefits to families with children. We benefit people who save and invest. Those were conscious decisions, but it also means that the tax code has become much more complicated. And I think the ignorance factor is a key problem where people are overpaying taxes simply because they don't know that they don't have to. For example, the number of people who qualify for a 401 (k) deduction and don't max out the amount that they could put in or who don't max out an IRA contribution is really terrible. These are really...

GIBBS: Well, maybe they need that money to live and pay the bills. They can't max out.

BARTLETT: Some do, but a lot of them don't. They just don't realize what's available to them, and then they complain about the taxes that they pay.

GIBBS: David, Bruce just mentioned that we give great credit and deductions to families with children, but a lot of families with children that live in very high tax areas, they're not, they're not getting that benefit. In fact they're attacked with this alternative minimum tax, and the bracket creep is another problem.

JOHNSTON: That's right.

GIBBS: What do they do about that?

JOHNSTON: Well, there's nothing they can do about it. If you make between $75,000 and $100,000, there's a 97 percent chance that you will lose part of your Bush tax cuts if you have two or more children and are married. And if you're married and have children, you're 30 times more likely to have to pay the alternative minimum tax than if you're a single guy like Bruce is. So there's family-friendly tax policy for you. Under the alternative minimum tax, Congress takes away from you your exemption for yourself, your spouse, your children, your state income tax deduction, your property tax deduction, if you don't itemize the standard deduction. Congress will even tax you for spending money to keep yourself or your child or your spouse alive if you spend more than 7.5 percent of your income on medical bills. About 100 members of Congress denounced this after I reported on it in The New York Times. But there's been no bill to correct it.

GIBBS: Should there be an estate tax, an inheritance tax?

JOHNSTON: Well, we can have or not have an estate tax, but what we need to do is discuss what it means if we do and we don't. If we eliminate the estate tax, it means we're shifting the burden of taxes off of very wealthy people at death, who've been able to defer taxes until they die, onto people who are working and living today. Now the design of any kind of repeal is very important. I point out in the book that if we do the design President Bush originally put forward, it would encourage family-held businesses to be sold immediately on the death of the patriarch or matriarch in the family. Congress, however, could easily create a system that encourages family-held businesses. So the design of how you keep or repeal a tax like this is very important to its economic effects.

GIBBS: Bruce, shouldn't celebutantes pick up some of the bill from the working poor?

BARTLETT: Well, of course they should. We have, and that's why they pay a lot of taxes during their lives. But I think David's wrong about one thing. I think the vast majority of people who favor abolition of the estate tax know perfectly well that it's paid primarily by the rich. There are a number of polls where they've specifically premised the question by saying, here's a tax that you have to earn whatever, $3 million to pay, do you still think we should get rid of it? And 70 percent or so of people consistently year in and year out say, "Yes, we should get rid of this tax." And I think it's because they just think it's fundamentally unfair to tax again at death assets that were already taxed during people's lives.

And I would also mention that we're not really getting rid of the estate tax anyway. We're replacing it with something called carryover basis, which means capital gains will be taxed at death, which presently are not taxed at death. It's kind of hard to explain this, but it will recoup a considerable portion of the revenue that would be lost just from getting rid of the estate tax.

GIBBS: So you're saying that in some ways this estate tax is double taxation. But there are other situations where we have double taxation and it flies.

BARTLETT: Well, that's right. I mean there's nothing per se wrong with double taxation. What matters is what is the effective tax rate at the end of the day. And I think we do overtax capital in this country. I think we want more saving, we want more investment, and rich people do most of the saving and investing in this country and create most of the jobs. So I think we have to think beyond just looking at is, should rich people pay more to ask yourself what is good for the economy as a whole, and I think that's the argument the Republicans have been trying to make. And by and large the American people supported them on this.

GIBBS: Is it just the special interests running it now?

BARTLETT: Well, the system is clearly broken. How it got broken and who's responsible I think is less important than trying to agree on how to fix it. And personally I favor something like the flat tax. I think that that is a fair, I think Americans instinctively view the idea that everybody pays the same rate as a fair idea, and there's a lot of, there's good economic analysis showing that this would be a good thing to do. But you can never figure out how to get from here to there, because you have to take away some things that the people believe in, such as the mortgage interest deduction.

Now David talks about these tax loopholes and exotic things like that, but the vast bulk of the deductions in the tax code are for things like mortgage interest and charitable contributions and things like that that the middle class primarily benefit from. In aggregate terms, it dwarfs these other things. And figuring out how to wipe the slate clean and start from scratch has proven to be pretty much impossible politically. I think the best we can try to do is tinker with it and use the opportunities that present themselves when there's an occasion to cut taxes or an occasion to increase taxes to try to fix some of these things and do them in a sensible kind of way.

GIBBS: David, Bruce mentioned two different tax changes. Now either the flat tax or the value added tax, the consumption tax. Am I wrong in thinking that that still shifts the burdens to the lower wage people?

JOHNSTON: Well, it still shifts the burdens, and actually they're the same thing. The flat tax grows out of an effort, remember George McGovern's hapless 1972 campaign? He was going to send us all a check for $1,000. An eminent economist named Bob Hall understood what McGovern was proposing to do, and he came up with the idea of a way to create a value added tax on an income tax base. When he did it, however, it had graduated rates. The more your income, the higher the rate that you paid, and he got talked into in the book turning it into a flat tax.

I'm concerned if we adopted a flat tax that it would turn us into a country of socialists. Steve Forbes and other inheritors of businesses would never have to pay taxes again because of the way the tax works. It is not what most people think it is. If you inherit business assets -- not financial assets, but business assets -- you get to write those all off day one against your income. So if you inherit a $1 billion and over your lifetime you only spend $500 million, you never pay taxes. There's a real fundamental problem with that I think, and I'm concerned that it would lead people who will never have capital or any substantial savings to begin thinking in a socialistic way about our country. And I don't think that would be good for economic growth and political stability.

GIBBS: Bruce, do you think taxes are still too high?

BARTLETT: I'll always think taxes are too high. If they cut them in half I'd still think they were too high.