MauledAgain

Advocates of the Fair Tax are treating Mike Huckabee's victory in the Iowa Republican caucus as a triumph for the Fair Tax proposal. According to the Fair Tax web site, Huckabee's victory indicates that the Fair Tax proposal is getting ready to sweep into the next set of primaries as a prominent factor in the 2008 election. It is not unrealistic to suppose that during the next few months, the Fair Tax proposal will get even more attention, though it is competing with a variety of other hot-button issues. Keeping public attention on the details of a tax issue is challenging, but important.

What is the Fair Tax?

The Fair Tax website lays out the basics. Under the Fair Tax, all federal personal and corporate income taxes would be repealed. So, too, would be the gift tax, the estate tax, the alternative minimum tax, social security taxes, medicare taxes, and self-employment taxes. Surely that will get people's attention. These federal taxes are replaced with a federal retail sales tax administered by state sales tax officials in state revenue departments. Each household would receive a check covering the estimated tax on expenditures up to the household's annual consumption allowance. This so-called prebate is intended to eliminate the proposed sales tax on expenditures up to the poverty level.

Proponents of the Fair Tax claim that one of its advantages is the elimination of the IRS. They assert that it would be a very simple system. They also claim that it would enable workers to keep their entire paycheck, retirees to keep their entire pension, American products to compete fairly, Social Security and Medicare funds to be maintained, along with some other alleged benefits.

Criticism of the Fair Tax is easy to find. One can read analyses by Bruce Bartlett, Linda Beale, The New York Times, and others. There have been so many criticisms that the Fair Tax advocates have dedicated a portion of their web site for rebuttals of the criticisms.

For the moment, I am going to focus on five concerns. The Fair Tax is not as simple as alleged. The administration of the Fair Tax will not be uniform. People will not keep their entire paychecks and pensions. To provide the promised funding, the Fair Tax will raise overall federal tax revenues. The Fair Tax isn't necessarily fair.

Though advocates of the Fair Tax assert it is simple and transparent, consider the proposed definition of a household and who is considered to be a member:

The term “qualified family” means one or more family members sharing a common residence. A qualified family consists of all family members sharing the common residence. Family members include an individual and his or her spouse, children and grandchildren, parents, and grandparents. Children/students living away from home are considered family members if they are registered as a student for at least five months out of the year and receive at least 50 percent of their support from the family unit. Children of divorced parents are considered to be family members of the custodial parent. Incarcerated individuals are not eligible to be members of a qualified family.
In order for a person to be counted as a member of the family for purposes of determining the size of the qualified family, a person must have a valid Social Security number and be a lawful resident of the United States. Unlike the Earned Income Tax Credit, the application/registration form that families who choose to receive the prebate must file is simple and straightforward. Those choosing not to register will not receive a prebate. The registration form requires only the following information:
1. The name of each family member who shares the residence;
2. the Social Security number of each family member;
3. the family member to whom the monthly prebate check should be paid;
4. a sworn statement that all listed family members are lawful residents, that all family members sharing the common residence are listed, and that no listed family members are incarcerated;
5. the address of the shared residence; and
6. the signature of all family members 21 years of age and older.

Each of the terms in this description need to be defined. What is a common residence? Who is the spouse? Is a person a spouse if he or she abandons the residence during the year? Who qualifies as a student? How is support calculated? What constitutes incarceration? What happens if someone is not a member of the household for some portion of the year due to illness? How are kidnaped children counted? In other words, all of the complexities that afflict sections 151 and 152 of the current Internal Revenue Code would still be with us. There are special rules for hobby losses that resemble section 183, special rules for gaming activities, an exemption for intermediate sales, provisions affecting purchases by governments, rules for mixed-use property, not-for-profit organizations, and financial intermediation services. Each of these provisions includes all sorts of terms that need to be defined. For example, the need for complex definitions dealing with non-profit organizations will be no less under the Fair Tax than under the current income tax. Bottom line? The Fair Tax is nowhere near as simple as advertised. That it is presumably less complicated than the current income tax is not a noteworthy achievement. Everything is less complicated that the current income tax.

The proposed administration of the Fair Tax will be a nightmare. Advocates of the Fair Tax, intent on eliminating the IRS, propose that each state administer the program through their revenue departments. What about states without a sales tax? Will they be compelled to create special departments to handle their Fair Tax duties? Where do they find people to administer the tax? Hire them away from other states? Outsource the work to other nations? Have the advocates of the Fair Tax ever taken a close look at the administration of state sales (and use) taxes? Do they think this is an improvement over IRS administration? What if one state defines a non-profit organization differently than does another? What if one state deals with kidnaped children differently than another? A tax that is not administered uniformly is not fair.

The assertion that workers will keep their entire paychecks and retirees their entire pensions is a semantic tap dance. When workers and retirees pay the proposed federal sales tax, they will be using part of their paychecks and pensions. Whether tax is withheld, or paid out of pocket, when the dust settles, the person does not have in his or her hand all of the paycheck or pension. A tax is a tax. Trying to fool people into thinking that they will receive a paycheck and not pay any taxes because there is no withholding is the style of snake oil sales reps. Playing on people's misunderstandings is manipulative. And wrong.

Advocates of the Fair Tax claim that enough revenue will be raised to fund Social Security, Medicare, and other federal programs. If that's to be the case, then the Fair Tax must raise more revenue than do current federal taxes, because the current system is causing the nation to incur deficits. In other words, the Fair Tax would increase federal revenue. That means somebody's federal tax payments will increase. Or perhaps a bunch of somebodies will incur tax hikes. Why not advertise this fact? Why lure people into thinking that the Fair Tax will reduce everyone's taxes and yet somehow increase total tax revenue? Something is out of whack.

The Fair Tax isn't all that fair. The impact on the people with incomes at or below the poverty line would be minimal, because the prebate would offset the taxes they pay. In contrast, because the wealthy spend relatively little of their income, their tax burden would be far less than what it would be if it applied to their entire income. So who pays the bill? The middle class, which spends most of its income and which therefore would pay a higher percentage of its income in tax than would the poor or the rich. Somehow, it seems to me that the Fair Tax is a refined version of what has been done with the income tax, namely, absolve the wealthy, particularly through the special low capital gains and dividends rates, and the poor, through the earned income tax credit, and let the middle class pay. Of course, once the middle class is taxed out of existence, what will the wealthy do with the hordes of poor people, particularly when they are frustrated and feel hopeless?

Finding the actual language of the proposal on the web site isn't easy. In fact, one must go to the Library of Congress Thomas website and search for the bill language. How many people can do that? Why not put the text of the bill on the Fair Tax web site? Perhaps because once people see it, they will question some of the assertions.

A quote from the current standard bearer for the Fair Tax, presidential candidate Mike Huckabee, reveals quite a lot about his own understanding of the Fair Tax: "Instead, we will have the Fair Tax, a simple tax based on wealth.” Excuse me, Mr. Huckabee, a tax based on wealth would not be computed by reference to consumption.

Chances of the Fair Tax becoming law are between nil and none. If those who seek the unquestionably necessary change in the federal tax system could direct their energies to support of a plan that did not require complex transition, did not shift more tax burden onto the middle class, eliminated computations based on joint and household concepts, and tied ability to pay with incidence of taxation reflecting benefits provided by society, federal tax reform's chances might slip beyond none into the realm of slim and possible. I am confident that if Americans avoid the sound bites and think carefully about the Fair Tax plan, they will see whose ox is going to be gored.

The Philadelphia real property tax system, riddled with flaws, inefficiencies, and injustice, has provided yet another reason that it needs to be terminated, pronto. This news ought not be surprising, given its long troubled history, as I’ve discussed in posts beginning with An Unconstitutional Tax Assessment System, and continuing through Property Tax Assessments: Really That Difficult?, Real Property Tax Assessment System: Broken and Begging for Repair, Philadelphia Real Property Taxes: Pay Up or Lose It, How to Fix a Broken Tax System: Speed It Up? , Revising the Board of Revision of Taxes, How Can Asking Questions Improve Tax and Spending Policies?, This Just Taxes My Brain, Tax Bureaucrats Lose Work, Keep Pay, Testing Tax Bureaucrats Just Part of the Solution, A Citizen Vote on Taxes, Freezing Real Property Tax Reassessments: A Nice Idea, The Tax Price of a Flawed Tax System, Can Bad Tax Administration Doom the Tax?, Taxes and Priorities, R.I.P., BRT, A Tax Agency Rises from the Dead, and Tax Law as Subterfuge: Best Use Valuation v. Current Market Valuation, How to Kill a Bad Tax System That Will Not Die?, and momentarily ending with The Bad Tax System That Will Not Die Might Get Another Lease on Life.

To understand the news reported in this Philadelphia Inquirer article, it is necessary to explore a little bit of how the property tax works. Generally, a property tax equals the fair market value of the property multiplied by a tax rate. That’s a fairly simple approach, although the determination of fair market value is a challenging factual question, and establishment of the tax rate involves the usual political discourse and maneuvering characteristic of taxation generally. What makes Philadelphia’s property tax system more complicated, and more flawed, is something called “common level ratio.” Instead of applying the tax rate against fair market value, the city applies the tax rate against an assessment that is supposed to equal 32 percent of fair market value. It is unclear what advantages this approach provides. From my perspective, none.

To make certain that assessments are fair, an entity known as the State Tax Equalization Board (STEB) examines property sale documents to compare the real property tax imposed on the property with the amount of the tax that would have been computed if the assessment equaled 32 percent of fair market value. The STEB computes a number called the common level ratio, which reflects the assessments actually used compared to fair market value. If the common level ratio is less than 32 percent, then any property owner whose assessment exceeds the common level ratio can appeal the assessment and have it lowered to reflect the common level ratio. To the extent an appeal is successful, the city’s revenue and the school district’s revenue decreases.

In July of 2011, the STEB concluded that the city’s common level ration was 18.1 percent, not 32 percent. The city appealed, giving the STEB more information, and earlier this week the STEB revised the common level ration to 24.8. After the July announcement, more than 2,000 appeals were filed, and most had been put on hold pending the city’s attempt to have the common level ratio revised. Had the common level ratio not been revised, and the appeals successful, the city and school district would have lost $80 million in revenue. With the revised STEB, the city stands to lose $18 million and the school district $23 million. These are not revenue decreases that either the city or the school district can afford.

The city has filed cross appeals in the assessment cases. Its budget director has asked City Council for $1.8 million to hire private assessors to develop evidence supporting the city’s cross appeals. City Council has not yet acted on the request. The Philadelphia Inquirer, Carnegie Mellon University, and the University of Pennsylvania Wharton School have independently computed the common level ratio and have concluded that it is more in the neighborhood of 12.2 percent. Property owners who make good use of these independent studies face favorable prospects in the litigation.

Proposals to base assessments on actual value, along with other reforms, have been floated for years. Several years ago the city adopted an Actual Value Initiative, but the process of assessing each property is taking quite some time. It remains to be seen whether City Council puts a final seal of approval on the initiative. This most recent addition to the string of property tax glitches ought to be the final nail in the property tax coffin, but somehow I get the feeling that the burial isn’t going to be quite so simple.

The long journey undertaken to bring Philadelphia's real property tax assessment system into conformity with state law and common sense is a wee bit closer to its destination. Recent news requires yet another chapter in a story that, to date, has been the attention of at least six MauledAgain posts: An Unconstitutional Tax Assessment System, Property Tax Assessments: Really That Difficult?, Real Property Tax Assessment System: Broken and Begging for Repair, Philadelphia Real Property Taxes: Pay Up or Lose It, How to Fix a Broken Tax System: Speed It Up?, and Not the Sort of Tax Loss Taxpayers Prefer.

Several days ago, the BRT announced that it had submitted to the mayor and city council of Philadelphia a list of what it considers to be the market value of almost 600,000 properties subject to the city's real property tax. If adopted, this would be the first assessment for which actual fair market value is used. Considering that state law has required the use of actual fair market for years, it's a wonder that it has taken this long, and there still remain several steps before the city is in compliance. For example, these values will not be used for fiscal year 2010 taxes.

The BRT expects the mayor and city council to implement the use of actual values by phasing in the changes. Otherwise, some property owners will face tax increases that would leave them with property tax bills that are double, triple, or even worse. Already, one city council member has moved in this direction.

According to this report, Councilman Frank DiCicco has prepared legislation that would cushion taxpayers against what might be, for some, "a significant increase" in their property taxes. One approach that DiCicco is considering would tax residents on a five-year average of their tax bills. Though this doesn't make sense, to compute a tax bill based on average tax bills, I think the intention is to impose the tax based on a five year average of assessed values. For example, if a property had been assessed at $80,000, but under fair market value assessment is re-assessed at $200,000, then for the first year under the new system, the tax would be computed by applying the tax rate to $104,000 (($80,000 + $80,000 + $80,000 + $80,000 + $200,000)/5). For the second year, it would be applied to $128,000 ((($80,000 + $80,000 + $80,000 + $200,000 + $200,000)/5), for the third year, $152,000 (($80,000 + $80,000 + $200,000 + $200,000 + $200,000)/5), and so on. That might work. Another approach being considered by DiCicco is a so-called "floating tax rate." Under a floating tax rate, the city would determine how much revenue it needs and set the rate to generate those revenues. Isn't that what gets done under present law?

The changes in assessment do not require, nor do they necessarily mean that there will be, an increase or decrease in overall revenue raised by the city from the property tax. It means two things. First, because the total assessed value of the almost 600,000 properties surely will be higher under fair market value assessment than under the current system, the rate can be reduced to keep the revenue flat. It would not be surprising, though, to see the city lower the rate but at the same time generate more revenue. Second, some taxpayers will find themselves paying lower real property taxes under a reduced rate because their assessments under fair market value assessment are the same or not much more than they are under the current system. Many other taxpayers will face increases, though of varying degrees, depending on how far below fair market values their current assessments are. Though complaints should be expected, this is precisely the outcome that should occur and surely a goal of fair value assessment. Under the present system, two taxpayers, each owning properties of equal value, are charged different amounts under the real property tax. Under fair market value assessment, that should not happen. That's why state law was amended years ago to compel fair market value assessment.

The next step appears to be city council approval of the revised assessments. Whether common sense and compliance with state law can trump the special interest group and political fund-raising protocols remains to be seen. It is likely there will be an eighth post on this topic.

For me, the difference between a myth and a lie is that the folks believing in the former don’t know any better and those spreading the latter surely do. In between is the twisting, which can reflect ignorance but also can be the consequence of deliberate word choice that suggests one thing even though it literally means something else. Recently, a distant cousin sent me a link to The Top 5 Tax Myths To Watch Out For This Election Season. All five so-called myths are ones that I had already seen and heard, many times.

The first myth, that “47% of Americans do not pay taxes” is a fairly new one, advanced to support the proposition that the poor should fork over more of their income and assets because the wealthy are over-taxed. The flaw in the statement is that it would be accurate if the adjectival phrase “federal income” were inserted before the word “taxes.” By leaving out those important words, the authors of the statement convey a meaning that is not supported by the facts.

The second myth, that “The American people and corporations pay high taxes” is a bit more difficult to parse. What is meant by “high”? Compared to a one-percent tax rate, there is a plausible argument that most American people and corporations pay high taxes, because even 15 percent is “high” compared to one percent. On the other hand, if the statement is intended to make people think that Americans are taxed at a higher rate than are people and corporations in other countries, the statement is misleading. In 2009, every developed nation except two imposed taxes as a percentage of gross domestic product at rates higher than those applicable in the United States.

The third myth, that “cutting taxes creates jobs and raises revenue” has been around for several decades. It makes for a great sound bite, but it’s factually erroneous. The lowest average annual growth in gross domestic product during the past 60 years has occurred when the top marginal rate is where it is today. The highest rate of growth occurred during years when the top income tax rate was in the high 70-percent range. The second highest rate of growth was when the top income tax rate was in the, indeed, 90-percent range, but that surely was attributable to the global war then being waged. The third highest rate of growth, within a whisker of second place, was when the top income tax rate was 39.6 percent, which is where it was before the Bush tax cuts went into effect. Those cuts drove the growth rate down to its lowest point. Surely the third myth is a pre-emptive strike against those who want to return to the rates as in effect before the Bush tax cuts, although opponents act as though people were advocating a return to the days of top rates in the 70-percent and 90-percent ranges.

The fourth myth, that “The US tax system is very progressive because wealthy individuals already pay a disproportionate amount of taxes” is another statement that loses its factual truth because the phrase “income tax” has been removed as a modifier of the word “system” and as a modifier of the word “taxes.” The progressive federal income tax has the effect of ameliorating what would otherwise be a very regressive overall tax system. As a practical matter, the progressive federal income tax causes the “US tax system” to be a flat system.

The fifth myth, that “The ‘Fair Tax’ or a flat tax would be more fair” simply opens up the debate about the meaning of “fair.” For many people, the rule requiring drivers in the left turn lane to turn left is “unfair” because it doesn’t acknowledge how special they are by letting them go straight out of the left turn lane, cutting ahead of the people in the go straight lane. For many people, any sort of tax system, and any sort of government reining in their impulses, is “unfair.” Certainly the flat tax is not progressive, and its adoption would remove the only thing keeping the entire tax system from being regressive.

Each of these so-called myths can be dissected by sitting down, looking at the facts, thinking carefully, and making computations (such as those that would demonstrate that most Americans would pay more federal income taxes under a flat tax that raised the same amount of revenue, because the lower income taxpayers would need to pay more to offset the revenue losses from the additional tax reductions afforded to the wealthy by the flat tax). These myths are not, of course, myths. They may become myths if they are permitted to circulate without objection. They are lies and twistings of the facts, nothing more. And as such, they need to be debunked. Progress is being made in that respect. I gladly play my part in defusing these provocative lies, as someone who laments tax ignorance. I add this post to the long list of those in which I have criticized the lack of tax education in this nation, and the opportunity for mischief it presents to those who benefit from, and seek to maintain, continued tax ignorance. Everything I’ve shared in Tax Ignorance, Is Tax Ignorance Contagious?, Fighting Tax Ignorance, Why the Nation Needs Tax Education, Tax Ignorance: Legislators and Lobbyists, Tax Education is Not Just For Tax Professionals, The Consequences of Tax Education Deficiency, The Value of Tax Education, Tax Ignorance of the Historical Kind, and Is It Any (Tax) Wonder? reinforces this point.

When people try to avoid or evade taxes, they often become creative. Tax creativity is good if it works, and is a nightmare when it fails. A recent case, Grainger v. Comr., T.C. Memo 2018-117, demonstrates how not to design a tax shelter. The taxpayer, a retired grandmother fond of shopping, developed what she called her “personal tax shelter.” When she learned that taxpayers generally may claim a charitable contribution deduction equal to the fair market value of donated property, she concluded that the fair market value of a retail item is the price at which the retailer first offers it for sale. So the taxpayer decided to purchase items that were “heavily discounted” from the original price on the sales tag and to donate those items. Her reasoning caused her to conclude that if a $100 item went on sale for $10, she could pay $10, donate the item, claim a $100 deduction, and save more than $10 in taxes.

The taxpayer started using her self-designed tax shelter in 2010. She reported non-cash charitable contributions of $18,288. In 2011, she claimed $32,672, and in 2012, the year in issue, she claimed $34,401. In the two following years, which were not in issue, her claimed deductions rose to $40,351 and $46,978. That’s a lot of shopping.

The items that she donated in 2012, for which she claimed a non-cash charitable contribution deduction of $34,401, cost her $6,047, consisting of $2,520 in cash, and $3,527 in store “loyalty points.” The items were described by her on Forms 8283 as dresses, jackets, and other clothing.

The IRS denied all but $2,520 of the claimed deduction, concluding that the taxpayer’s method of determining fair market value was not a qualified method. On appeal, the IRS increased the deduction to $6,117, mostly by including the loyalty points. It’s unclear why the $6,117 exceeded the $6,047 outlay. Thereafter, the IRS issued a notice of deficiency and the taxpayer filed a petition with the Tax Court. The IRS moved to reduce the allowed deduction by $3,527, arguing that it had erred when it included the loyalty points in the allowed deduction, but the court denied the motion because it was untimely and would prejudice the taxpayer.

The Tax Court denied the taxpayer’s claimed deductions in excess of what the IRS had allowed. It did so because the taxpayer had failed to obtain a qualified appraisal, required because the clothing items, when grouped together as required, exceeded $5,000 in claimed value. The Forms 8283 that the taxpayer had attached to her return were not executed by an official of the donee organizations. In addition, the court held that the taxpayer had not obtained the contemporaneous written acknowledgments. The court then explained that even if the taxpayer had provided the required substantiation, her claimed deduction would be disallowed because she did not use a qualified method for determining fair market value. The court pointed out that fair market value of an item is not the price at which a retailer initially offers the item for sale. The fair market value is the price for which the item was transferred from the retailer to the purchaser, which was the amount the taxpayer had paid. And, the court added, even if the taxpayer could establish that the fair market value of the items exceeded what she paid for them, because she donated them shortly after purchasing them, she would be required to reduce the deduction by the amount of gain that would not be long-term capital gain had the taxpayer sold the items for the claimed fair market value.

One of the many symptoms of the current tax law’s sickness is the ease with which the wealthy can enter into tax shelter arrangements that are unavailable to taxpayers of much lesser means. Tax shelter promoters, whether hawking legitimate or not-so-legitimate deals, turn their attention to the wealthy, in part because it doesn’t pay to offer $10 tax shelters, in part because investment regulations block people of modest means from most private offerings, and in part because the wealthy are in a better position to cause the enactment of legitimate tax shelters in the tax law that are feasible only for those with sufficient funds. It is not surprising that a retired grandmother, whose income from the facts appears to have been quite modest, would engage in a creative but misguided scheme to reduce her tax liability.

Calls to reform federal taxation are almost everyday events, and the introduction of bills in the Congress to do so gets their advocates some attention, even if it is transitory. Sometimes a bill, though unlikely to become law, can spark serious debate. Such is the case with H.R. 25, the Fair Tax Act of 2003. Essentially, it replaces the federal income tax, estate tax, etc. with a federal sales tax.

The bill is advertised as enacting a 23% federal sales tax (in lieu of an income tax whose rates range from below 23% to above 23%). But, as I often tell my students, let's do a bit of statutory analysis (though in this case it's bill language analysis because it's not yet a statute).

Proposed section 101(b)(1) states: "In the calendar year 2005, the rate of tax is 23 percent of the gross payments for the taxable property or service."

Looks like a 23% rate, right?

Wait.

Proposed section 101(a)(5) provides; "The term `gross payments' means payments for taxable property or services, including Federal taxes imposed by this title."

So, if I buy something for $100, the proposed sales tax is NOT $23. It is 23% of $100 increased by the sales tax. We need some algebra. The tax is $30. How? 23% of $130 is $30. The tax is 23% of $130 ($100 plus the $30 tax).

Whoa. Why not simply a 30% tax on the $100. Same thing, right?

Yes, it's the "same thing" in terms of the $30 tax result. But it's a totally different thing when it comes to selling the tax to the public. Replacing the income tax with a 23% tax is going to attract more support and votes than replacing the income tax with a 30% tax.

This is a proposed 30% tax. It's being sold as a proposed 23% tax. That's misleading.

Discussion among some tax law professors drew some mixed reactions. There are some existing taxes that are "inclusive" of tax, for which there are stated rates. One argument is that there is no difference between saying that the cost of an item is $100, plus $30 must be paid in tax, and saying that the cost of an item is $130, of which $30 is remitted as tax. That's true, but that misses the point.

The point is that most Americans, other than perhaps a few who can think in terms of "exclusive of tax" and "inclusive of tax" rate setting, think that a stated 23% tax means, pay $100 for something plus pay $23 in tax. They don't think it means, pay $100 for something plus pay $30 in tax, even if the tax of $30 is 23% of the $130 that comes out of the purchaser's pocket including the tax.

Another argument is that the VAT (value added taxes) used in Europe are "inclusive of tax"). So what? This isn't Europe and the general public doesn't think that way about sales taxes. Sometimes I wonder at the chasm between academic theory and the general public's day-to-day life.

Americans are accustomed to thinking in what academics call "tax exclusive" terms, and it is totally misleading to shift gears without notice. Yet it was argued that there is nothing wrong in framing the issue in a way most palatable to the goals of the advocates of the legislation, because, after all, lawyers and advertisers do that all the time. Maybe that's why lawyers and advertisers top the list of "most admired persons" and "most admired professions." Sorry about the sarcasm. Just because something is done, even if it is done often, doesn't make it right.

The discussion inspired me to contribute a description of a cartoon:

*****s comment about math disingenuity reminds me of the Calvin and Hobbes comic in which failure to understand math boomeranged. Hobbes says to Calvin: So how'd you do on the math test?

Calvin replies: I bet Suzy Perkins a quarter that I'd get a higher score.

Hobbes: Did you?

Calvin: No, but I got back at her. I paid her only three dimes.

I don't know how to describe the look on Hobbes' face.

Great cartoon, it's missed, and it sometimes presented a quip of use in teaching tax and for teaching generally.

This brought a negative reaction, which puzzled me. I share now my response. When I re-read it, I decided it really does represent my opinion of folks who just can't put it square on the table, for the desire to win so overwhelms the willingness to play fair:

The Calvin and Hobbes reference, for which I am responsible, was intended to make the following points: those who do not study carefully the words and numbers used in others' expressions are doomed to being fooled, and when it comes to the question "fooled by whom?" the answer is "by themselves."

And it is on that ability of an oft-unschooled citizenry to fool itself (into thinking it knows and understands) that the merchants of "cleverness" (be they politicians, lawyers, or product sellers) construct careers. Taking advantage of another's disability doesn't earn high marks with me. If I know that someone will be misled I have an obligation, and I make every bona fide effort, to see to it that what I am saying is understood. I expect no less of those who advocate in the public arena. Of course, I understand that my expectations are close to futile.

Hence, although one can argue that in some worlds three dimes equal a quarter (which they do for certain old quarters whose value is beginning to creep up a wee bit on the hopeful road to being worthwhile collectibles), I don't understand the annoyance with the reference. Of course, in a world where three dimes rarely are considered to be equal to a quarter, thinking that they are (or that they are less) is just as much a twist as is the use of a tax inclusive rate ballyhooed in a world where tax rates are almost universally considered to be tax exclusive.

All of this can be avoided if precise and accurate statements, long as they may need to be, trumped the soundbite mentality of the so-called post-modern culture. I wonder who would be most unhappy with a requirement that a proposed rate for a proposed national sales tax be expressed in a manner that precluded any twist. Surely those who, in lieu of "23% rate" would need to say (their choice), "30% of pre-tax cost" or "23% of tax-inclusive amount". The latter, of course, would need to be explained to most of the citizenry whom legislators are obliged to serve, which would surely turn on the lights with a brightness that would reach into the deepest, darkest corner.

My spirits were lifted by the private emails in which people expressed agreement. Why is it so difficult for things to be cleared of the smoke and mirrors? When I think of who benefits from the "cleverness" I begin to understand why the world is such a mess.

Almost two years ago, in The Taxation of Kidney Swaps, I concluded that taxpayers who swapped kidneys for transplantation into their respective spouses have gross income because that's what the black letter law of tax states. I also questioned whether the IRS would pursue the matter if the taxpayers did not report gross income. About a month later, BNA published my essay, Taxation of Kidney Swaps, as part of its "Insights and Commentary" series, but the link no longer works and I cannot find the article on-line.

Only recently have I discovered that both the MauledAgain post, The Taxation of Kidney Swaps, and the BNA essay have generated reactions. In Blawg Review #46, Sean Sirrine writes: “If you want to get real serious, you can read [Prof. Maule’s] "The Taxation of Kidney Swaps" in which he makes a good argument that people who are swapping kidneys should (legally speaking) be paying taxes on the exchange. Talk about a topic to get your blood boiling!” My tax blogging colleague Joe Kristan, in KIDNEY SWAPS: NOT A 1031 EXCHANGE?, suggested, tongue in cheek I’m sure, that the solution is for the two couples to divorce and make use of the section 1041 nonrecognition provision.

But over at Tax Guru, Kerry Kerstetter recorded a question that pointed out the BNA version of Taxation of Kidney Swaps and that wondered “Can you be taxed on receipt of a kidney? What I wonder is, if you and I each have a car of equal market value and we trade them, would we be taxed? Beyond the obvious bio-ethics issues, I don't see the difference.” Kerry’s response:

As learned and entertaining as Professor Maule is, this is a perfect example of how ivory tower academics (and some attorneys I have known) love to let their imaginations go wild and conjure up scary tax scenarios out of what are actually innocent events.

If I were advising these people from my real world perspective on tax matters, I would have them sell their kidneys to each other for one dollar each and completely avoid the entire subjective valuation of a bartering transaction. While the black market price for kidneys may be as much as $50,000 (per a recent episode of Nip/Tuck), each person is actually entitled to establish her own price. While some cold-hearted bastards might say they should auction the kidneys to the highest bidders, basic private property rights allow us to set out own prices for things we own; so who is to say one dollar isn't appropriate?

They can each prepare a bill of sale for one dollar and report the transactions on Schedule D of their 1040s, with a cost basis of zero. The tax on one dollar of long term capital gain (acquisition date = date of their birth) will be the least of their worries.

When I read this planning tip two thoughts crossed my mind. First, no one in the ivory tower considers me an ivory tower academic, as I am one of the few who focuses on the law practice world far more than on the legal philosophers’ arena. Second, it just can’t be that the tax consequences of a barter exchange are avoided simply by pegging each component as a one-dollar sale. So, off I went to do some research. Not on the first question, though that might be a fun survey to conduct, but on the second.

In Rev. Rul. 79-24, 1979-1 C.B. 60, the IRS analyzed the tax treatment of barter club members who exchanged legal services for housepainting services. The IRS concluded that the fair market value of the services received by the lawyer and the housepainter was includable in income. The fair market value of the services is not a nominal one dollar, but the amount for which the services would sell or trade on the open market.

The courts that have dealt with the question make it clear that when there is an exchange, the value must be determined according to an objective market place and not according to values arbitrarily assigned by the taxpayers. For example, in Rooney v Commissioner 88 T.C. 523 (1987), the Tax Court held that “under sec. 61, I.R.C. 1954, an objective measure of fair market value must be employed to measure compensation received in goods or services; thus, Ps must include in income their share of the normal retail price of the goods and services received by the partnership.” The Court explained:

We agree with the court's reasoning in Koons. In our judgment, section 61 requires an objective measure of fair market value. See Koons v. United States, 315 F.2d at 545; Kaplan v. United States, 279 F. Supp. 709, 711 (D. Ariz. 1967). Under such standard, the petitioners may not adjust the acknowledged retail price of the goods and services received merely because they decide among themselves that such goods and services were overpriced.

The Court further concluded:

In our judgment, the petitioners must value their compensation by applying an objective measure of fair market value. For such reasons, we hold that the fair market value of the goods and services received by the petitioners is the prices charged by the partnership's clients to their retail customers.

Similarly, in Baker v. Commissioner, 88 T.C. 1282 (1987), the Tax Court explained:

Gross income includes the fair market value of property received in payment for goods and services. Sec. 61(a); 1 sec. 1.61-2(d)(1), Income Tax Regs. The amount of commission income received by petitioner in 1981, therefore, is to be determined on the basis of the fair market value of the trade units petitioner received as commissions in 1981. This apparently is the first case involving the valuation, for Federal income tax purposes, of trade units received by members of an organized barter exchange. Our recent opinion in Rooney v. Commissioner, 88 T.C. 523 (1987), involved accountants who, on an ad hoc basis, agreed to accept goods and services in payment of delinquent accounts. We held that in valuing the goods and services received by the accountants, an objective standard was to be used. We stated that -

section 61 requires an objective measure of fair market value. * * * Under such standard, [taxpayers] may not adjust the acknowledged retail price of the goods and services received merely because they decide among themselves that such goods and services were overpriced. [Rooney v. Commissioner, supra at 8-9.]

In Koons v. United States, 315 F.2d 542 (9th Cir. 1963), an employee received household moving services in partial payment for accepting a job at a new location. The Ninth Circuit in Koons rejected the argument that the amount of income charged to the employee with respect to the moving services should be measured on the basis of a subjective valuation thereof by the taxpayer. The Ninth Circuit stated that -

the use of any such [subjective] measure of value as is suggested is contrary to the usual way of valuing either services or property, and would make the administration of the tax laws in this area depend upon a knowledge by the Commissioner of the state of mind of the individual taxpayer. We do not think that tax administration should be based upon anything so whimsical. * * * We think that sound administration of the tax laws requires that there be as nearly objective a measure of the value of services that are includible in income as possible, and the only such objective measure * * * is fair market value. * * * [315 F.2d at 545.]

In the context of summons enforcement proceedings, a number of courts have accepted as reasonable respondent's contention that barter exchange transactions create circumstances that are conducive to improper tax avoidance. United States v. Pittsburgh Trade Exchange, Inc., 644 F.2d 302, 306 (3d Cir. 1981); Korpi v. United States, an unreported case ( D. Mass. 1984, 84-1 USTC par. 9203 at 83,344 n. 1, 53 AFTR 2d 84-1048 n. 1); United States v. Island Trade Exchange, Inc., 535 F. Supp. 993, 996-997 (E.D. N.Y. 1982). We share that concern.

In 1982, Congress expanded the return reporting requirements of section 6045 to make barter exchanges, among other organizations, subject thereto. Sec. 311 of the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248, 96 Stat. 324, 600-601. The purpose of this change in section 6045 was to improve compliance with respect to the reporting of taxable transactions conducted through barter exchanges. S. Rept. 97-494, at 246 (1982). Thus, it appears that Congress also has recognized the potential for tax avoidance inherent in barter exchange transactions.

The absence of the use of currency and the tax reduction motives suggested in literature of the exchange suggest to us that the operations of the exchange and the tax effect of transactions occurring within the exchange deserve close scrutiny. The above factors also further support the adoption, for tax purposes, of an objective test for the valuation of trade units received by petitioner and by members of the exchange.

In other words, the idea of avoiding the tax consequences of a barter exchange by setting the value at a nominal amount such as one dollar had been tried, and generated a strong negative reaction by Congress, and thereafter by the courts. The revenue ruling and cases that I’ve noted have been cited with approval and followed in more than a few other cases, and in an FSA. Paul Caron reached a similar conclusion through a similar analysis in Tax Consequences of Kidney Donations.

So what Kerry proposes won’t fly. I worry that the IRS not only would reject the nominal amounts, but impose penalties for trying to avoid tax consequences through a strategy that has been roundly rejected by the authorities.

I hesitate to make a comment about the supposed “ivory tower” nature of my original The Taxation of Kidney Swaps post. Support for my conclusion can be found in IRS pronouncements and court opinions. It doesn’t get much more real world than that. Whatever shortcomings I have, and I have them, it doesn’t include being an ivory tower academic, much to the chagrin of many in the so-called law school academy.

Few people like to pay taxes, even if they're receiving more from the government than they're contributing, and even fewer like to experience a tax increase. So it's no surprise that the tax reform group, Philadelphia Forward, has urged all Philadelphia real property owners to file appeals in response the city's reassessment of their properties for real property tax purposes.

Philadelphia Forward advocates use of full market valuation for property tax purposes, something that the city of Philadelphia does not use. Under full market valuation, properties are assessed at full fair market value, and the tax rate is applied to that assessment. The advantages of full market valuation include fairness, ease of determining whether properties are being properly assessed, and logical correlation between taxation and value. The disadvantage is that costs money and takes time to pin a fair market valuation on each property.

Citing the Clifton case that I discussed a few months ago in An Unconstitutional Tax Assessment System, Philadelphia Forward explains that Judge Wettick found that "Using income tax terminology, one out of every four Philadelphia property owners was in a tax bracket of at least 3.35% and one out of every four property owners was in a tax bracket that did not exceed 1.42%." It also notes that

The Philadelphia Tax Reform Commission established that: "Philadelphia’s property assessments do not meet industry standards for accuracy; all across the city, assessed values diverge widely from market values. Philadelphia’s property assessments do not meet industry standards for equity; properties in poorer neighborhoods are, on average, assessed at a higher percentage of market value than properties in more affluent neighborhoods. The inaccuracy and regressive nature of Philadelphia’s assessments violate standards of vertical and horizontal equity."

A map of the disparities in effective rates gets the point across in a strong visual way.

It's more complicated than just convincing city officials to value properties at fair market value rather than at some other amount determined in some way that isn't very clear or obvious to homeowners or taxpayers. The people who make the assessments have no authority to set or change the tax rate, so if the assessments are established at fair market value, most property owners in the city would experience whopping tax increases, and the city would experience a surge of tax revenues.

The determination of how much property tax revenue the city should collect is a question separate from determining how that tax should be apportioned among property owners. The first question is part of the larger issue of establishing city spending, the scope of services provided by the city, and related matters such as public employee retirement and other benefits. The second question has been answered by the state Constitution and judicial decisions, including that of Judge Wettick in Clifton. Property taxes must be assessed uniformly. Someone who owns a property worth twice the value of a property owned by a second person should pay real property taxes twice the amount imposed on the second person.

Because determinations by two different components of city government establish a property owners' real property tax, those two components need to sit down together and map out a plan under which properties are assessed at fair market value, and the rate adjusted so that the overall tax revenue is unchanged. Thereafter, if the city wishes to increase revenue, it can do so using the process for increasing the real property tax rate, in a way that is transparent and provides taxpayers with an opportunity to comment on the wisdom or folly of such an increase.

As it presently stands, the so-called reassessments not only would fail to bring uniformity, they also would trigger a tax increase. I'm not sure what would happen to the assessment appeals system if all 400,000 property owners take the advice of Philadelphia Forward and appeal, but we may be finding out soon. On the Philadelphia Forward web site are instructions for filing the appeal, and the organization pledges to assist property owners and accompany them to hearings.

The system needs to be fixed. I have a sense things will become more complicated and frenetic before they are resolved.

A week and a half ago, in Tax Hogs at The Tax Trough, I criticized the proposal that Treasury, independent of Congressional action, index adjusted basis for purposes of computing taxable gains. Of course, I was not alone in lambasting the proposal. Similar, and additional, reasons to reject the proposal were raised by the Tax Policy Center, other law professors, the New York Times, New York Magazine, and numerous other commentators who understand the realities of tax policy.

Of course, it wasn’t long before the defenders of increased wealth and income inequality stepped up to defend the indefensible. Consider the arguments made by Ryan Ellis of the Center for a Free Economy. He argues that because one-fourth of capital gains reflects inflation, that increasing adjusted basis to reflect inflation is justified. Of course it would be, but for the fact that special low tax rates on capital gains reflect intent to offset the inflation element of the gains. When income, in the form of capital gains, is taxed at zero, 15, or 20 percent, and ordinary income is taxed at rates as high as 37 percent, it is obvious that those special low capital gains tax rates offset inflation by much more than inflation. Ellis, unhappy with the portrayal of this proposal as a handout to the wealthy, which, of course, it is, tries to demonstrate that the proposal would assist “normal, middle-class Americans.” His examples include sales of long-held residences by married couples that generate more than half a million dollars in gains, farmers who sell land held for decades, retired individuals selling stocks, and collectors of various memorabilia. As I pointed out in my earlier commentator, I’m all for indexing adjusted basis, provided that, in turn, the special low capital gains tax rates are abolished. When someone argues that because inflation exists they ought to get both special low rates and basis indexation, I return to the vision of tax hogs at the tax trough. And, of course, for every dollar of capital gains that a middle-class taxpayer would escape with indexation of basis, the wealthy escape hundreds, if not thousands, of dollars of gains. Once again, advocates of making the wealthy wealthier think that throwing crumbs to the peasants justifies serving rich pastries to the engorged.

Ellis asks, “If a child buys a toy in 1980 for $5 and can sell it today for $100, why can’t they use the $5 number in today’s inflation-adjusted terms ($16) instead when figuring gain on the sale?” The answer is simple. The $95 of gain is taxed, if at all, at no more than 20 percent, rather than at 37 percent. A fair tax system would required the toy seller to compute gain of $84, using indexed basis, and then pay tax at regular rates on the $84. It’s obvious why the special low capital gains rate structure, rather than basis indexation, was selected by investors when the tax policy debate was framed decades ago. But now, having made their choice, they’re back to grab both. Oink, oink.

And consider the thoughts expressed in the anonymous Washington Examiner editorial. The writer argues, “It’s a bit of a stretch to describe indexing of capital gains to inflation as a tax cut.” There is no question, at least among those who understand taxation, that indexing basis will reduce the tax liabilities of those who sell assets with indexed adjusted basis. A reduction in tax liabilities is a tax cut. Tax cuts exist not only when tax rates are reduced, but when exclusions, deductions, or credits are increased, and when gains, or other inclusions, are reduced. The anonymous writer tries to defend the absurd claim that a tax reduction is not a tax cut with this gem: “True, people will owe less in capital gains taxes as a result, but that's because the federal government will no longer use fake gains to take real money away from them.” I’m all for removing fake gain from the tax base provided the advocates of inflation-indexed basis agree to remove fake tax rates from the Code. Why do I call those special low capital gains rates fake? Because once fake gains are removed from the definition of income, then income is income from whatever source derived, and ought to be taxed at the same rate whether it arises from the sweat of labor or the winnings from playing the lottery or the stock market. The anonymous writer gives a silly example, writing, “ If you buy a stock at $20 and it grows to $30, but $8 of that gain is because of inflation, 80 percent of your gain is notional, not real. Why should you be taxed on $10 when you only made $2?” The answer is simple. First, rarely, if ever, would 80 percent of the increase in stock growing by 50 percent be on account of inflation. Second, under present law, the practical effect of the special low capital gains rate is to tax only a small portion of the $10 overall gain. Of course, using realistic numbers would demonstrate that special low capital gains rates removes the inflation portion of gain from taxation. The anonymous writer claims that “Envy never looks good once it's stripped of its camouflage of concern for fairness.” Somehow this writer wants people to think that grabbing both special low rates and indexed basis is fair. I wonder if this writer thinks it is fair when someone takes a second helping from the buffet table before others even get their first go at the buffet.

These supporters of double dipping by the wealthy are either ignorant of the history of how gains are taxed or are deliberately failing to provide a complete explanation in the hope that keeping people ignorant of reality will increase support for a foolish, dangerous, and unjustifiable idea. The fact that this idea is getting traction among the acolytes of the wealthy proves, once again, that education is valuable because education dispels ignorance. Too few people have been educated with respect to tax policy. It’s time for that to change.

Recently I was talking with someone about the person’s tax return. The person was trying to compare their 2017 tax situation with their 2018 situation. Because income had changed, it was not enough simply to compare total tax liability. Instead, what mattered was the person’s effective tax rate in each year. What’s an effective rate? It’s the total tax liability divided by total income.

So it was more than interesting to read a Philadelphia Inquirer article by Joel Naroff, in which he commented on a study by the Institute on Taxation and Economic Policy (ITEP). Setting up his observations, Naroff shared some background, which those familiar with taxation already know but which is important for those just getting started with tax analysis to understand. He explained that there are all sorts of state and local taxes, including income, property, and sales. He explained the different between progressive taxation, in which rates increase as income increases, and regressive taxation, in which rates decrease as income increases. He observed that creating a “fair” tax system is difficult because different families, or individuals, are affected differently and thus view their tax burdens differently depending on their own particular circumstances.

Naroff put his commentary in the context of the phrases “high tax state” and “low tax state.” The ITEP study focused on state and local taxes. Looking at the nation as a whole, the lowest 20 percent income group faced an 11.4 percent state and local effective tax rate. The top one percent’s state and local effective tax rate was only 7.4 percent. To anyone familiar with state and local taxation, the study’s conclusion that state and local taxes are regressive is not a surprise.

Because he was writing for a Philadelphia area newspaper, Naroff looked more closely at the situation in the three states parts of which are in the Philadelphia metropolitan area. Pennsylvania, considered to be a “low tax” state by many, has its lowest 20 percent income group facing a state and local effective tax rate of 13.8 percent, above the national average, and its top one percent facing a state and local effective tax rate of 6 percent, below the national average. Delaware has its lowest 20 percent income group facing a state and local effective tax rate of 5.5 percent, and its top one percent facing a state and local effective tax rate of 6.5 percent. New Jersey, considered to be a “high tax” state by many, has its lowest 20 percent income group facing a state and local effective tax rate of 8.7 percent, below the national average, and its top one percent facing a state and local effective tax rate of 9.8 percent.

It turns out that most of the states considered to be “high tax” states have “modestly regressive state and local taxes” whereas two of the states considered to be “low tax” states, Florida and Texas, are among the states with the most regressive taxes. The lowest 20 percent income group in Texas faces a state and local effective tax rate of 13 percent, and in Florida, it’s 12.7 percent. So, in other words, the top one percent have a very different sense of which states are “high tax” and “low tax,” and unfortunately, not only does the perception of the very wealthy end up as the perceived characteristic generally, it also causes people taxed at low rates in what the wealthy consider to be a “high tax” state to conclude that their tax burden is high, while people in lower income brackets who think they would face lower taxes if they move to a “low tax” state end up, if they do move, being taxed more steeply than they were in the state they departed.

But what caught my eye, and should worry any American concerned about their own economic future, was this point. As Naroff puts it, “Finally, there is one result that should open the eyes of all middle-income households. In all but four states, the middle 60 percent pay higher effective tax rates than upper-income households.” Of course, those who have been paying attention know that for all the hype about the top federal income rate, when it comes to federal income tax effective rates, the secretaries are facing a higher rate than are the oligarchs.

Naroff concludes, “I suspect if that result were known, there just might be a national movement to change the way services are funded and taxes are collected at state and local levels.” Indeed. And it also would address the way services are funded and taxes are collected at the federal level.

There is a meme that has been floating around for some years now in various forms. The gist of the message is simple. The rich have convinced the middle class that the poor are the reason that the middle class is suffering. It ought to be clear from the ITEP study that it’s not the poor, saddled with the highest effective tax rates, who are putting the burden on the middle class, because it’s not the middle class that benefits from the lowest effective tax rates. Put another way, those “low tax” states that seem so appealing are low tax states for the wealthy, an outcome financed with reduced services, weaker education, and higher effective tax rates on the poor and middle class.

A reader sent along a comment and two questions about my How Simple and Fair is Fair? posting on the FairTax, and asked me to explain. I welcome the opportunity to elaborate.

First, the reader commented:

Yes, we will all pay taxes whether it is withheld from our paychecks or paid at the register; but the big difference is that under the Fair Tax plan we have the CHOICE to NOT make the purchase or save our money and NOT pay taxes. Under our current tax system I do not have a choice.

In response, I analyzed the difference between theoretical choice and practical needs:

In theory, a person can choose not to spend their money and thus avoid the proposed federal sales/consumption tax. But that person must eat, needs a place to live, must have transportation of some sort, needs health care, requires clothing, and has other needs that preclude the option of not making purchases. The proposed prebate does not cover sufficient purchases for people living in most metropolitan areas. A similar argument can be made of the income tax. A person can avoid the income tax by not having income. That person wouldn't last long, either.

Second, the reader asked

Why do the critics keep saying the rich don't spend their money? Does the good fairy provide them expensive homes, cars and vacations?

In response, I provided an example of why critics of the FairTax think it lets the wealthy off the hook relative to other taxpayers:

The rich spend proportionately far less of their money than do the poor and middle-class. For example, a person earning $100,000 probably spends all of it. Perhaps they save a little and spend $80,000. For ease of computation I'll use 25% as the proposed federal sales tax rate. The person just described would pay $20,000 or $25,000 depending on if they saved $20,000 of the $100,000. Let's say the prebate gives the person $6,000 back. So the person incurs a tax of $19,000 or $14,000. That's an effective rate of 14% or 19%. Contrast the rich person who has $1,000,000 of income. That person spends, say, $400,000 (which buys a lot, quite a lot). The tax? $100,000, or $94,000 after prebate. Effective rate on their income? 9.4%. Now let's add in the ease with which the rich person can spend some of the $400,000 abroad, say on a vehicle or house they keep in Portugal. Good luck collecting the tax. Short answer: there are all sorts of studies showing that as incomes rise, the proportion that is spent decreases. The sales tax is a regressive tax. Add in the prebate and the tax gets the classic bubble, namely, highest effective marginal rate on the middle incomes.

The comment and questions focus attention on issues that don't get sufficient treatment in campaign soundbites. When people have a chance to think analytically about the FairTax, and look behind the slogans and superficial summaries, they can get a better picture of what the FairTax does, and base their decision to support or reject it on facts and analysis rather than platitudes.

Reader Morris directed my attention to a BCRNews article describing the unhappiness of a restaurant-owning couple caused by the enactment of a parking tax that applies to the monies they collect when they charge people to park in their parking lot. According to Scott Reeder, John and Sandy Fulgenzi close their restaurant in Springfield, Illinois, for part of each August because the traffic generated by the state fair discourages people from patronizing their restaurant. To make up for some of the revenue loss, they charge fair visitors $5 per day to use a space in the parking lot. The Fulgenzis have learned that beginning in 2020 they will be liable for a state parking tax on the parking lot revenue that they collect. The tax also will apply to homeowners who rent out driveways or yards for parking during the state fair.

John Fulgenzi asks why they are being subjected to a parking tax even though they pay an income tax and a property tax. That, I think, is not a question that focuses on the problem. As Reeder puts it, “The state is taxing parking to pay for non-transportation related infrastructure.” To me, the question should be, “Why are the revenues from a parking tax being used for expenditures that have nothing to do with parking?” If the parking tax revenues were used to inspect parking spaces for safety, to maintain parking spaces, or otherwise to benefit parking, or even related transportation infrastructure such as curbs and streets, John Fulgenzi’s question could easily be answered. But the answer to the actual question, “Why are the revenues from a parking tax being used for expenditures that have nothing to do with parking?” is, according to Reeder is simple. “The reason is straightforward. They are counting on your ignorance. Their sincere hope is that you will blame the parking lot owners for your higher rates, rather than the lawmakers who imposed the tax on them.” Indeed.

Tim Butler, one of the state legislators who supported enactment of the tax, and who represents the Fulgenzi’s town, claims that “it never was the intent of lawmakers to tax people like the Fulgenzis.” He adds, “The idea behind this was to tax those big parking garages in downtown Chicago. I wanted to make sure it didn’t tax municipal parking garages in Springfield, but it never occurred to anyone that it might affect parking near the state fair.” Sorry, Tim Butler, if that’s what the legislature intended, then it should have drafted language to that effect. But it didn’t.

There are two problems with this tax. One, as just noted, is the inconsistency between the alleged legislative intent and the language of the statute. That problem is widespread among legislatures. The other is the enactment of a tax on an activity that is not used to benefit that activity.

It is difficult to defend this tax. What is worse is that the enactment of this sort of tax encourages a backlash against taxes in general, including taxes that are easily defended. Legislatures need to do better. Much better.

Usually, when I write about the Philadelphia real property tax, it’s a matter of dealing with assessment complaints, procedural snags, and collection issues. I have described these concerns in posts such as An Unconstitutional Tax Assessment System, Property Tax Assessments: Really That Difficult?, Real Property Tax Assessment System: Broken and Begging for Repair, Philadelphia Real Property Taxes: Pay Up or Lose It, How to Fix a Broken Tax System: Speed It Up? , Revising the Board of Revision of Taxes, How Can Asking Questions Improve Tax and Spending Policies?, This Just Taxes My Brain, Tax Bureaucrats Lose Work, Keep Pay, Testing Tax Bureaucrats Just Part of the Solution, A Citizen Vote on Taxes, Freezing Real Property Tax Reassessments: A Nice Idea, The Tax Price of a Flawed Tax System, Can Bad Tax Administration Doom the Tax?, Taxes and Priorities, R.I.P., BRT, A Tax Agency Rises from the Dead, and Tax Law as Subterfuge: Best Use Valuation v. Current Market Valuation, How to Kill a Bad Tax System That Will Not Die?, The Bad Tax System That Will Not Die Might Get Another Lease on Life , Robbing Peter to Pay Paul, Tax Style, Don’t Rob Peter to Pay Paul: Collect Unpaid Taxes, The Philadelphia Real Property Tax: Eternal Circles , A Tax Problem, A Solution, So Why No Repair?, Can the Philadelphia Real Property Tax System Be Saved?, and Pay Tax Now? Pay Tax Later?.

This time, however, I am writing about an issue that involves not only the Philadelphia real estate tax but taxes generally. A recent Philadelphia Inquirer article describes the unhappiness of Philadelphia property owners who are facing increases in their real estate taxes, not because of a rate increase but because the assessed values of their properties have increased. Unlike some Pennsylvania jurisdictions, Philadelphia is not required to lower the tax rate when the tax base, that is, the combined assessed values of properties subject to the real estate tax, increases. Some city officials have proposed that the rate be lowered. Others point out that because the city itself, as well as the school district that also relies on the tax, face higher expenses, lowering the rate would require raising other taxes, cutting services, or some combination of both. At least one politician wants “revenue-neutral assessments” but that approach, though arithmetically possible, would require assessing properties at less than fair market value, which would violate state law.

The revenue neutrality debate caused me to think about another tax that increases as values increase. Consider the sales tax. With a fixed rate, the amount of the tax increases if the price of the item increases. Trying to implement a reduced sales tax rate to keep sales tax revenues level when overall prices increase would be somewhat of a nightmare for merchants and state revenue departments, even with the assistance of digital technology. It would not surprise me if, when someone advocated making the sales tax revenue neutral, opponents of the idea would point out that the overall price increases causing sales tax revenues to increase would also cause the costs faced by state and local governments to increase.

Then the word “tariff” popped into my mind. Prices of many items in this country are beginning to increase substantially thanks to tariffs imposed in a futile effort to inflict financial pain on other countries. Tariffs, of course, are not paid by other countries but are paid by domestic merchants and residents of this country. Take, for example, automobiles. Almost all jurisdictions, perhaps all jurisdictions, that impose a sales tax subject automobile purchases to that tax. If tariffs cause the price of automobiles to increase, as surely they will, a $3,000 increase in the price would generate, in Pennsylvania with its 6 percent tax, an additional $180 of sales tax revenue. Multiply that by the number of automobiles sold in the state, add in boats, trailers, airplanes, and everything else subject to the tax, and the tariff is generating not only an inflationary increase in the price of goods, but an increase in state and local taxes. True, the higher prices might compel those who are not wealthy or sitting on piles of corporate cash to cut back on their purchases, but at least a majority of Americans are already limiting their purchases to bare necessities because of the nation’s income and wealth imbalance, and don’t have the luxury of bargaining in the marketplace and they certainly don’t control the marketplace. They’re stuck. I wonder if the tariff advocates let their thinking process go this far in analyzing the consequences, assuming that a thinking process and not a limbic system reaction inspired the tariff decisions.

Two weeks ago, in An Immoral Tax?, I explained, as I have done previously in Capital Gains, Dividends, and Taxes, As I Expected, Tax Deform(ity), and The Rich Get Richer: The Tax Law’s Role?, that repeal of the estate tax makes sense and has its advantages provided unrealized appreciation does not escape taxation at death. In response, a reader directed me to William G. Gale’s Adjusting the President’s Capital Gains Proposal.

Although Gale describes the proposal to tax unrealized appreciation at death as “a welcome change that would close a huge loophole,” he points out “a serious flaw,” namely, the challenge of keeping records so that unrealized appreciation can be computed at death. That computation requires two facts. One is the fair market value of the asset. The other is the adjusted basis of the asset. Because fair market value must be computed not only for the few taxpayers who are subject to the federal estate tax, but also for purposes of taxpayers who are subject to state estate and inheritance taxes, as well as those who sell inherited property, determination of fair market value does not pose significant challenges. The value of most assets can be determined from market quotes, appraisals, and similar information.

Determining the decedent taxpayer’s adjusted basis in property can be problematic. Many taxpayers do not keep track of their adjusted basis in property, particularly property that is not publicly traded or that was acquired many years previously. This conundrum is what caused the failure of carryover basis to stick. Carryover basis would give the heirs the decedent’s adjusted basis rather than a basis equal to fair market value at death.

What doesn’t get much attention is the fact that when the taxpayer gives property to another person during lifetime, the donee’s adjusted basis is the decedent’s adjusted basis. If determining the taxpayer’s adjusted basis is as impossible as the defenders of the basis step-up at death loophole claim, then why has it endured in existing tax law for almost as long as the federal income tax has existed?

Gale proposes that taxpayers be permitted to compute adjusted basis by allowing them to claim a “standard basis,” a concept derived from the standard deduction. Just as the standard deduction provides an alternative to computing actual itemized deductions, the “standard basis” would provide an alternative to computing actual adjusted basis.

Gale suggests, as an example, setting standard basis at 20 percent of fair market value. He explains that by keeping the percentage low, taxpayers would be encouraged to keep basis records. That might make sense going forward, but there are trillions of dollars of existing assets for which at least some taxpayers have not maintained records.

Gale’s idea makes sense, though I would modify it. I would scale the percentage based on how long the taxpayer held the property. Perhaps "standard basis" should equal the fair market value of the asset multiplied by the standard basis percentage. The standard basis percentage would equal 100 percentage points reduced by 2 percentage points for each year the property has been held, but would not be less than 10 percent. Because the gain would be reported on the decedent’s final income tax return, two special adjustments should be provided. First, to the extent that ordinary income rates apply to unrealized gain, after computing that portion of the tax liability, it would be cut in half to offset the impact of income bunching. That reduction would not apply if the tax rate were a flat rate, such as the rate applicable to capital gains. Second, all taxpayers would be permitted to reduce unrealized appreciation by a standard amount, perhaps twice the exclusion applicable to sales of a principal residence, in order to avoid imposing taxes on principal residences and very small estates.

Perhaps people were surprised or even shocked when various reports, including this Reuters article, shared the testimony of the IRS Commissioner given to the Senate Finance Committee that the tax gap approaches and possible exceeds $1 trillion annually, a substantial increase since the last official estimates in 2011 through 2013 of a $441 billion annual shortfall.

The tax gap is the difference between what taxpayers should be paying if they were in full compliance with the tax law and successful in avoiding mistakes and what taxpayers actually pay in taxes. Note that the tax gap in question is the federal income tax gap, and surely states, especially those whose tax liability computations start with federal gross, adjusted gross, or taxable income, have their own income tax gaps.

I was not surprised by the Commissioner’s testimony. In , Tax Gap Becoming a Tax Chasm, I noted that “The tax gap for calendar year 2003, the latest year for which sufficient statistical information is currently available, is $1.0417 trillion.” My guess is that the tax gap in 2018, 2019, and 2020 probably exceeds not only $1 trillion but $1.5 trillion. What does surprise me is the willingness with which authorities accept the low figures reported by the IRS. For example, in Closing the Federal Tax Gap , I noted that in 2006, three years after the Bureau of Economic Analysis had computed the $1 trillion figure, the National Taxpayer Advocate issued a report pegging the annual tax gap as “somewhere between $250 to $300 billion.” I suppose the IRS is caught between a rock and a hard place. It could report the higher number in an effort to encourage Congress to stop cutting its budget and restore its ability to ramp up audits and foster compliance. But reporting that higher number poses the risk that Congress and others would judge the IRS as unworthy of any funding by treating it as the cause of the tax gap.

Much paper, ink, and digital bytes have been dedicated to discussion of the tax gap and proposals for dealing with it. I have no intention of trying to write a treatise about the tax gap. I simply will review some of the things I have written about it over the years. In Tax Gap Becoming a Tax Chasm, I noted:

One must wonder what motivates noncompliance. Perhaps some psychologists will conduct surveys to determine if it simply greed, or a growing rebellion in which people are "voting with their feet" by appropriating unto themselves their own special tax break that they cannot get through the Congress because they lack the clout of the lobbyists who have managed to reduce the tax on capital gains to extremely low levels. How much of the noncompliance is simple ignorance, stupidity, carelessness, or confusion? How much of the gap arises from people trying to hide information about the activities generating the income?

Some people may not realize they are contributing to the tax gap, because they are making good faith efforts to comply with an absurdly and unjustifiably complex income tax system. Others know full well what they are doing when they engage in "pay cash, pay less" schemes, launder money, or simply fail to file. I suppose this reflects our culture, for surely it resembles what one finds on our highways: drivers who try to comply and succeed, drivers who are ignorant, stupid, careless and confused, and drivers who think they are so much more important than or better than everyone else that they flaunt whatever rules get in the way of their own self-centered approach to life.

A fun calculation is to determine how much tax has not been paid on the tax gaps for 2002, 2001, 2000, and earlier years, add interest and penalties, and imagine what happens if Treasury had the ability to collect the total amount due. The shock to the world economy might be staggering. We'll never know, because Treasury lacks the ability to collect even a minute fraction of this amount. Why? Because Congress has not implemented a system that ensures all taxpayers pay their fair shares.

Until Congress does two things, the tax gap will continue to grow, and the ultimate outcome might be far worse than the impact of quadrupled prices for oil and gas, shortages of concrete, or devastating hurricanes. Congress must reform the income tax system so that it is easy to understand, inviting of compliance, and difficult to evade. Congress must also put in place safeguards that prevent noncompliance and punish tax evaders. Ideally, a well-designed system that prevents tax evasion will reduce the number of tax evaders and thus reduce the need for prosecution of tax evaders. Law enforcement could then redirect more resources to the prevention of, and prosecution of, other crimes.

In Closing the Federal Tax Gap, I shared these thoughts:

The tax gap fascinates me and frustrates me. * * * I'm both fascinated and frustrated by the willingness of people to avoid their legal responsibilities. Of course, that fascination and frustration is not limited to tax avoidance devotees but also the behavior of those who violate a variety of rules and regulations.

* * * * *

[The National Taxpayer Advocate’s] report points out that when taxable transactions are properly reported to the IRS, the rate of tax collection exceeds 90 percent, but when payments are not reported compliance drops to a range of 20 to 68 percent, depending on the type of transaction. Sometimes reporting does not occur because people are noncompliant. Sometimes reporting does not occur because it is not required. * * *

[The National Taxpayer Advocate] recommends expanding the list of transactions that must be reported. This is the sort of suggestion that makes one wonder why it wasn't done decades ago. The answer is easy. As [the National Taxpayer Advocate] points out, tax revenues would climb if every taxable transaction was subject to reporting requirements. That, however, would be an onerous burden. * * *

I add that compliance is enhanced when withholding takes place, because withholding shifts the tax payment and not just information to the Treasury.

A year later, in Closing the Tax Gap Requires Congressional Introspection, I described a GAO report, "TAX COMPLIANCE Multiple Approaches Are Needed to Reduce the Tax Gap." I described the report thusly:

The report concludes that the tax gap "has multiple causes and spans different types of taxes and taxpayers." Accordingly, "Multiple approaches are needed to reduce the tax gap. No single approach is likely to fully and cost-effectively address noncompliance since, for example, it has multiple causes and spans different types of taxes and taxpayers."

Three major approaches are considered:

1. Simplifying or reforming the tax code.

2. Providing the IRS with more enforcement tools.

3. Devoting additional resources to enforcement. Minor approaches include "periodically measuring noncompliance and its causes, setting tax gap reduction goals, evaluating the results of any initiatives to reduce the tax gap, optimizing the allocation of IRS’s resources, and leveraging technology to enhance IRS’s efficiency."

The report points out that billions of dollars of the tax gap could be avoided if the tax law were simplified or fundamentally reformed. It explains, for example, that the IRS "has estimated that errors in claiming tax credits and deductions for tax year 2001 contributed $32 billion to the tax gap."

Unfortunately, the report then concludes that "these provisions serve purposes Congress has judged to be important and eliminating or consolidating them could be complicated." Even fundamental reform, in which tax preferences are limited and "taxable transactions are transparent to tax administrators," is "difficult to achieve." The report provides an almost irrefutable axiom, that "any tax system could be subject to noncompliance." Finally, it provides another difficult-to-rebut observation: "Withholding and information reporting are particularly powerful tools."

I criticized the report because it presupposed Congress as a whole does not even know what is in the tax law though some individual members are aware of whatever provision they championed. I also questioned why members of Congress caved in to the lobbyists whose clients oppose the expansion of reporting and withholding and who misrepresented attempts to increase withholding by falsely describing the effort as a “new tax.” I then explained:

Left to instinct, most people would prefer to pay no taxes, and exist as beneficiaries of others. History teaches that most of those who can grab have done so, and that many who could not exerted themselves to find ways to do so. The tax gap is a reflection of some unintentional errors and lots of intentional evasion. Careful intellectual reasoning, though, teaches us that civilization requires taxation, economic principles tell us that taxation should be efficient, common sense tells us it should be simple, and ethical principles tell us that it should be fair. It takes leadership to persuade the civilized world why it makes no sense, in the long-run, to behave in ways that generate tax gaps. Fraudulent behavior by taxpayers contributes to the tax gap. So, too, does the way in which Congress does business. Ought not the Congress take the first step in leading by example? Until the Congress understands that the way it does business encourages the non-filers, the protesters, the illegal tax shelter promoters, and the rest of the noncompliant population to act in ways that undermine the tax law and fuel the rapid growth in the tax gap, talking about closing the tax gap is not much more than rhetoric. Yes, I talk and write about it, but I've not undertaken the responsibility that members of Congress have sought and accepted. If they don't think they can or want to fix the problem, no one will stop them from returning home.

Shortly after I wrote those words, I received a letter from Senator Max Baucus, chairman of the Senate Finance Committee, and Senator Charles E. Grassley, ranking member of that committee, in which they asked for "suggestions on ways to improve compliance with our tax laws, including specific recommendations to reduce the tax gap." I described my response in Congress Invites My Ideas for Improving Tax Compliance and Of Course I Respond, and I included in that posting a copy of the letter I sent to the Congress. I do not republish it today because a quick click on the preceding link should suffice. In summary, I pointed out that a six-prong approach is required, namely, making tax education a part of high school curricula, simplifying the tax law, increasing reporting, expanding withholding, funding increased and improved audits, and strengthening the ability of the Department of Justice to prosecute tax crimes. I closed that day’s post by telling readers “I will let you know if I receive a response.” I did not. I did not receive a direct response. Nor have I seen the Congress respond by taking steps to deal with a rapidly ballooning tax gap.

Almost a decade later, in Tax Compliance and Non-Compliance: Identifying the Factors, I reacted to yet another report from the Taxpayer Advocate. The report focused on characteristics of so-called high-compliance and low-compliance taxpayers. I noted:

Some of the findings are not surprising. According to the survey underlying the report, high-compliance taxpayers are more trustful of government, appear to be more intent on minimizing mistakes on their tax returns, viewed government positively, are more likely to rely on tax return preparers, and were motivated by moral concerns and deterrence. Low-compliance taxpayers are less trustful of preparers, are less likely to follow a preparer’s advice when using a preparer, tend to think that other taxpayers have negative views of law and the IRS, are suspicious of the tax system, and are more likely to consider the tax system unfair. All taxpayers viewed the tax law as complicated.

Other findings struck me as unexpected. Low-compliance taxpayers are “more likely to participate in local organizations.” They also asserted that they had a moral duty to report income accurately. Non-compliance is higher among sole proprietors of construction companies and real estate rental firms than sole proprietors of other types of businesses.

Though the IRS explains that geographic location is not a factor in selecting returns for audit, the survey results revealed that low-compliance taxpayers were clustered in specific areas. Towns and neighborhoods near San Francisco, Houston, Atlanta, and the District of Columbia, including Beverly Hills, California, Newport Beach, California, New Carrollton, Maryland, and College Park, Georgia, were among 350 communities in which low compliance taxpayers were clustered. In contrast, very few of the 350 communities were in the Midwest or Northeast. What about high-compliance taxpayers? The top of the list consisted of the Aleutian Islands, West Somerville, Massachusetts, Portersville, Indiana, and Mott Haven, a neighborhood in the Bronx.

It did not take long for stories about the Taxpayer Advocate’s report to focus on the nature of the identified communities. For example, an MSN report noted that the low-compliance clusters were in very wealthy neighborhoods. A Yahoo news story put the conclusion in its headline, “IRS Report Shows Many of Biggest Tax Cheaters Live in Wealthy Areas.”

The Taxpayer Advocate report does not disclose whether the low-compliance taxpayers in these clusters were high-income individuals, but it is safe to assume that at least a significant number of them were. Yet what sort of conclusions can be drawn? Is it possible that most low-income taxpayers are not low-compliance taxpayers because they don’t have much income to begin with, and thus no income to hide? Is it possible that because most low and middle income taxpayers realize most of their income from wages subject to tax withholding they have far fewer opportunities to cheat on their taxes? It would not surprise me to discover that someone will argue that the wealthy do cheat more, but would reduce their cheating if their tax rates were lowered. As logical as that proposition might sound, to the extent that greed and money addiction energize every sort of tax reduction attempt, whether lobbying for special breaks and low rates or taking the cheater’s route, it is unlikely that anything other than a zero percent tax rate will satisfy these folks, and even that probably is not enough.

And then, again almost a decade later, I drew attention to a major cause of the tax gap. In Tax Noncompliance: Greed on Steroids, I described the news revealed in a report by the Treasury Inspector General for Tax Administration issued a report, High-Income Nonfilers Owing Billions of Dollars Are Not Being Worked by the Internal Revenue Service:

The news is bad.

After pointing out that the tax gap – the shortfall between what the law requires taxpayers to pay and what taxpayers are in fact paying – is estimated to be $441 billion for 2011, 2012, and 2013, the report reveals that $39 billion is due from taxpayers who fail to file tax returns. Most of this shortfall is attributable to “high-income nonfilers.” The Inspector General determined that although the IRS is developing a new approach to dealing with nonfilers, it has not yet implemented that approach, and when implemented, it will be “spread across multiple functions with no one area being primarily responsible for oversight.”

Worse, the Inspector General determined that for taxable years 2014 through 2016, 879,415 high-income nonfilers failed to pay roughly $45.7 billion in taxes. Of those 879,415 high-income nonfilers, the IRS did not pursue 369,180 of them, accounting for an estimated $20.8 billion in unpaid taxes. Of the 369,180 were not put into the queue for pursuit of the unpaid taxes and the cases for 42,601 were closed without further action. The other 510,235 of the 879,415 high-income nonfilers “are sitting in one of the Collection function’s inventory streams and will likely not be pursued as resources decline.”

Even worse, because the IRS works on each tax year separately rather than combining cases when a taxpayer fails to file for more than one year, it “is missing out on opportunities to bring repeat high-income nonfilers back into compliance.” Of these high-income nonfilers for 2014 through 2016 that the IRS failed to address or resolved, the top 100 owed an estimated $10 billion in unpaid taxes. The Inspector General has proposed seven changes to deal with these problems, but the IRS agreed in full only to two of them, partially agreed with four, and disagreed with one. The IRS objected to putting the nonfiler program under its own management structure.

Here and there a failure to file arises from an understandable problem, such as a taxpayer falling ill without anyone realizing it in time, or developing dementia or similar mental impairments. Sometimes the failure to file arises from financial setbacks for taxpayers who don’t realize that in those situations it is best to file and indicate the inability to pay. Some instances of failure to file are expressions of principled protest against specific government policies. A significant portion reflect a deep greed rooted in a taxpayer’s perception that they have no obligation to contribute to society, with the failure to file and pay almost always defended as a justified expression of the taxpayer’s anti-tax philosopy.

Is it any wonder that so many people are enraged? Though there are many ingredients fueling social unrest, an important one is the growing sense among Americans that they are fools for complying with tax laws when “high income nonfilers” are “getting away with it.” Would it be a surprise if more taxpayers choose not to file, knowing that the IRS lacks the resources to chase them down? This sort of mob mentality is no less likely to spread among taxpayers as it can spread among crowds encouraged to break other laws.

Though it is easy to suggest that Congress needs to wake up and provide sufficient funding to the IRS, especially because every dollar invested returns roughly seven, but the Congress is incapable of doing this. Enough of It is controlled by the anti-tax, anti-government crowd that it lacks the ability to do what needs to be done. Until the makeup of the Congress changes, the tax gap will persist and even increase, adding to the growing deficit that threatens to cause havoc more catastrophic than what currently afflicts the nation. The greed that is fueling the income and wealth inequality contributing to so many of the nation’s problems is growing as though on steroids, and needs to be neutralized expeditiously.

We are at a tax system breaking point. We are here because the worst offenders have persuaded the non-offenders and the minor offenders that any effort to put an end to the shenanigans of the worst offenders will produce the most harm for the non-offenders and the minor offenders. Here is a helpful analogy. Underfunded highway troopers driving vehicles that are too slow to catch the “rocket ship” drivers instead focus on the speeders who are 5, 10, or 15 miles per hour over the limit. When a proposal is made to purchase high-end chase cars for the troopers so that they can catch, ticket, and even arrest the worst speeders, the lobbyists for those “entitled to speed without restriction because of freedom, freedom, freedom” characters persuade the majority of drivers, who are either not speeding or speeding just somewhat, that the proposal will cause the authorities to arrest the compliant drivers and confiscate their vehicles. What’s evil is the lobbying message. What’s sad is the fact that it works way too often. It is time to stop worrying about the specks and to start dealing with the logs.