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When it comes to the IRS, bigger isn't always better.

Chris Edwards — Thu, 25 Nov 2021 07:35:00 +0000

While Democrats want to approve President Biden's massive Build Back Better proposal in the House, they will almost certainly face stiff opposition in the Senate. Indeed, they’ve already been forced to scale back their proposal for Internal Revenue Service snooping on personal bank accounts after that provision’s rollout went less favorably than expected. However, that feature was only a small portion of their $80 billion IRS growth proposal, which threatens to boost taxpayer compliance costs while also jeopardizing civil freedoms.

Under the plan, the IRS would be built back bigger. It would double the IRS workforce, with three‐quarters of the expansion directed toward increasing enforcement. More enforcement, they argue, is justifiable since it would increase government income, but they overlook the costs that this will undoubtedly impose on the private sector. For many law-abiding taxpayers, increased IRS enforcement would entail additional paperwork, lawyer expenses, and agony. It may also jeopardize our financial security and privacy.

While reducing the number of tax fraudsters in the United States is a worthy aim, more rigorous enforcement might have unintended consequences. We could recruit an army of IRS agents to routinely examine every home in the country and inflict root canal audits on everyone if we wanted to reduce cheating to zero through enforcement. A free people, on the other hand, do not desire such government involvement, hence every democratic society has a "tax gap" between what is owed and what is paid.

The U.S. tax gap appears to be low by international standards. One study estimated that our tax gap, at 3.8 percent of gross domestic product, is lower than the average tax gap in Europe of 7.7 percent. Another study estimated that among 157 countries, we have the second smallest shadow economy — that is, economic activity outside the government’s tax and regulatory net.

Because the tax gap in the United States is already fairly small, the expense of closing it any further through increased enforcement is likely to be prohibitive. That is especially true of the Democratic proposal to seize data from millions of family bank accounts, which would be extremely invasive and likely result in huge compliance costs for financial companies.

Another enforcement provision in the bill would repeal taxpayer protections against unfair IRS penalties. In response to IRS abuses in the 1990s, Congress enacted tax code section 6751, which requires supervisors to sign off when IRS employees are seeking punitive 20 percent penalties. The National Taxpayer Advocate said that this “provision protects a taxpayer’s right to a fair and just tax system.” But the Democratic plan would repeal this important procedural check on the powerful tax bureaucracy.

The IRS is not staffed by angels — nor is any government department, for that matter. But this agency is particularly prone to making mistakes. As the tax‐litigation specialist Dan Pilla recently noted in these pages, “[the] IRS’s audit results are incorrect between 60 and 90 percent of the time.” More enforcement would mean more audits, many of which may produce “false positives” — or the targeting of taxpayers who are innocent. Individuals and businesses would have to invest more time and money in lawyer fees to defend themselves. The income tax already imposes compliance costs on taxpayers of more than $400 billion a year; increased enforcement actions would only push those costs higher still.

Enforcement advocates want the IRS to collect more data from individuals and businesses, but they do not sufficiently consider how such databases are ideal hacking targets for criminals and foreign governments. The IRS experiences “1.4 billion cyberattacks annually” and has a “track record of data breaches,” including data from 724,000 returns leaked in 2016.

Earlier this year, ProPublica published information on high‐income taxpayers gained from thousands of stolen tax returns it had obtained. A leaky IRS computer system could induce a rash of tax‐return theft from other well‐known figures with the aims of making a media splash, selling information, or extorting payoffs.

If more IRS data‐grabbing and enforcement is not the answer, what is? Major tax reform to simplify the code. That would make the system harder to manipulate and IRS administration much easier. The Tax Foundation estimated that a simple flat tax with no loopholes would slash taxpayer compliance costs by about 90 percent.

Unfortunately, the Democratic tax proposal would go the other way by introducing dozens of small tax benefits for energy, housing, industry, education, and other goods. This would make it more difficult for the IRS to administer the system, and it would encourage people to make more mistakes and commit fraud.

Consider the record of current narrow tax breaks. The earned‐income tax credit suffers from a huge 24 percent error‐and‐fraud rate, while the low‐income‐housing tax credit is plagued by abuse from developers because the credit is so complex and IRS oversight is minimal. Adding more tax credits and other breaks to the code would increase the tax gap.

While increasing IRS enforcement may appear tempting at first glance, it would be detrimental to the private sector in actuality. Simplifying the tax law is a viable option that would benefit everyone involved. The IRS would profit from easier administration and a smaller tax gap, while taxpayers would benefit from cheaper compliance costs and fewer civil rights incursions.

Rich People's Tax Rates

Chris Edwards — Tue, 19 Oct 2021 16:43:00 +0000

Conservative economists want fewer progressive tax codes than liberals because progressive tax systems are harmful to economic growth. However, economists on both sides of the debate agree that the existing tax structure is quite progressive.

At least they used to. Not content with data from the Congressional Budget Office, Joint Committee on Taxation, Tax Policy Center, and the Internal Revenue Service showing that high earners pay the highest tax rates, far‐left economists are inventing dubious figures to try and show the opposite. They do not like what the accepted data shows, so they are trying to move the goalposts to fit their anti‐wealth narratives. Two Biden appointees in the White House have concocted data purporting to show that the rich pay an average income tax rate of just 8 percent.

Let’s look first at data published by career experts at the Treasury. The chart below shows estimated average effective tax rates by income decile under current law for 2022. It includes federal individual income, corporate, payroll, excise, and estate taxes. Within each decile (or 10 percent group), the figures are total taxes paid divided by income. The chart also shows the Treasury’s data for the top 0.1 percent of families.

The red bars show that average income tax rates range from less than zero for the bottom 40 percent of families to 22.7 percent for the top 0.1 percent. The bottom 40 percent pay less than zero because of refundable tax credits. Note that the top group’s tax rate is much higher than the rates on middle‐ and upper‐middle income groups.

The blue bars show that average rates for total federal taxes range from near zero for the bottom 30 percent of families to 31.8 percent for the top 0.1 percent. The top group’s tax rate is about twice as high as the rate on middle‐income groups.

The Treasury data in the chart is roughly consistent with data from CBO, JCT, TPC, and the IRS as I show here. But it is entirely inconsistent with frequent claims by President Biden that high earners are not paying their “fair share” and rhetoric from Bernie Sanders that CEOs pay lower tax rates than their secretaries.

The left has a solution to this glaring inconsistency: invent new data that tries to buttress the Biden‐Bernie claims about taxes on the rich.

A recent article on the White House website by Greg Leiserson and Danny Yagan argues that the top 400 wealthiest families pay an average income tax rate of just 8 percent. The media immediately jumped on the new figure and widely reported it. Never mind that the average income tax rate for the top group in the Treasury data is 22.7 percent, in CBO data 24.4 percent, in JCT data 29.5 percent, in TPC data 24.0 percent, and in IRS data 22.9 percent.

The fact that Leiserson and Yagan included unrealized capital gains in the denominator of their computed tax rate is the key reason for the low figure of 8%. The strategy is based on Haig Simons' communist theory that the tax system should account for changes in all asset values in income each year. Even if Jeff Bezos' Amazon shares increase in value by $10 billion, it is "income" that should be taxed immediately, even if Bezos has not realized the gains or utilized them for consumption.

The left likes to focus on companies with high profits and rising values, but large wealth disappears all the time as companies fail and investors lose money. If we had a Haig‐Simons tax, the government would be hitting shareholders with taxes on unrealized gains in companies that haven’t figured out yet how to earn profits. The graveyard of failed technology companies is vast. They generated unrealized gains at one time, but then they vanished.

The Leiserson and Yagan article only examines the top 400, but consider if we included unrealized gains in calculating tax rates for the middle class. A person earns $60,000 in wages and pays $6,000 in income taxes for a 10 percent tax rate. But if her house increased in value by $20,000, her “income” would now be $80,000 and her tax rate just 7.5 percent. Or consider a small business person with $100,000 of income and $15,000 in income taxes for a 15 percent tax rate. Her hard work is paying off and her business gains $50,000 in value as demand for her products increases. Then her “income” would now be $150,000 and her tax rate just 10 percent.

Leiserson, Yagan, and other analysts on the left write as if everyone agrees that income for tax purposes should be Haig‐Simons income, but many economists do not agree. They argue that such a tax base would favor consumption over savings, unfairly favor the spendthrift over the frugal, and undermine economic growth, as I examine here. Haig‐Simons taxation would also be more complex than consumption‐based taxation, as I examine here.

Left-wing analysts make a mistake by confusing gains with typical income flows. Their methodology contradicts the definition of income in the National Income and Product Accounts, which includes labor and capital returns but excludes asset price fluctuations. When predicted future returns fluctuate, asset prices change, and a well-designed tax system would tax those returns when they are earned or consumed in the future. Taxing them again in the form of gain is a sort of double taxation that is bad.

Consider the value of human capital. When a student graduates from college with a degree in high demand, her human capital grows, and she can expect to earn a higher wage in the future. But imagine the government imposed a capital gains tax on the increase in her estimated future wages when she graduated. Such a tax would be insane since it would discourage individuals from learning new skills and developing themselves. A Haig Simons tax, on the other hand, punishes gains in value and inhibits investment in other sorts of capital.

In sum, the denominator of the claimed 8 percent tax rate is not an appropriate measure of income for a fair and efficient tax system. Because of the impracticality, unfairness, and anti‐growth aspects of a Haig‐Simons tax base, the federal income tax has always been a compromise between Haig‐Simons and consumption‐based taxation, as have the income taxes of other countries. No high‐income country taxes unrealized gains in their income tax, and just about every country has favorable treatment of realized capital gains as well.

Congress should use the current tax revenue gusher to reduce dangerously high deficits and debt

Chris Edwards — Fri, 15 Oct 2021 17:05:00 +0000

New data from the Congressional Budget Office show that federal tax revenues are soaring. Despite the Republican tax cuts of 2017 and the ongoing pandemic, taxes are pouring into the U.S. Treasury. If Congress restrains its spending appetite, this is good news as it will reduce the government’s dangerously high budget deficits.

The chart below shows the major sources of federal revenues from fiscal 2000 to fiscal 2021, which ended September 30. The GOP tax cuts were effective January 2018, which was part way through fiscal 2018.

A few observations:

Income tax revenues gyrate with economic cycles. Payroll tax revenues are more stable but stagnated after the recession a decade ago when employment was slow to recover.
Individual income tax revenues rose in 2018 and 2019, fell in 2020 during the pandemic, then rose sharply in 2021.
After the GOP tax bill passed, CBO projected that individual income tax revenues would rise to $1.900 trillion by 2021, but they came in 8 percent higher than projected at $2.052 trillion.
Corporate tax revenues stagnated from 2018 to 2020 but then rose sharply in 2021.
After the GOP tax bill passed, CBO projected that corporate tax revenues would rise to $327 billion by 2021, but they came in 13 percent higher than projected at $370 billion.
Revenues in 2021 are higher than projected even though GDP for 2021 is down 2 percent from what CBO had projected after the tax bill passed.

Total federal tax revenues were $3.32 trillion in 2017, $3.33 trillion in 2018, $3.46 trillion in 2019, $3.42 trillion in 2020, and $4.05 trillion in 2021. Revenues in 2021 are 22 percent higher than prior to the tax cut in 2017.

Congress should use the current revenue gusher to reduce dangerously high deficits and debt. Government debt in the United States at 141 percent of gross domestic product is above the average of other high‐income countries, and it is well into the danger zone above 100 percent of GDP where it appears to reduce economic growth.

The government is currently enjoying a revenue bounty, but Congress should not squander it on new spending. Instead, policymakers should encourage growth by reducing regulations, and they should use rising revenues to reduce perilously high deficits and debt.

President Biden’s new minimum wage proposal is a bad idea. Here's why...

Chris Edwards — Tue, 02 Feb 2021 15:15:00 +0000

If enacted, the higher mandated wage would eliminate jobs for younger and less‐skilled workers. In 2019, 58 percent of minimum wage workers were age 24 or younger. Biden’s website says that he wants to create jobs for young people to “reach full employment as fast as possible,” but his minimum wage plan would do the opposite. Young people need entry‐level jobs to start climbing the career ladder but raising the minimum wage would break the bottom steps.

A minimum wage increase would also damage labor‐intensive small businesses. Biden’s website promises: “Building back better means helping small businesses and entrepreneurs come out the other side of this crisis strong … Biden will help small businesses manage through the pandemic and recover.” But Biden’s minimum wage plan would do the opposite, and it would be very ill‐timed as small businesses have been hit hard by the crisis.

Federalism

Minimum wages are set higher than the federal minimum in 29 states and dozens of cities and counties. The highest state rate is Washington State’s at $13.69 an hour.

All 50 states could impose a $15 rate on their own. A small number are phasing that rate in, but most are not. There is no reason to think that federal politicians have better judgment than state politicians on this matter, so there is no basis for them to override state choices.

Minimum wage mandates are a bad idea in general, and they are more harmful when imposed nationwide since they do not account for regional variations in living costs, policy preferences, and economic structures.

The political left likes to think that it supports diversity and democracy but imposing a nationwide minimum wage hike would undermine both.

Small Business Impact

Small businesses have relatively more minimum wage workers because they tend to pay lower wages. In 2019, average wages in private sector establishments with fewer than 100 workers was $976 a week, which compared to $1,914 a week for establishments with more than 1,000 workers. That is a big difference. Almost half of minimum wage workers are employed at businesses with fewer than 100 employees.

Small businesses were hit harder than large ones by the crisis, and low‐wage employment was hit harder than high‐wage employment. A Bureau of Labor Statistics analysis found that “occupations with lower wages are more common in the shutdown sectors than elsewhere in the economy.” So Biden’s proposal would particularly hurt occupations and businesses damaged by the crisis.

Over the longer run, businesses adjust to higher minimum wages by substituting machines for workers, cutting entry‐level positions, reducing benefits, raising prices, and other changes. But in the near term, business finances take a hit.

A 2019 study by Sudheer Chava, Alexander Oettl, and Manpreet Singh examined how minimum wage laws affect small businesses. They used a large dataset of small business finances over the 1989 to 2013 period and studied variations in minimum wage rates. They found that

increases in the federal minimum wage worsen the financial health of small businesses in the affected states. … Increases in the minimum wage also lead to lower bank credit, higher loan defaults, lower employment, a lower entry and a higher exit rate for small businesses. … Our results document some potential costs of a one‐size‐fits‐all nationwide minimum wage, and we highlight how it can have an adverse effect on the financial health of some small businesses.

After a brutal year, the unemployment rate remains high and the economy is still recovering. We need startups to fill the void of lost jobs and output. We need, for example, more than 110,000 restaurant startups to replace the eateries lost over the past year. But Biden’s minimum wage hike would sabotage startup activity.

A 2017 study by Xiaohui Gao examined minimum wages and startup survival rates across the states from 1982 to 2014. She found that “a 1% increase in the minimum wage is associated with a 3.5% decline in the survival rates of startups.” Biden’s proposed increase is a lot more than 1%. The problem Gao noted is that “new and young firms tend to have a workforce with [a] higher proportion of minimum‐wage workers. They often tend to operate on thin or even negative profit margins, leaving them exposed to mandated increases in labor costs in their incipient years.”

In sum, Biden’s proposed minimum wage increase would hurt startups and small businesses, undermine the recovery, and be a blow to the industries hit hardest by the crisis.

Further reading on the minimum wage is here, here, here, here, and here.