Friday, March 29, 2013

Taxing Damages 

The tax treatment of damages depends on what the damages represent. In the basic federal income tax course, students learn that the first step in determining the tax treatment of damages requires an exploration of what the damages replaced. Thus, an employee who sues an employer for wages and recovers damages has compensation gross income. A creditor who sues a debtor for unpaid interest has interest gross income. Yet if the same creditor sues for repayment of the loan principal and recovers, the damages are excluded from gross income because they are a recovery of capital. In the case of damages for personal physical injury and sickness, section 104 provides an exclusion that overrides the substitution principal, and thus a taxpayer who is injured and receives damages that reflect, in part, lost wages can exclude that portion of the damage award from gross income. Of course, because jury or the settling parties know this, they take the nontaxable nature of the award into account when computing the damages.

So what happens if a person sees an on-line advertisement for an automobile for an attractive price, and yet when arriving at the seller’s venue is told that the advertised price was an error and that the actual price is $20,000 higher? The taxpayer in Cung v. Comr., T.C. Memo 2013-81, sued and settled for a payment of $17,000. The taxpayer ended up in the Tax Court because the taxpayer did not include the $17,000 in gross income. In the words of the Tax Court, the taxpayer’s argument “appears to be more along the lines that the settlement proceeds represent lost value or a constructive reduction of the improperly asserted price of the car.” In the complaint filed by the taxpayer against the seller, the taxpayer “The complaint in the civil suit alleged four causes of action: (1) violation of California unfair competition law; (2) violation of California false advertising law; (3) violation of the California consumer legal remedies act; and (4) breach of contract,” and “sought specific performance, compensatory damages, and punitive damages.” As too often is the case, the parties did not include in the settlement agreement any sort of allocation of the $17,000 among the claims or between the compensatory and punitive damages.

The Tax Court resolved the matter by concluding that the taxpayer had failed to carry his burden of showing that the damages represented lost value, and that he failed to show how much of the damages represented compensatory damages. The court thus did not need to address the doctrinal question of whether damages received on account of a lost opportunity, in this case, purchasing a car for $20,000 less than its actual price, must be included in gross income. It is clear that when a person does not earn profits because of a lost opportunity caused by someone else, and the person successfully sues, the damages are included in gross income because they represent the profits that would have been earned and that would have been taxed. The ultimate test is whether the person is economically wealthier. In this instance, the taxpayer was $17,000 wealthier than he had been before he successfully sued the seller. The $20,000 savings that the taxpayer thought that he was going to incur but did not obtain do not represent a loss to the taxpayer because the taxpayer’s economic assets remained unchanged when he was told by the seller that the car would not be sold for the advertised price but only for a price $20,000 higher. A similar principle would apply if a person instructed a stock broker purchase stock, the broker neglected to do so, the stock doubled in price, and the person successfully sued and recovered the gain that would have been obtained. The damages would be included in gross income.

In this case, it would not have done the taxpayer any good to divide the $17,000 among the four claims or between compensatory and punitive damages. In all events the damages would have ended up in gross income. In many cases, however, it does matter, and it is essential that the parties who are settling, or the judge or jury determining damages, specify how the total amount of damages is apportioned among the various claims for recovery. It may not matter to the case itself, but it surely will matter to the plaintiff – and in some instances to the defendant with respect to possible deductions – when it is time to file a tax return.

And how did the IRS discover that the taxpayer had received $17,000? The taxpayer’s attorney who had handled the lawsuit against the seller issued a Form 1099-MISC to the taxpayer, with a copy to the IRS, for the $17,000, characterizing it as nonemployee compensation. The taxpayer, who claimed to have done some research, concluded that the $17,000 was not taxable, and did not give the Form 1099-MISC to his tax return preparer. Two bad decisions rolled into one tax case. Not only did the taxpayer end up with tax liability with respect to the damages, he also ended up getting hit with penalties.

Wednesday, March 27, 2013

How Privatization Works: It Fails the Taxpayers and Benefits the Private Sector 

Every time a person blinks, another privatization proposal pops up. The private sector, which considers itself infinitely superior to the public sector despite the tsunami of failure, frauds, and foolishness that has permeated the supposedly “free” market, is determined to take over every government function it can grab, leaving people at the mercy of unelected corporate officials and bereft of what matters most in a democracy, namely, the free market of voter choice.

About five months ago, in When Privatization Fails: Yet Another Example, I examined a case of privatization that demonstrated how greed can destroy the quality of life for Americans. Three years ago, in Are Private Tolls More Efficient Than Public Tolls?, I reviewed what was then the most recent instance of private sector intrusion into a specific government function, namely, highway infrastructure, sharing links to the long stream of previous posts in which I had discussed the failures of almost all of those attempts. As usual, the private sector entities made out like bandits and the taxpayers and ordinary citizens suffered.

Now comes yet another story of a privatization boondoggle gone bad. This time it involves parking garages. The story begins when Morgan Stanley Infrastructure Partners, affiliated with the Wall Street behemoth Morgan Stanley, organized Chicago Loop Parking. This entity won the bid to operate, and take all revenue from, four of Chicago’s municipal garages, for 99 years. No restrictions were placed on the rates that Chicago Loop Parking could charge. Demanding protection for its investors, Chicago Loop Parking extracted a promise from Chicago that it would not permit anyone else to open public parking garages within a specified area of downtown Chicago. Several months after signing the agreement with Chicago Loop Parking, Chicago approved plans for a new private high-rise building that included a public parking garage, within a block of a Chicago Loop Parking facility, that would be operated by Standard Parking Corporation. Chicago Loop Parking sued Chicago, took the case to closed-door arbitration, and prevailed. The three arbitrators ordered Chicago to pay $57.8 million to Chicago Loop Parking. Thought Chicago has 90 days to appeal, the contract with Chicago Loop Parking states that arbitration rulings are final and binding. The only good news is that Chicago Loop Parking had been seeking $200 million from Chicago.

Of course, the $57.8 million will come out of the pockets of taxpayers, either in the form of higher taxes or reduced services in other areas. And it gets worse. Another Morgan Stanley affiliate, Chicago Parking Meters LLC, which has a 75-year contract for control of the city’s parking meters, is suing Chicago because it had to take some meters out of service and is required by law to provide free parking to people with disabilities. How do taxpayers benefit when a private group is permitted to hold a monopoly on parking, coupled with a serious restraint of trade that makes a mockery of the notion of a free market?

As I have pointed out, privatization increases the cost to taxpayers because the private investors seek profits, and they seek profits that are a better return than what they could get in other investment opportunities, such as the stock market, the bond market, real estate, or gold. Though the advocates of privatization claim that private ownership is more efficient and thus saves more money than what the private investors extract in profits, experience shows otherwise, as explained in Are Private Tolls More Efficient Than Public Tolls? and the commentaries referenced therein.

Privatization mania is a bipartisan syndrome. The Chicago contracts were put in place by the administration of former mayor Richard M. Daley. Politicians of every allegiance succumb to privatization temptations, not because privatization is the savior its proponents claim that it is, but because politicians benefit electorally by doing things for big investment outfits that have money clout unavailable to the typical American. So long as the nation’s citizens tolerate politicians selling out the nation’s democratic principles by selling out to the unaccountable private sector, the nation’s citizens will continue to suffer. They will continue to complain, until they learn that they are the instruments of their own discomfort, and that the solution is to elect a different sort of person to office, namely, a servant-leader rather than a politician. In the meantime, taxpayers are being fleeced by the real takers, who hide by financing disinformation campaigns to put the “taker” tag on those who are being fleeced.

Monday, March 25, 2013

Tax Meets the Chicken and the Egg 

When I teach the basic federal income tax course, I make certain that the students understand, early on, that tax law is much more than playing with numbers. I emphasize throughout the semester that tax law touches pretty much every activity, every transaction, every property, and every person. And sometimes the questions that must be asked seem almost absurd, but they are very real.

Recently, a reader directed my attention to a case that is more than forty years old, but which grabbed the reader’s attention much the same way some of the situations examined in the basic income tax course grab the students’ attention. The case, Purdue, Inc. v. State Department of Assessments and Taxation, 264 Md. 228, 286 A.2d 165 (Md. Ct. App. 1972), addressed whether the taxpayer qualified for either or both of two exceptions to a property tax on its inventory of hatchery eggs. One exception prohibited the state or any political subdivision from taxing “all poultry.” The other prohibited the taxation of “raw materials of a manufacturer.” Thus, the two questions facing the court were whether chicken eggs constitute poultry and whether hatching and raising chickens constitutes manufacturing.

Though the taxpayer argued that the term “all poultry” included “all domestic birds in all their forms, [including eggs],” the court concluded that eggs are a product of poultry, that poultry consists of domestic fowls reared for the table or for their feathers or eggs, that eggs are something produced by poultry, and that, accordingly, eggs and poultry are “separate and distinct from each other.” The court explained that poultry does not exist until the chicken emerges from the egg.

Though the taxpayer argued that it was engaged in manufacturing because it took eggs as raw material and used them to produce chickens, the court explained that manufacturing means making by hand, by machinery, or other agency, in a process that applies labor or skill to material in a manner that changes it to a new, different, and useful article. Thus, the court reasoned that the taxpayer “simply takes a naturally fertilized egg which has the capacity of life and places it in an environment conducive to further development.” Treating this activity as manufacturing would “disregard the rather essential part the hen and rooster play.” The court held that incubation is not manufacturing, that considering the state of technology at the time, manufacturing does not exist if the end product is a living organism. The court analogized the situation to the process of planting a tomato seed in a hot house, controlling the environment, and harvesting tomatoes.

Though the case is a state tax case and not a federal tax case, and although it deals with a property tax and not an income tax, it demonstrates how tax practitioners indeed are, as one of my tax colleagues put it years ago, “the last of the general practitioners.” As students in the basic tax class work their way through the problems in the book and those raised by the classmates or by me, they are asked questions such as, “Are groceries meals (as mentioned in Structuring the Basic Tax Course: Part XII), and does the section 119 meals exclusion apply to pet food (as discussed in Pets and the Section 119 Meals Exclusion). Tax practitioners and students dealing with state sales taxes face such wonderful questions as whether candy bars made with flour are candy subject to the sales tax or baked goods that are exempt (discussed in Halloween and Tax: Scared Yet?), whether pumpkins are food (discussed in Halloween Brings Out the Lunacy), whether large marshmallows are food or candy (discussed in Don’t Tax My Chocolate!!!), and whether an Oreo cookie is food or candy (discussed in No Telling What’s Taxable (and What’s Not) in Pa.).

People who understand what tax involves also understand that tax is more than numbers. Interpreting tax laws properly requires a skill set that transcends arithmetic. People who understand what tax involves also understand that tax is not boring. Helping clients with tax problems often requires the tax practitioner to become familiar with how chickens are raised, how cookies are manufactured, and what people can buy in a “grocery” store. It’s not just the computational side of tax that makes tax practice challenging.

And before tax practitioners begin to think they’re the only ones facing these sorts of questions, consider the issue confronting agriculture law and food law practitioners. Are rabbits considered to be poultry? A number of sites, such as this rabbit rescue organization and this advocacy group, claim that the U.S. Department of Agriculture considers rabbits to be poultry. Although I cannot find something that specifically says so, the USDA does include rabbits in its web page providing instructions on how to cook poultry. And so perhaps my friends and I laughed too soon when, three years ago, we saw a sign above a store that stated it sold all types of poultry, including “chickens, turkeys, ducks, and rabbits.” The opinion in the Purdue case makes it clear that for Maryland property tax purposes, a rabbit is not poultry. I wonder how the conversation will go when someone invites a tax practitioner and a food law attorney to a dinner party. Just please don’t serve up rabbit.

Friday, March 22, 2013

So How Does This Tax Plan Add Up? 

The answer is simple. It doesn’t. The tax plan in question is the latest Paul Ryan budget. The Ryan plan maintains aggregate revenue. However, because it contemplates eliminating all taxes connected with health care, and specifies replacement of the income tax rates with two brackets, one at 10 percent, and one at 25 percent, it falls short when it comes to adjustments that would maintain revenue.

An analysis of the Ryan plan by Citizens for Tax Justice millionaires would get an average tax cut of $345,640, and taxpayers in the $500,000 to $1,000,000 income category would get an average tax cut of $51,020. In contrast, according to the Tax Policy Center, those with income between $43,000 and $68,000 would see an average tax cut of $900, and those below $22,000 would see an average tax cut of $40. Even if all tax preferences favoring upper-income taxpayers were repealed, which isn’t going to happen under the Ryan plan, those with incomes over $1,000,000 would still get an average tax cut of $203,670, and those in the $500,000 to $1,000,000 range would be looking at an average tax cut of $20,180.

Cutting tax rates and eliminating health care taxes, while at the same time maintaining aggregate revenue, requires elimination or reduction of gross income exclusions, deductions, and credits. The revenue loss caused by the proposed tax rate cuts and health care tax elimination is substantial. Making up that revenue would require substantial cuts in exclusions, deductions, and credits. Which taxpayers would be affected by those cuts? Removing all exclusions, deductions, and credits for upper-income taxpayers would not generate sufficient off-setting revenue. Taxpayers in the middle class, and perhaps some or all of those in the lower income brackets, would be affected. Considering that Ryan is a champion of the special low tax rates on capital gains and dividends, a benefit that is far more valuable to upper-income taxpayers than to any other taxpayers, the need to cut back on exclusions, deductions, and credits available to the middle class would be inescapable.

So where does the Ryan plan find the money to fund the tax cuts for the wealthy? Cutting all tax breaks for the wealthy won’t do it. But cutting exclusions, deductions, and credits for taxpayers in the middle and lower income brackets would generate revenue. And those cuts would also trigger tax increases for non-wealthy taxpayers that would exceed the rather meager tax cuts that the rate reductions would provide. It is for this reason that Ryan’s plan is big on theory and concept and short on specifics. If he were to disclose what he intends to do with exclusions, deductions, and credits, taxpayers would find it very easy to figure out that very few taxpayers would benefit. Put another way, the one percent would benefit from tax cuts funded by tax increases on the 99 percent.

About the only positive comment that comes to my mind is the thought that these folks are, if nothing else, persistent. Perhaps a better word is stubborn. One way or another, under the pretext of building up the middle class and opening the road to opportunity, they remain married to ideas that have harmed the non-wealthy and that, if continued and enlarged, will destroy the middle class, which, to the chagrin of the wealthy, is the true heart and soul of the American economy and the American dream.

These issues will be getting more attention in the coming weeks and months. It will remain important to cut through the superficiality and to get to the underlying reality. More and more people are learning that “we are cutting your tax rate” does not mean “we are cutting your taxes.” In the case of the Ryan plan, it means the opposite. Once enough people understand this, the Ryan plan will go where it belongs. The dump.

Wednesday, March 20, 2013

The Aggravation of Tax Paperwork 

Usually, when people mention the aggravation of managing paperwork for income tax purposes, they are referring to the annual ritual of collecting invoices, bank statements, letters, and other documents – whether in digital or paper format – so that they or their tax return preparers can engage in the process of tallying up the taxpayer’s transactions for the taxable year in question. But there is another type of paperwork burden, and that is the chore of generating contemporaneous records. One instance of this responsibility involves the charitable contribution deduction.

The general rule for the charitable contribution deduction is that to be entitled to a deduction, before taking into account limitations on the amount, the taxpayer must make a gift of money or property to, or for the use of, a qualified organization. To make a gift, the taxpayer must not receive goods or services in return. Technically, if goods or services are received, there is a gift if the amount transferred exceeds the value of the goods or services. To prevent taxpayers from claiming charitable contribution deductions when, in fact, a gift has not been made, the tax law requires the taxpayer to substantiate the contributions. For cash or property contributions of less than $250, Regs. Section 1.170A-13 provides that substantiation can be accomplished with a canceled check, a receipt, or some other reliable evidence showing the name of the charity, the date of the contribution, and the amount of the contribution. For cash or property contributions of $250 or more, section 170(f)(8) requires the the taxpayer to obtain a contemporaneous written acknowledgement. The acknowledgement must contain a description of any property contributed, a statement as to whether any goods or services were provided to the taxpayer, and a description and good-faith estimate of the value of any goods or services so provided. To be contemporaneous, the written acknowledgment must be obtained on or before the earlier of the date on which the taxpayer files the tax return or the due date for the return.

A recent Tax Court case, Villareale v. Comr., T.C. Memo 2013-74, demonstrates the disadvantages of not generating the required documentation. The taxpayer was a cofounder of the NDM Ferret Rescue & Sanctuary, an animal rescue organization specializing in rescuing ferrets. NDM was a qualified charity. During the taxable year in issue, the taxpayer was NDM’s president. She was responsible for managing NDM’s finances, paying its bills, and managing its bank accounts. During the taxable year in issue, the taxpayer made 44 contributions to NDM, in varying amounts. Of the 44 contributions, 27 were for less than $250, and 17 were for $250 or more. The taxpayer made the contributions by making electronic transfers from her personal bank account to NDM’s account or by requesting the bank manager to do so.

The IRS disallowed the 17 contributions for $250 or more because no contemporaneous written acknowledgement was transmitted by NDM to the taxpayer. The Tax Court rejected the taxpayer’s argument that the bank statements were sufficient to substantiate her contributions because they did not state that the taxpayer did not receive any goods or services in exchange for the contributions. The Tax Court also rejected the taxpayer’s argument that because she was on both sides of the transaction “it would have been futile to issue herself a statement that expressly provided that no goods or services were provided in exchange for her contributions.” The Court pointed out that the substantiation requirements have a dual purpose, both of helping taxpayers determine the deductible portion of transfers to charities and helping the IRS process tax returns on which charitable contribution deductions are claimed. Accordingly, although the taxpayer did not need assistance in determining the deductible portion of her transfers to NDM, the IRS nonetheless needed the benefit of the contemporaneous written acknowledgement. Finally, the Tax Court rejected the taxpayer’s claim that she substantially complied with the substantiation requirements because there is no substantial compliance exception to those requirements.

The outcome in Villareale is the sort of result that turns people against the income tax and its technical requirements. There is no question that the taxpayer made transfers to a qualified charity, and it is highly unlikely, under the circumstances, that she received anything in return. Yet, because of a failure to issue a letter on the charity’s stationery, the taxpayer, who was not at the mercy of a third-party charity but controlled the charity herself, ended up paying more income taxes than she ought to have paid. Surely in the hectic activity of running a rescue shelter, and making donations at moments when funds were low, finding time to make notations or set up a system to issue contemporaneous written acknowledgements probably falls into the “too busy to do that” category. Though the taxpayer had until April of the following year to issue the acknowledgements, by the time April rolled around, those transactions had faded into her memory. The solution is to make a notation at the time of the transfer, and to put a reminder in the file that holds the personal income tax information. It’s unclear from the opinion whether the taxpayer prepared the return or made use of the services of a tax return preparer. A savvy preparer would have reminded the taxpayer that she needed to issue the written acknowledgements and still had time to do so. As an aside, I cannot help but observe, in light of an interview I gave last week to a reporter examining the federal “Ready Return” proposals, that Ready Return would not provide the opportunity for remediation that a private sector tax return preparer can provide.

The lesson is one that most of us don’t want to hear, but that we are well advised to learn. Determine what records need to be generated. Take steps to have those records produced. Keep those records. Failure to do so can be expensive.

Monday, March 18, 2013

So Why Are Law Students Becoming Less Literate? 

Thanks to a post on the Legal Skills Prof Blog, my attention was directed to an article in the Chronicle of Higher Education by Michele Goodwin, who teaches law at the University of Minnesota. Goodwin was reacting to a warning by “Kenneth Bernstein, a retired award-winning high-school teacher,” that “students educated under the No Child Left Behind and Race to the Top policies are heading” to college and graduate school. Goodwin’s reaction was simple: “He was right to warn us, except for one error: Those students have already arrived. She notes that “Very bright students now come to college and even law school ill-prepared for critical thinking, rigourous reading, high-level writing, and working independently.” She explains that many law faculty are concerned about law students whose “writing skills are the worst they have ever encountered,” who just want “the answers,” and who are so incapable of learning on their own that they ask for their professors’ teaching notes. More then a few law students do not know how to write business letters, and write exams that are difficult to decipher because of deficient writing skills.

But is the cause really federal education policy as some suggest? Or is it something else? Or perhaps an array of factors?

Critics of post-modern education claim that “teaching to the test” is the reason that students leave high school lacking so many essential skills. The problem with this criticism is that teaching to the test is a problem if what is on the test is irrelevant to what students should be learning. If students are not being tested for financial literacy, grammar, spelling, or logic, then teaching to the test isn’t going to help them learn those skills. On the other hand, if the tests require students to demonstrate abilities with respect to those skills, the students who successfully prepare for the test, and thus learn what needs to be learned, will develop financial literacy, grammar, spelling, and logic skills. Put another way, although there are critics who claim that teaching to the test “overshadows (if not supplants) teaching critical thinking, higher-order reasoning, and the development of creative-writing skills,” it is possible to design tests that require students to acquire these skills. The problem, I suggest, is not so much teaching to the test, but the curriculum. Specifically, the skill set that the K-12 system, and some private schools, are trying to imbue in students is not the appropriate skill set. It is incomplete, and perhaps includes skills that are nowhere near as important as the ones that are being overlooked.

It is true, that part of the problem is test design and the grading process, but again, the problem lies in the details. Multiple-choice questions are perceived as inconsistent with developing writing skills, but if the multiple-choice question requires selection of the best – or worst – sentence or paragraph from among the choices, the student’s ability to distinguish good writing from bad writing can be evaluated. It is true that many essay question responses are graded with a focus on the substance and without regard to the spelling, grammar, and other literacy errors. That is something that is easily fixed, though it may require sending a fair number of K-12 instructors back to school.

Goodwin concludes by predicting that “What goes around in K through 12 comes around in postsecondary courses, and eventually in society at large.” She is correct. For me, it’s not news. Nor is it, for my readers. See, e.g., Does It Matter Who or What is to Blame? (Oct. 1, 2008) (“And more than three years ago, in Economically Depressing? I referred to ‘my expressed desire that K-12 education be revamped so that high school graduates enter society with the survival tools needed for life in the 21st century.’”) On several occasions I have explored the impact of K-12 education on law school education. See, e.g., No Wonder Tax Law Seems So Difficult (Jan. 20, 2006) and the follow-up, Students Fail When We Fail Students (Jan 22, 2006). The longer the nation fails to fix its education problems, the more difficult it will be to recover from the effects. If we wait too long, it might be impossible.

Friday, March 15, 2013

Tax Depreciation: Do the Math 

When I teach the depreciation deduction in the basic federal income tax course, I try to balance conceptual notions with computational aspects. I keep students from getting mired in the computational issues by ignoring section 167 and ACRS, the mid-quarter convention, and some other details. At the conceptual level, I try to get students to understand that the principal issues include whether a particular property can be depreciated and how the cost of property is deducted over a period of time. As do many other tax teachers, I describe the deduction as a matter of “spreading the cost” over the appropriate recovery period. When it is time to do the problems, I show the students how the depreciation deductions for each year during the recovery period add up to the original cost, so that they can see how the cost is “spread” over the period and so that they have a method to check their use of the MACRS table to make certain they have done the computation properly.

Thus, when I read the opinion in Castillo v. Comr., T.C. Memo 2013-72, I was taken aback by the following description of one of the issues in the case:
On November 22, 2006, petitioner purchased a Hummer for $34,799. He sometimes used the Hummer in advertising PMZ real estate activities by attaching a removable advertising sign to the side of the Hummer. * * * * * On his 2006 and 2007 tax returns, petitioner claimed that he used the Hummer, * * * * * 100% for business. For 2006, he claimed a depreciation deduction of $56,000 under section 179 in relation to the Hummer (which had a cost basis of $34,799).
No matter how well a student in the basic tax course masters the depreciation deduction to the extent it is studied, that student knows that the total depreciation with respect to a property cannot exceed its cost. All of the students would find themselves bewildered by the proposition that depreciation deductions on a property that cost $34,799 would total $56,000.

The Tax Court did not focus on this question because the only taxable year before it was 2007. Accordingly, the issue that was presented was recapture in 2007 of the 2006 deduction under section 280F(b)(2). The Court found that the petitioner had not used the vehicle 100 percent for business, and had not substantiated its use. There was no explanation of how or why the petitioner computed a $56,000 depreciation deduction on property costing $34,799. But one thing is clear. It just doesn’t add up.

Wednesday, March 13, 2013

Financial Literacy and Economic Inequality 

My two most recent posts on financial literacy, specifically A School Tax Question: So Whose Job Is It to Teach Financial Literacy? and Additional Thoughts on Financial Literacy . . . and Taxes, have triggered responses from a reader. The reader directed my attention to several reports.

One report examined financial literacy in terms of gender, ethnicity, and education. It was not surprising that financial literacy correlates with level of education. The report also examined financial literacy on a state-by-state basis, and one aspect that stood out is that lack of correlation between a state’s supposed political color and the level of its residents’ financial literacy. A county-by-county examination might be more instructive. The report also concluded that there was a negative correlation between poverty level and financial literacy. That is not surprising, because there also is a correlation between poverty and inadequate education. For me, this report suggests that education is the pathway to financial literacy and escaping poverty. That’s old news.

A second report examined the growing literature that describes research into the effect of financial education programs on financial literacy and financial behavior. It concluded that “Some financial education programs improve financial literacy, but not financial behavior; others lead to improved behavior and outcomes without improving financial literacy; and still others do not appear to be effective at all.” The authors of the report examined a variety of financial literacy programs, including those offered by schools, by employers, and by institutions counseling specific individuals with respect to specific programs. The outcomes were mixed across the board, although the overall conclusion was that most of the studies were flawed in some respect and that some sort of improved evaluation method is required.

A third report concluded that mandated high school financial literacy courses were not as effective as expanding the number of students taking, and the scope of, high school math courses. The authors concluded that mandating high school financial literacy courses might be “misguided.” The authors added “We feel that alternative methods, “such as on-line educational videos, provision of information at point of sale or financial decision, and financial counseling, may be more effective, and more cost-effective.

A fourth report, in the form of a working paper, suggests that “higher earners typically have more hump-shaped labor income profiles and lower retirement benefits which, when interacted with precautionary saving motives, boost their need for private wealth accumulation and thus financial knowledge.” Thus, the authors conclude, “endogenous financial knowledge accumulation has the potential to account for a large proportion of wealth inequality” and that “The fraction of the population which is rationally financially ‘ignorant’ depends on the generosity of the retirement system and the level of means-tested benefits.” In other words, the poor are on the low end of the wealth and income distribution charts because they do a poor job handling their investments. Of course, the fact that they don’t have any investments because they cannot find jobs suggests makes the notion that if they improved their financial literacy they would find high-paying jobs a silly one. It is important to note that the paper reflects not an examination of real world data, but the results of a “calibrated stochastic life cycle model featuring endogenous financial knowledge accumulation,” that generates substantial wealth inequality, over and above that of standard life cycle models.”

The reader who sent the links to these reports asked me, “Can financial literacy education improve income inequality in the U. S. and the world?” My response is that there are enough people at the top of the income and wealth distribution charts who are very deficient in terms of financial literacy to demonstrate that high levels of wealth and income are not precluded if a person’s financial literacy is low. Persons born with talents that can be parlayed into wealth and persons born into wealthy families aren’t hindered by a lack of financial literacy provided they possess good judgment when it comes to evaluating potential financial advisors. Similarly, there are enough unemployed people looking for jobs, who have high levels of financial literacy, to suggest that financial literacy does not guarantee employment or income. Improving one’s financial literacy can’t hurt. In some instances, it can give an edge to a job applicant. It can help someone who otherwise would make a bad financial decision avoid that mistake, though for many people the challenge is the same one facing the wealthy, that is, having the good judgment to stay away from financial advisors who do more harm than good. On the other hand, financial literacy makes a difference when it comes to evaluating what the politicians and commentators are saying about the economy, and so financial literacy on a collective basis can be very powerful when it comes to making electoral decisions.

Monday, March 11, 2013

Who Are Your Tax Policy Friends? 

There is wealth distribution video making the rounds of the web and email. It compares what people think wealth distribution should be, what people think it is, and what it actually is. The comparisons, though not surprising to those of us who pay attention, are shocking to people who haven’t previously given much thought to the specifics of wealth distribution. The presentation also shows the “dreaded socialism” to demonstrate not only that the nation’s economic situation is so far removed from socialism that it isn’t even a plausible outcome, but also to demonstrate that 92 percent of Americans, in describing what they think wealth distribution ought to be, are advocating nothing like socialism.

So what does this have to do with tax policy? The answer is simple. Everything. The period during which the wealth distribution inequality has been growing corresponds with the period during which the income tax has been attacked, and its progressivity diminished not only in terms of rates but also in terms of federal spending for the wealthy disguised as tax breaks. The progressive income tax generates a counterbalance to the compounding effect of wealth inequality growth. Without a progressive income, or similar, tax, wealth inequality will grow until one person owns everything. The reason is that wealth feeds on wealth, or, to put it in other terms, it’s the magic of compounding.

It’s not surprising that those who are vying for the “one person takes all” award detest the progressive income tax or anything else that stands in the way of their economic domination goal. Nor should it be assumed that everyone at the top of the income distribution charts opposes progressive income taxation, because enlightened individuals understand that overall wealth grows fastest when it is equitably distributed. Being the winner of the “one person takes all” contest means little if the “all” isn’t very much. The point is that wealth inequality destroys wealth in the long run. History teaches that lesson.

Opponents of progressive taxation like to argue that membership in the upper reaches of the income distribution charts turns over rather frequently. But that turnover is not complete. The people at the top of the wealth distribution charts are either cleverly not in the income distribution charts because they have hidden some or most or all their wealth, or remain members of the upper reaches of the income distribution charts while others join them there for brief periods of time insufficient to permit permanent membership in the upper reaches of the wealth distribution charts.

Opponents of progressive taxation like to argue that income taxation impedes growth and that progressive taxation destroys growth. Neither proposition is true. What progressive taxation does is to remove from those at the top of the wealth distribution chart the power to control how everyone else contributes to the growth that the ultra-wealthy wish to encourage. Opponents of progressive taxation like to point out that the ultra-wealthy finance all sorts of budding business, scientific, and other ventures, but ultimately the ultra-wealthy fund only those projects that they wish to see funded. The rest of the nation does not get a vote. It’s not as though the ultra-wealthy are somehow more adept at making the correct investment choices, considering that a huge number of them live in the upper reaches of the wealth distribution charts because of what someone else did, either generations ago or while being exploited in some fashion.

Many Americans sense the problem, and direct their anger in the direction of government. In many ways, they are encouraged to do so by the ultra-wealthy who want to deflect attention from themselves. Yet, ironically, the ultra-wealthy don’t oppose government, provided government continues to do what they pay it to do, which includes protecting the system that permits the wealth inequality chart to become increasingly more inequitable as each year goes by. While the ultra-wealthy continue to persuade Americans that their plight is the result of taxation and government regulation, they manage to persuade those suffering from the effects of severe wealth inequality to argue for policies that would increase their own suffering. It’s as though medieval nobility managed to persuade the peasants and serfs to oppose the enactment of any limitations on the power of the ruling class. Come to think of it, they did manage to do that, for a few centuries. Then the roof caved in. It might be wise for those who oppose progressive taxation to pull out the history books and do a little reading. After watching the video, of course.

Friday, March 08, 2013

Selecting a Tax Return Preparer 

A few days ago, a Philadelphia Inquirer article suggested that taxpayers hire a professional tax return preparer and then offered advice on selecting one. The writer suggested getting referrals, meeting with the preparer, and asking questions. Among the questions were those seeking information on the size of the preparer’s firm, fees, identification of the person working on the return, the preparer’s continuing education history, and identification of the research services to which they subscribe. The article refers to the professional tax return preparer as an “accountant.”

My take on the issue is different.

First, for many people, a program like Turbotax or the IRS FreeFile program is more than enough. For example, most individuals whose only income is wages, who are unmarried, and who have no children or other dependents are well served by simple tax return preparation software. Even individuals with more complicated situations don’t necessarily need a professional tax return preparer.

Second, accountants are not the only professional tax return preparers. There are tax attorneys who prepare tax returns, and in some instances it’s better to work with someone who has been professionally educated to read the Internal Revenue Code, the Regulations, and case law. Of course, when times were good, most attorneys were happy to hand off the drudgery of tax return preparation to accountants. Now that the law practice world has evolved, attorneys are trying to re-establish themselves in that field.

Third, asking someone about their tax research subscriptions isn’t necessarily very informative. In pre-digital days, a tax professional could show a potential client the professional’s tax library. Now, with most tax research services on-line, that’s more difficult to do. The more serious concern is that the question ought not be what subscriptions exist but whether the professional uses them. That’s a difficult answer to obtain other than on trust.

Fourth, although it makes sense to walk away from a tax professional who does not engage in continuing education, the fact that someone enrolls in a continuing tax education course doesn’t mean much in and of itself. Continuing education courses are not graded. Though a person can prove that he or she attended a program, or sat through a webinar, that doesn’t mean the person learned anything or learned things properly.

Fifth, though I agree that referrals are important, I would add the suggestion that the tax professional be asked for the names of clients who are willing to endorse the professional’s work. If the tax professional hesitates, so, too, should the individual thinking of hiring that person.

Sixth, do a background check. It is important to know if the tax professional has been disciplined by the relevant licensing authority. It is important to know if the tax professional has been successfully sued for malpractice or for some other reason. It is important to know if the tax professional has been indicted or charged with tax crimes. Keep in mind that when an individual retains a tax professional to prepare a tax return, the individual is giving the professional everything necessary to engage in identity theft.

Seventh, ask the tax professional about data security. Where and how is paper data stored while in the hands of the preparer? Where is the digital data stored? What precautions are in place to minimize the chances of a third party breaking into the office or the digital servers and obtaining information? If the individual hands over paper records without keeping copies, which is an unwise move, what happens if the tax professional’s office burns down?

Eighth, ask about insurance and guarantees. What coverage is there for tax liabilities, interest, and penalties caused by the preparer’s mistakes? What coverage is there in the event of identity theft or lost data?

I do agree with the article that hiring a tax return preparer is a process that requires careful thought and careful investigation. Turning over tax return information to someone is pretty much the equivalent of giving that person the key to one’s life. A careless decision can be catastrophic.

Wednesday, March 06, 2013

Additional Thoughts on Financial Literacy . . . and Taxes 

In response to Monday’s posting on School Tax Question: So Whose Job Is It to Teach Financial Literacy?, a reader sent me several links to stories about financial literacy. As I followed those links, I found myself discovering even more stories about financial literacy. Much is being said and written about financial literacy, but how much is being done?

A 2010 Visa Inc. survey disclosed that 93 percent of Americans think all high school students should learn financial literacy. The survey also revealed that only four states require students to enroll in a semester-long personal finance course. The survey apparently did not ask whether respondents would agree to tax hikes to fund this education or, alternatively, what existing programs and courses should be eliminated or curtailed to make room, both in terms of funding and a place in the school schedule, for the financial literacy course.

Another 2010 survey, this one by Capital One, indicated that only one-fourth of parents create shopping budgets with their children. According to the survey, only 27 percent of teenagers discuss money and banking concepts with their parents. The survey results, according to Capital One’s Director of Financial Education, indicate that there are “gaps” in parental guidance when it comes to children learning about finances. It’s information of this sort that explains why schools have had to take on the cost of remedial education in a variety of areas that are the consequence of ineffective or neglected parental attention to the teaching that needs to take place at home. Another survey from the same time period suggests that one reason children aren’t learning financial literacy at home is because their parents did not learn financial literacy. Financial illiteracy is a problem that perpetuates itself.

An educated electorate is essential for a democracy to thrive. When many of the problems facing a nation involve issues of finance, taxation, economics, and budgeting, financial literacy must be an essential element of citizen education. Though there are those who profit from an uneducated citizenry, and those who stand to gain as financial literacy decreases, those who understand the value of education must speak out and demand that the nation, through its schools, do a better job of educating its citizens. Otherwise, financially gullibility makes too many people become the victims of political misrepresentations and lies.

Monday, March 04, 2013

A School Tax Question: So Whose Job Is It to Teach Financial Literacy?  

The other day I received a press release from TVP Communications, bringing to my attention a report titled “Money Matters on Campus.” According to the press release, the report concluded that “Colleges and universities . . . have an obligation to improve financial literacy.” Though I could not find this language in the report, I did find this proposition: “This directly addresses the previously mentioned idea that the responsibility of addressing college student financial literacy cannot just fall in the lap of a financial aid department—it is the responsibility of the entire institution, which includes student affairs, counseling and psychological services, and academic affairs.”

There is no doubt that the financial literacy of most Americans is deficient, if not totally lacking. Almost three years ago, in Tax Education is Not Just For Tax Professionals, I wrote:
My concern about education gaps with respect to taxes, finance, and civics is not a new one. A year and a half ago, in Does It Matter Who or What is to Blame?, I wrote:
And more than three years ago, in Economically Depressing?, I referred to "my expressed desire that K-12 education be revamped so that high school graduates enter society with the survival tools needed for life in the 21st century." According to the 2005 report of the National Council on Economic Education, the latest I could find, only seven states require personal financial education as a high school graduation requirement, one requires high schools to offer a course in the subject though it is not a required course, and one state requires that it be taught in middle school. There are 50 states in the union, plus the District of Columbia and some overseas possessions. Surely personal finance is no less important than other subjects being taught in middle school and high school.
Whatever it is that colleges and universities can do to alleviate the shortcomings of K-12 education with respect to financial literacy, it ought not be the solution. The more time and resources that undergraduate education pumps into remedial education to deal with the shortcomings of the K-12 education, the more time and resources graduate programs, including professional schools, must pump into remedial education to deal with the undergraduate education shortcomings generated by the diversion of resources from teaching what ought to be taught at the undergraduate level to teaching what ought to have been taught at the K-12 level. Of course, K-12 educators will point out that they are dealing with the remedial education required to overcome the shortcomings in parental education of children.

The role of K-12 education is two-fold. It is to prepare students to live life, and to prepare students who wish to continue their education to do so. To prepare students to live life, the K-12 system needs to teach the things that ought to be known or understood by all citizens regardless of chosen profession. Financial literacy is one subject that comes to mind, along with civics, first aid, reading, writing, and arithmetic. Undergraduate education should focus on the subjects that are necessary or helpful to acquiring a skill in a particular area, whether it is chemical engineering, statistics, biology, or anthropology. Graduate and professional education should focus on the subjects that are necessary or helpful to pursuing a career in the specific profession or area of study. The fact that law schools have hired individuals to teach basic writing and grammar skills to law students that ought to have been learned long before high school graduation not only is symptomatic of the deterioration of the American education system but also one of the answers, though a small one, to why the costs of legal education have increased.

But I suppose all of this is what happens when education is underfunded and education dollars are misallocated. School tax reform requires more than tax reform.

Friday, March 01, 2013

Spending Cut Advocate Advances Spending Proposal 

Trying to eliminate the deficit by cutting spending doesn’t work, for the simple reason that all of the spending that has contributed to the existing deficit has already taken place. Considering that a substantial portion of the deficit was caused by unwise tax cuts, it would make sense that something more than spending cuts is required to undo the damage done by fiscal mismanagement during the first decade of this century.

In addition to the silliness of using spending cuts to offset tax cuts that were coupled with spending increases, another problem facing the anti-tax, anti-government advocates is that there isn’t enough spending to be cut. As I pointed out in Taxes and Spending: Theory Meets Reality and Questions Go Unanswered, “cutting all of the programs so detested by the anti-tax, anti-government crowd would barely make a dent in the deficit.” I had previously explained the spending cut dilemma in posts such as Some Insights into the Tax Policy Mess and The Grand Delusion: Balancing the Federal Budget Without Tax Increases. On more than a few occasions, I have asked the spending cut advocates to identify what they would cut, doing so in posts such as Cutting Taxes + Failing to Identify and Enact Spending Cuts = Default? and Spending Cuts, Full Disclosures, Hearts, and Voices. The response has been deafening in its silence, except for the occasional suggestion that cutting a few billion dollars from the Department of Education, Small Business Administration, and the National Endowment for the Arts will somehow make a $1.3 trillion deficit disappear.

Now comes news that representative Mike Conaway, a Republican who is a leading opponent of federal spending and an outspoken advocate of spending cuts, wants the federal government to turn the childhood home of George W. Bush into a National Park. Conaway has asked the Park Service to take some of its scarce resources away from existing parks that are suffering from budget cuts to pay for a reconnaissance survey of the George W. Bush childhood home, as the first step in what could become a rather expensive commitment.

According to his biography, Conaway has “the credibility to be a vocal proponent in reducing the national debt” and has sponsored legislation “to change the House rules on spending to require that the creation of any new federal program be joined with the elimination of an existing federal program of equal or greater cost.” So what program gets cut or axed to fund Conaway’s pet project? His biography also explains that he “worked with George W. Bush as the Chief Financial Officer for Bush Exploration” and that he “developed a lasting friendship with President Bush as together they learned what it takes to run a business.” One can read more about how to run, or not run, a business by reading about what happened to Bush Exploration.

Conaway’s efforts make it obvious that when the spending cut advocates push for spending cuts, what they intend to cut are programs that they don’t like. They see no problem in dishing out tax credits to corporations that have done much to hurt and little to help the economy and proposing to toss federal dollars at a program honoring a president on whose watch government spending went through the roof, adding more than $1 trillion to the deficit, while chopping funds for feeding the hungry, educating the next generation, taking care of veterans, assisting the elderly who gave their all and then some to their country, policing the nation’s food and drug supply, fixing the infrastructure, or otherwise helping those who for some reason don’t matter as much to the spending cut advocates.

It’s clear that Conaway has no qualms about digging into scarce public dollars in an effort to elevate his personal friend and business colleague to some sort of heroic level. He has already managed to have a court house named after both Presidents Bush. Let’s face it. If the nation is going to spend money turning the childhood homes of presidents into National Parks, the name of George W. Bush ought not be at or near the top of the list. Conaway has not yet issued any sort of explanation for how a spending cut advocate can keep a straight face while proposing that federal funds be used to glorify a president who is no less responsible for the federal deficit than is anyone else. Perhaps the Conaway and other admirers of the former President can use some of their tax cut monies to create and fund a private organization that would preserve the Bush childhood home. After all, isn’t that what the favorite solution of these folks, privatization, is all about?

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