Spending Problem or Revenue Problem?

Much of the debate surrounding the size of the federal debt, a situation that surely poses grave danger to the nation, involves claims that federal spending is too high. On the other side, there are those, including myself, who claim that federal revenue is too low. To the anti-tax anti-government crowd, my position is unacceptable, because that group’s goal is to shrink or eliminate government. They use the debt as an excuse to advance their agenda, and considering that they helped enlarge the debt by pushing through unwise tax cuts at the same time they significantly increased military spending, it is indeed a clever and manipulative ploy.

Now comes some interesting analysis about the extent of federal revenue and spending, especially the changes that have occurred during the past 30 years. In We Don't Have a Spending Problem. We Have an Aging Problem, Kevin Drum points out some important information:

• In 1981, federal spending was 22.2 percent of GDP.
• By 2000, federal spending had dropped to 18.2 percent of GDP.
• By 2017, it is estimated that federal spending will increase to 22.2 percent of GDP.
• There have been spikes in federal spending during recessions, after which spending goes back down.
• There was a huge spike in federal spending in the 2000s due to the cost of fighting two wars, expanding Medicare, establishing TARP, and increasing spending for other domestic and defense programs.
• There was another big spike in spending as a result of the Great Recession, which was the biggest recession since the Great Depression.
• In 1981, federal revenue was 19.6 percent of GDP. By 2017, it is estimated that it will be 19.2 percent of GDP.

Drum points out that what is driving future federal spending is chiefly health care costs, in part because the population is aging. He thinks that barring a decision, to use his terminology, to immiserate the elderly, federal spending will climb to 23 or 24 percent of GDP over the next 20 or 30 years. He concludes that the problem is an “aging problem” and a “taxing problem.”

In Revenue Problem or Spending Problem?, James Joyner questioned Drum’s conclusion. Joyner’s position is that if federal spending was “the problem” in 1980 when it was 22.2 percent of a much smaller GDP, then the current problem is not a revenue problem if huge increases in the debt are taking place with a “negligibly smaller revenue share of GDP.” He notes that the budget could be balanced if spending were cut to 19.2 percent of GDP. Joyner does agree that healthcare spending is a significant factor in the analysis, suggests that there are ways to reduce healthcare spending “without immiserating the elderly,” but concludes that the massive restructuring of the healthcare system that would be required isn’t going to happen. Joyner points out that the only other “big ticket item” in the budget that could be cut is defense, that as a percentage of GDP it is almost double the comparable percentages in China, France, and the United Kingdom, that bringing it down to those nations’ percentages would almost balance the budget, but that this won’t happen considering the reaction to the possible sequestration of a much smaller piece of the defense budget. He concludes that without cutting spending, the choice is one between more revenue or more national debt.

For me, this discussion reinforces several points that I have been making over the years. First, the decision to cut federal income taxes while simultaneously increasing military spending to fight two wars contributed to the economic disaster of the last decade. I’ve made that point many times, including posts such as A Memorial Day Essay on War and Taxation, Peacetime Tax Policy While Waging War = Economic Mess, Some Insights into the Tax Policy Mess, and What Sort of War is the “Real Budget War”?. Second, there simply is no way around revenue increases to bring revenue back in line with where it was when the economy was in much better shape, before the unwise tax cuts of the last decade were enacted. I made that point in posts such as The Grand Delusion: Balancing the Federal Budget Without Tax Increases. Third, the people who want to cut federal spending need to step up and identify what would be cut, with more specificity than simply cutting a particular department or some general conceptual theme. I stressed the need for this sort of spending cut proposal transparency in posts such as Cutting Taxes + Failing to Identify and Enact Spending Cuts = Default?, Spending Cuts, Full Disclosures, Hearts, and Voices, and Taxes and Spending: Theory Meets Reality and Questions Go Unanswered.

If there is a spending problem, it’s the problem of tax breaks that are, in reality, expenditures on behalf of special interest taxpayers. If there is an aging problem, it’s that the debate between the anti-tax anti-government forces and those who appreciate the positive value of government on society has endured too long without any worthwhile outcome. If there is any problem that lies at the heart of the deficit and debt mess, it’s the revenue problem. It’s the revenue problem that was created by lowering taxes for taxpayers who promised to do wonderful things for employment and the economy and who have done nothing of the sort. If the Congress does not straighten out the tax and spending mess, and if Americans fail to pressure Congress to do what is right rather than what is politically expedient for purposes of guaranteeing re-election, the problem is going to tower over revenue, spending, and aging. It’s going to be an existentialist problem, and when enough people finally recognize it, they will recognize its causes and unfortunately realize it’s too late to turn back and fix it. This nation can do better than it has for the past decade and a half. And if it doesn’t, then we have no one to blame but ourselves.

When Is a Tax Increase Not a Tax Increase?

With all the opposition to tax increases overshadowing the needs of the nation, it is important to identify tax increases. One way of avoiding opposition to a tax increase is to claim that it is not a tax increase. Personally, I’d rather call a tax increase a tax increase and argue about why it is or is not necessary. I prefer that approach to the alternative of claiming that the tax increase is not a tax increase because it is something else.

So who would claim that a tax increase is not a tax increase? For one, the governor of Pennsylvania. Governor Corbett, according to this report, has proposed an increase in the state gasoline tax. Corbett, who ran for office with a “no tax increase” plank in his platform, explained that what he is proposing is not a tax increase. It is, he says, “merely the lifting of ‘an artificial and outdated cap’ on a wholesale tax paid by oil and gas companies. Removing the cap, in stages, will cause the oil company franchise tax to increase by 28.5 cents over five years. As a practical matter, it will show up at the pump, either totally or in part if oil companies or dealers absorb part of it.

It is easy to understand why Corbett wants to characterize the tax increase as something other than a tax increase. As I explained in If the Government Collects It, Is It Necessarily a Tax?, Corbett, who has signed the Grover Norquist anti-tax pledge, came under fire from Norquist when he proposed an impact fee on Marcellus shale drillers. Corbett knows that the wrath of Norquist will descend on him if he supports a tax increase. The irony is that Norquist surely will conclude that what Corbett is proposing is a tax increase. Not that I oppose the increase, but I think it ought to be called what it is.

The lifting of a cap on a tax is a tax increase. There’s no way around that conclusion. Many years ago, when federal income tax rates were very high, there was a maximum rate on earned income. Here’s the 1972 Form 4726 and instructions, for those who are curious or bored and need something to read. When that provision (section 1348) was repealed, it was because the regular rates were reduced and the maximum rate limitation was no longer required. If the maximum rate had been repealed while the regular rates were unchanged, taxpayers with earned income above the appropriate level would have encountered a tax increase.

There are some who argue that if a rate is left unchanged, there is no tax increase. That, of course, is not true. Suppose a state with a food and clothing exemption to the sales tax repeals the exemption. Almost everyone will pay more sales tax. Eliminating the exemption, without changing the sales tax rate, generates a tax increase. Thus, removing the cap on the oil company franchise tax is a tax increase.

Corbett not only wants to remove the cap, which makes sense at a time when Pennsylvania’s transportation infrastructure is falling apart, but he also wants to reduce the liquid fuels tax by 2 cents from its current 12 cents per gallon rate. This would cushion the impact of the cap removal, but it also reduces the funds available to deal with the state’s four thousand – yes, four thousand, not four hundred – structurally deficient bridges and its more than 10,000 miles of below-standard highways, up from 7,500 miles six years ago. Despite inflation and the continuing deterioration of its roads, Pennsylvania has not raised the liquid fuels tax since 1997, more than 15 years ago.

What often gets overlooked is that if the funds available to repair highways and bridges increase, construction contractors will have more jobs to do and thus will need to hire workers. With all the talk about job creation, here’s something that, unlike tax cuts for the ultra-wealthy, actually creates jobs. But don’t call it a tax increase. The people who claim they want to see an increase in jobs will oppose the very thing that will create jobs. So it’s understandable why Governor Corbett is trying to do linguistic gymnastics by finding some other way to describe a tax increase.

Tax Ignorance As Persistent as Death and Taxes

Sometimes tackling tax ignorance appears to be as pointless a task as trying to shovel all the sand off a beach. Every time I blink, I read or hear some manifestation of tax ignorance that erodes my confidence that this nation can get its tax policies in order. If I wrote a commentary for every bit of tax ignorance that I encounter, I would set a record for the number of blog posts. As it is, I’ve returned time and again to this democracy-threatening condition, in posts such as 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, More Tax Ignorance, With a Gift, Tax Ignorance of the Historical Kind, A Peek at the Production of Tax Ignorance, When Tax Ignorance Meets Political Ignorance, Tax Ignorance and Its Siblings, and Looking Again at Tax and Political Ignorance.

Several days ago, in reading this letter to the editor of the Philadelphia Inquirer, I was reminded how herculean a task it is and will continue to be, to purge America of the tax nonsense that feeds on tax ignorance. The letter writer argued:

With the federal government (over half of its budget being military) hard-pressed for revenue, programs have been cut that once funded states. State budgets are then cut, forcing schools and municipalities to raise property taxes. So, if you are a fan of the military-industrial-congressional complex, you're also a fan of higher property taxes. Money that should fix potholes is going for bombs.

The errors in this letter jumped out at me.

First, although I am no fan of the decision to increase military spending to fight two wars without raising taxes and simultaneously cutting taxes, it simply is not true that “over half of [the federal government’s] budget [is] military.” In 2012, military spending accounted for roughly 20 percent of federal spending. Defense spending has not been at or above 50 percent of the federal budget since before 1962.

Second, when the federal government cuts funding to states, it almost always is cutting a federal program that is administered by the state. In most instances, the state does not make up the difference by cutting other state programs. In most instances, the federal program administered by the state ends up shrinking.

Third, when state budgets are cut, local municipalities and school districts may or may not be impacted. They are, if the state legislature decides to reduce funding to localities and school districts as part of the budget cutting. State budget cutting occurs for a variety of reasons, including reduction in state tax revenues and political decisions to cut state government spending as a matter of economic philosophy. Blaming federal government cuts to federal programs administered by states for reduction in state funding of local municipalities and school districts is a matter of ascribing universality to an incidental situation.

Fourth, property taxes are raised for a variety of reasons. Property taxes, however, are used for the most part to fund schools, local police, local trash and recycling, local zoning code enforcement, and the maintenance of local roads. Most potholes occur on major roads, such as state and federal highways, because, as explained in this article, the number of potholes is pretty much proportional to the volume and weight of traffic. The cost of fixing potholes on federal and state highways is funded by liquid fuels and similar taxes, not property taxes.

Fifth, money being collected from liquid fuels taxes is not being diverted into federal military spending. It is being used to repair roads. The problem is that there isn't enough money being collected from liquid fuels taxes.

In addition to these issues, the letter writer assumes that if federal military spending is cut, local property taxes would be cut. That’s not going to happen. It isn’t going to happen because the presumed chain of connection imagined by the letter writer doesn’t exist, nor does its opposite-direction counterpart exist. It also isn’t going to happen because if federal military spending is cut, it will be as a deficit-reduction measure, and will not trigger increases in funding to states.

The letter-writer’s approach to tax issues reflects a conflation perspective that afflicts too many Americans. How often does one hear or read a reference to “the government”? When I hear that phrase in a conversation, I ask, “Which government? Federal? A particular state? A particular county? A township?” There are multiple governments, they act independently, they often act inconsistently, and although influenced by each other, they make their own decisions. There is no one “the government.” Similarly, too many people think that tax is tax, and fail to grasp the peculiar characteristics of different taxes, including which jurisdiction imposes them, how they are computed, and the extent to which their revenues are dedicated to specific purposes. There is no one “the tax.”

This conflation gets in the way of solving the nation’s problems. Yes, there are potholes that need to be repaired, and this problem is part of a larger transportation infrastructure challenge. If potholes are to be fixed, road funding needs to be fixed. That’s a different issue from federal military funding, and the solution to the road, bridge, and tunnel funding needs has been discussed in Tax Meets Technology on the Road, Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, Change, Tax, Mileage-Based Road Fees, and Secrecy, Pennsylvania State Gasoline Tax Increase: The Last Hurrah?, Making Progress with Mileage-Based Road Fees, Mileage-Based Road Fees Gain More Traction, Looking More Closely at Mileage-Based Road Fees, The Mileage-Based Road Fee Lives On, Is the Mileage-Based Road Fee So Terrible?, Defending the Mileage-Based Road Fee, and Liquid Fuels Tax Increases on the Table.

Looking Again at Tax and Political Ignorance

A little more than a week ago, in Tax Ignorance and Its Siblings, I lamented the adverse impact that ignorance has on the nation’s political system and its tax system. My visit to this topic was just the latest in a long series of reactions to tax and political ignorance, in posts such as 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, More Tax Ignorance, With a Gift, Tax Ignorance of the Historical Kind, A Peek at the Production of Tax Ignorance, and When Tax Ignorance Meets Political Ignorance.

Today I return to this topic because I’ve been made aware of a new study from the American Political Science Review. According to this article, the authors of “Sources of Bias in Retrospective Decision Making: Experimental Evidence on Voters’ Limitation in Controlling Incumbents” have shared the outcome of their exploration of voter decisions. One description of the study says it “has thrown doubt on the ability of the average voter to make an accurate judgment of the performance of their politicians, showing that voter biases appear to be deep-seated and broad.” According to the study, voters ignore cumulative incumbent performance because they focus on the most recent performance of incumbents, voters are distracted by “rhetoric and marketing,” and voters often vote against incumbents because of events not within the control of the incumbents.

None of these findings surprise me. When the authors explain that voters lack attention spans sufficient to analyze an incumbent’s entire record, it simply reminds me of what an older student told me some years ago when I was struggling with understanding why students could not sustain analysis through a multi-step tax checklist. “Professor,” he said, “understand you are dealing with the MTV generation. We don’t stay focused on much of anything.” I see evidence of this almost every hour, and not only is it sad and unfortunate, it’s dangerous in many ways. When the authors point to the effect of “rhetoric and marketing,” I think of my statement in Tax Ignorance and Its Siblings, “To me, it seems that those who don’t stand a chance of prevailing when the facts are accepted try to win by twisting, distorting, or hiding the facts, using misinformation as one of their tools.” And, of course, blaming incumbents for things beyond their control, while absolving them of responsibility for what they have mismanaged, is a classic symptom of what the authors kindly call “irrational behavior.”

The author of the article describing the report suggested that the using the term “irrational” is “a nice way of refraining from calling them ‘stupid’.” They conclude that the report “is perhaps a reminder that voters are not blameless and bad choices don’t exist in a vacuum.” There is no better proof than the fact that approval ratings for the Congress are in the single digits and yet incumbent after incumbent is sent back to Washington to do more of the same. In professional sports, when the team isn’t playing well, rosters experience turnover. There’s a lesson there.

The study’s conclusion is disheartening. The authors conclude that incumbents can get themselves elected by associating themselves with good news for which they ought not take credit because they are not responsible, support policies that generate good news for their districts even if they are bad for the nation, and to use rhetoric to distract voters from the incumbents’ histories. Ever wonder why so much junk ends up in the tax law? Though it has been said that crime does not pay, it appears that propaganda works. No wonder there is so much ignorance.

Another “Flat Tax” Proposal That Falls Flat

I suppose it’s expecting too much to discover that there are points on which all people can agree. After all, there still exists a Flat Earth Society. So it ought not be a surprise that the advocates of the “flat tax solves all problems” myth persist in trying to persuade the rest of us that a flat tax will solve the federal budget problem while making the federal income tax as easy as filling out a postcard. This is not the first time that I have described the failings of the flat tax movement. I did so, to cite a few posts, in The Flat Tax Myth Won’t Die, Fighting Tax Ignorance, Flat is Not Simple, At Least Not with Taxes, and The Revived Forbes Flat Tax Plan.

Earlier this week, in The 12% Revenue Solution, Prof. Michael Busler added his reasons for proclaiming the flat tax as the savior of all things financial, economic, and budgetary. He contends that replacing “the tax code with a single-rate of 12 percent on all income above a livable minimum, with absolutely no deductions” would raise $2.5 trillion in additional revenue over a ten-year period. He claims that this approach would “please . . . Republicans who want tax rates as low as possible.” He also claims it would make “the economy grow at a more rapid pace” and “creat[e] numerous entry-level positions for young people.” He explains that to determine tax liability, a taxpayer would “simply add up her income from every source, subtract the livable minimum, and then multiply the balance by 12 percent.”

Flat tax advocates are big on theory and fall short on practical application. Nowhere does Prof. Busler define income. Students in the basic federal income tax course invest several classes and a few hours outside of class dealing with the question, “What is income?” Nowhere does Prof. Busler address exclusions. Under current law, gifts are income but are excluded from gross income. Do flat tax advocates plan to remove all exclusions? Is it any less complicated to administer a tax system in which gifts are included in gross income? What about scholarships? What about inheritances? What about life insurance proceeds? If they retain that exclusion, the complex question of what constitutes life insurance proceeds remains.

What does Prof. Busler think will happen if the section 121 exclusion is eliminated? Taxpayers who are required to pay tax on the gain realized from the sale of their principal residences will be compelled to “downsize” because of the liquidity issue that is the reason for section 121 being in the tax law. And if section 121 is retained, it will continue to contribute to the complexity of tax law. What is the principal residence? What is use? What is ownership? How are surviving spouses treated? What happens if there was business use of the home? And so on.

Speaking of gains, how would they be computed? Would basis and adjusted basis be retained? If so, how does the complexity contributed by basis issues diminish or disappear?

Consider deductions. Prof. Busler suggests eliminating all of them. Does that include business deductions? He refers to “business profits” as a type of income but how are business profits computed? Answering that question adds all sorts of complexity to the tax law. Keep in mind that being employed is a business, and there are employee business deductions. Does he propose eliminating those? And what of the alimony deduction, designed to prevent double taxation of alimony payments. By eliminating deductions, Prof. Busler would remove the deduction for investment losses. Is that what he truly intends?

To the extent that deductions are eliminated, even if some of them remain, taxpayers will increasingly turn to nonrecognition provisions, and to the use of timing techniques. Nowhere does Prof. Busler address those issues. Both types of provisions are responsible for a significant amount of tax law complexity. Removing the like-kind exchange nonrecognition provision would afflict businesses with liquidity and compelled down-sizing issues similar to those arising from repeal of the section 121 exclusion.

When Prof. Busler suggests a “livable minimum,” he simply suggests it could be one dollar amount per adult and a lower dollar amount per child. But who gets to claim which child? The determination of who is a dependent child for which adult is one of the most vexingly complicated issues facing substantial numbers of taxpayers. Prof. Busler provides not a whisper of how his “livable minimum” is less complicated that current law, let alone how it would create jobs or raise revenue.

Whether the proposal that Prof. Busler offers in fact would raise revenue cannot be determined, because there is a total lack of information on how “income” would be computed, which exclusions, if any, would be eliminated, which deductions, if any, would be retained, how installment sales would be treated, and so on. If it did raise revenue, it would meet objections from the anti-tax crowd because they are opposed not simply to high rates, but to revenue increases. So on that score the proposal falls down.

Prof. Busler ends his commentary with a question. He asks, “who could possibly oppose such a plan?” My answer is, “I do.” And I would guess that many tax professionals, honed on the tax law and tempered by the experience of working with tax clients and preparing tax returns, would also object. And I would guess that many other professionals would raise the same concerns and criticisms.

The flaw with flat tax plans is that most of them are offered by people who have little practical on-the-ground experience with the reality of taxation. Philosophical concepts make for interesting chats at dinner, but they are useless without practical details. Yes, the devil is in the details, which is why a flat tax proposal in the form of “here is what the Internal Revenue Code would be” would be far more instructive and valuable than simplistic sound bites. I’m looking forward to seeing the Prof. Busler version of the Internal Revenue Code. Only then does his conceptual idea stand any chance of finding defensible support.

Tax Law Warning: Don’t Cut Mom a Rent Break

When I teach section 280A, I point out to students the necessity of reading section 280A(d) very carefully. Section 280A(d) specifies rules for counting days of personal use of a residence, too many of which trigger the section 280A(a) limitation on the deduction of expenses related to the residence. I draw their attention to the provision in section 280A(d)(2)(A) that attributes a family member’s use of a residence to the taxpayer. The example I use involves a taxpayer who carefully arranges to use a vacation residence for one fewer than the number of days that would trigger the limitation, only to discover that one weekend late in the year one of the children took his or her friends to the place for a two-day party. I also focus their attention on the provision treating rental of a residence for less than fair rental as personal use by the taxpayer. Because of time constraints – one can do only so much in a three-credit course – I do not invest classroom time in the exploration of section 280A(d)(3), which provides that a taxpayer is not treated as using a residence for personal purposes by reason of a rental arrangement for any period if for that period the residence is rented at fair rental to any person for that person’s use of the residence as the person’s principal residence.

In a recent case, Langley v. Comr., the taxpayers discovered that being nice to the wife’s mother was an tax-foolish decision. The taxpayers purchased a single-family residence with the intention of remodeling it and then selling it at a profit to finance their children’s college educations. Unfortunately, by the time the taxpayers finished the renovations in 2008, the real estate market had taken a major downturn, and they were unable to sell the residence. So the taxpayers decided to let the wife’s mother live in the property while they continued to try to find a buyer or a renter. The mother agreed to move out immediately if a buyer or renter were found. By the time of the Tax Court trial, the mother was still living in the residence. No lease agreement was signed by the parties. The taxpayers did not obtain a rental license from the local government, nor did they advertise the property for rent during 2008.

The taxpayers claimed that they charged the mother $600 per month in rent. When doing the renovations, the taxpayers had obtained appraisals of comparable properties in the area, which included information indicating that average market rents for comparable properties ranged from $800 to $1,100 per month. The taxpayers testified that the monthly mortgage payment on the property was $928.

On their federal income tax return for 2008, the taxpayers did not report rental gross income, but deducted utilities, taxes, repairs, mortgage interest, insurance, cleaning, maintenance, auto and travel, and advertising expenses. The taxpayers, using TurboTax software, limited their total rental loss to $25,000 under section 469(i).

The IRS argued that the taxpayers had not demonstrated that the mother paid any rent at all. The Tax Court concluded that even if she did pay the amount the taxpayers claimed she paid, that amount was not a fair rental. After explaining that the determination of a fair rental is a question of facts and circumstances of each particular case, the Tax Court concluded that $600 was “significantly lower” than the average monthly rent of $800 to $1,100 reported in the appraisals. The taxpayers argued that the appraisals were done before the real estate market downturn, and that comparable rents were closer to $900 per month. The Tax Court concluded that even if that were the case, the rent charged to the mother “was still significantly lower” than comparable rents in the area. Accordingly, the mother’s use was treated as the taxpayers’ use, the exception in section 280A(d)(3)(A) did not apply, and section 280A(a) disallowed all deductions, although section 280A(b) permitted the taxpayers to deduct real estate taxes and mortgage interest. Although the Tax Court did not so state, the numbers suggest that the section 280A(c)(3) exception permitting deduction of other expenses was limited by the section 280A(c)(5) limitation because the real estate taxes and mortgage interest exceeded the rent allegedly paid by the mother.

The taxpayers made what appeared to them to be a sensible decision. Rather than leaving the residence vacant and thus more likely to be vandalized or otherwise damaged, they asked the wife’s mother to move in. Perhaps they charged her rent. It is unclear, but perhaps they asked her to pay the rent that she had been paying wherever she had been living. In return, she would have a presumably more spacious place to live. It is quite possible that at no time did tax law concerns cross the taxpayers’ minds, and it appears that they were not getting professional tax advice. Yet as I tell my students, tax law is everywhere, and there is little that one can do that does not have a tax consideration hanging over it. As unkind as it sounds, avoiding adverse tax consequences required the taxpayers to tell the mother that they were going to charge her full market rent.

Tax Planning: A Chore That Never Sleeps

Six years ago, I had the opportunity to review Julian Block’s "Year Round Tax Savings," and shared my thoughts in Another Tax Book for Tax and Non-Tax People to Read (Feb. 2007). Now, Julian has published an updated version of this helpful guide to tax planning, renamed “Julian Block’s Tax Tips for Year Round Savings.” As usual, he has done his typically fine job with the topic.

The world of tax handbooks is replete with guides to year-end tax planning. Too often, people and businesses wait until December and then engage in frantic efforts to rearrange transactions to reduce tax liability for the year. Unfortunately, there is only so much that can be done in December. The other eleven months of the year provide opportunities that fade away as the page on the calendar turns to the next month. For some planning opportunities, actions must begin in January if the opportunity is to be maximized.

Julian begins by explaining why tax planning is important, and illustrates the parameters that apply to the process. Though tax professionals might find this explanation to be quite familiar, the typical taxpayer without a tax practice background almost certainly will benefit by reading this chapter. Where there are opportunities to make year-end decisions that make use of available deductions or that reflect the impact of the decision, Julian examines those situations. For example, he explains why two people considering marriage should run the numbers when deciding on a December or a January wedding date.

Julian recommends keeping track of potential itemized deductions during the year so that by the end of the year decisions can be made more sensibly in terms of the timing of payments that can be made in December or January. Sometimes it makes sense to postpone a deduction and sometimes it makes sense to accelerate it. He points out that in many years more than half a million taxpayers claimed the standard deduction even though they would have reduced taxable income had they itemized their deductions. Julian then devotes chapters to each of the major itemized deductions, giving coherent explanations even of the complicated ones such as the medical expense deduction and the charitable contribution deduction.

Julian also examines how to plan for income. There are times when it makes sense to accelerate income into the current year and times when it makes sense to postpone it. However, making the timing decision stand up to scrutiny often requires making arrangements long before December. Julian deals with the opportunities for both the employee and the self-employed individual. He then examines investment income and discusses investment strategies available to taxpayers.

Gift tax planning and dealing with inherited property also get attention from Julian. He also explains how to compute a taxpayer’s “real tax bracket,” a lesson that needs to be learned by the taxpayers who confuse nominal marginal rate with effective rate. His subchapter on “Taxpayer Illiteracy” reminded me of some of the commentary I’ve shared on MauledAgain. He shares my concern that most people do not understand the difference between a deduction and a credit, the meaning of progressive tax, and a variety of other important basic tax concepts. Julian explains why these things are important and why taxpayers should attempt to learn about them. And then his book proceeds to provide a capsule summary of how the overall tax system works, with an eye to helping people take advantage of the year-round planning tips.

After exploring the alternative minimum tax, another concept most taxpayers don’t understand, Julian closes the book with a three-pronged conclusion. He returns to the importance of making tax planning a year-round job, provides suggestions for where and how to get tax advice and to learn more about taxation, and advocates leaving a “letter of final instructions” to help survivors make sense of the decedent’s tax, investment, financial, and other situations.

I recommend this book just as I recommended Julian’s previous books, "MARRIAGE AND DIVORCE: Savvy Ways For Persons Marrying, Married Or Divorcing To Trim Their Taxes - And They’re Legal," which I reviewed in Tax and Relationships: A Book to Read and Give (Feb. 2006), "THE HOME SELLER’S GUIDE TO TAX SAVINGS: Simple Ways For Any Seller To Lower Taxes To The Legal Minimum," reviewed in A New Book on Taxation of Residence Sales: Don't Leave Home Without It (Aug. 2006), "TAX TIPS FOR SMALL BUSINESSES: Savvy Ways For Writers, Photographers, Artists And Other Freelancers To Trim Taxes To The Legal Minimum," reviewed in A Tax Advice Book for People Who Write and Illustrate Books (Dec. 2006), "Year Round Tax Savings," reviewed in Another Tax Book for Tax and Non-Tax People to Read (Feb. 2007), "Travel and Moving Expenses: How To Take Maximum Advantage Of Every Tax Break The Law Allow," reviewed in Tax Travels and Tax Moves: Book It with Block (Sept 2007), "Ultimate Tax-Saving Resource '08," reviewed in Helping Tax Clients Understand Taxes (June 2008) and "Julian Block’s Tax Tips for Marriage and Divorce," reviewed in Julian Block Talks Tax with Married, Divorced, and Other Couples (Jan. 2011), “Tax Deductible Travel and Moving Expenses: How To Take Advantage Of Every Tax Break The Law Allows!,” reviewed in Julian Block: On the Road Again (July 2011), and “Julian Block’s Easy Tax Guide for Writers, Photographers, and Other Freelancers,” reviewed in A Tax Book for Writers (and Others) (Oct 2011).

A Tax Question: So What Do You Do With Your Time?

One of the pieces of advice that I give to newly enrolled law students is that they should budget their time. The demands of law school are substantial, and students who don’t pay attention to how they are using their time can easily find themselves with more to do than there are hours remaining before a deadline. I explain that there are 168 hours in the week, that they need to allow themselves 70 hours a week to sleep, eat, and tend to personal concerns, that they need roughly 15 hours for classroom attendance, and roughly 45 hours outside of the classroom to prepare for class and to assimilate what they have learned. That leaves 38 hours, which might sound like a lot, but it can disappear quickly. It doesn’t take too many outings to sports events and bars, television viewing, and general time wasting to burn through 38 hours.

Many people would consider this advice to be, at best, sensible for law students and perhaps other students but useless or unhelpful for everyone else. Yet time management is a skill required in many professions and occupations. Keeping track of how much time is required for assorted tasks and projects and how much time is available is a critical aspect of planning.

A recent Tax Court decision, Hudzik v. Comr., T.C. Summary Op. 2013-4, demonstrates not only the importance of keeping time records but also the value of budgeting time allocation. The issue in Hudzik was simple. The taxpayer deducted losses from rental real estate activities, asserting that the passive loss limitations did not apply because she was a real estate professional. Under section 469(c)(7)(B), a taxpayer is a real estate professional if two conditions are satisfied. First, more than one-half of the personal services performed in trades or businesses by the taxpayer during the taxable year must be performed in real property trades or businesses in which the taxpayer materially participates. Second, the taxpayer must perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

The parties stipulated that during the taxable years in issue, 2006 through 2008, the taxpayer worked 1,650 hours each year as a full-time treaty manager for a corporation, and commuted 64 miles each way between her residence and the office. The taxpayer, with her husband, owned two rental properties, one in New Jersey and the other in Florida. According to the Court, the taxpayer

introduced [into evidence] three logs reflecting the amount of time she purportedly spent on rental real estate activities during each of the years at issue. The logs do not indicate when they were prepared, and every activity listed on the logs is either “Craigslist/email/responses” or “Craigslist/email/responses/open house.” The logs have a column in which [taxpayer] identified the property and the activity performed. Some of the time entered on the logs is listed as spent on “Cranford/Florida,” and does not break down how much of the time entered was spent on each property.

The taxpayer contended that during the three years in issue she spent, respectively, a total of 1,942.25 hours, 1,790 hours, and 1,680.75 hours on real estate activities.

The Court rejected the taxpayer’s assertion that she qualified as a real estate professional, relying on two rationales. The Court concluded that the taxpayer had “failed to provide any underlying documentary evidence to substantiate the hours reflected in the logs.” The Court also concluded that “the hours reflected in the logs [are] implausible, given that [taxpayer] already worked 1,650 hours per year at [her corporate job] and would have had to spend almost all her remaining time working on the rental properties.” When I read the latter statement, I wondered, is it possible to put in the number of hours that the taxpayer claimed she invested in her trade or business activities? The answer would not affect the outcome in the case, because the taxpayer had failed to substantiate her claim, but the answer matters for a taxpayer who can substantiate those sorts of hours. If the hours are substantiated, it ought not matter that the hours consume a substantial portion of the taxpayer’s time. In Hudzik, the taxpayer’s claim, if accepted, would indicate that she spent a total, for each of the years respectively, of 3,592, 3,490, and 3,331 hours on trade or business activities. That’s roughly 70 hours per week. More than a few people work 70 hours per week. There are people who hold down two full-time or near full-time jobs to make ends meet. My advice to law students suggests that they invest 60 hours per week in their educational activities, and they still have 38 hours to allocate prudently after allowing 70 hours for sleeping and eating, etc. Most people who work 70 hours a week sleep fewer than eight hours a night, and so they could still end up with 38 hours or more each week to devote to activities other than sleeping, eating, and working. The hours claimed by the taxpayer in Hudzik are far from impossible, but those hours needed to be proven and they weren’t.

An interesting exercise for almost anyone is to sit down and figure out how they use the 168 hours that we have available each week. Time flies, and the question, “Where did the time go?” is an oft-repeated one. Sometimes the answer matters for tax purposes. But tax aside, the answer matters for a variety of other reasons. It’s a fun exercise. I’ve done it several times a year or more ever since I started high school. No, I’m not going to share the results.

Tax Ignorance and Its Siblings

There’s just something about ignorance that disturbs me. It always has. Even as a very young child, it bothered me more than just a little bit when someone spouted nonsense or shared misinformation. It did not matter whether it was an adult, such as several of my elementary school teachers whose cluelessness bewilders me even to this day, or a child. The harm that is generated by ignorance can be devastating. Unquestionably my exposure to ignorance from every direction was a significant factor in my decision to become a teacher.

My reaction to ignorance has remained the same over the years, but something has changed. Either I’ve become more adept at spotting ignorance or the extent of ignorance has increased significantly in the past few years. I understand that modern communications technology and social media give ignorance a wider audience, but I would also expect a wider dissemination of factually accurate information that left ignorance with its traditional percentage share of the information pool. Instead, it seems as though ignorance has been claiming an ever-increasing share of the attention and is crowding out good information.

Because my major area of professional interest is tax, I’ve focused on what I call tax ignorance. I’ve returned time and again to the problems caused by tax ignorance, looking at this issue in posts such as 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, More Tax Ignorance, With a Gift, Tax Ignorance of the Historical Kind, A Peek at the Production of Tax Ignorance, and When Tax Ignorance Meets Political Ignorance.

Tax ignorance, of course, is but one part of political ignorance, as I explored in When Tax Ignorance Meets Political Ignorance. But political ignorance, it seems to me, is just one aspect of an even wider affliction, namely, the predisposition of humans to wallow in ignorance of every kind. It seems as though tax ignorance is just one child of this phenomenon and that it has many brothers and sisters, including historical ignorance, political ignorance, medical ignorance, nutrition ignorance, and so on. The problem is more than just the complexity of tax law, and the solution is more than just the tax education that I advocate.

Two commentaries recently brought to my attention highlight the ignorance epidemic. Both illustrate why those interested in a specific area of study can benefit from exploring research in other areas.

In Why Think By Numbers?, Mike P. Sinn explains why ignorance is so prevalent. When I read the article, my first thought was that he was saying what I’ve said for years, though I don’t take credit for what had been explained to me years ago. Though I cannot condense Sinn’s article into several sentences and urge everyone to read it, the short version is that the limbic system refuses to yield gently to the brain’s reasoning system. That’s why people tend to vote for candidates based on things like looks, why people repost goofy things such as the “reverse ATM pin brings police” and “five Mondays/Tuesdays/Wednesdays in one month happens only every 823 years” nonsense, why people cling to ineffective strategies, and why people have all sorts of absurd ideas about the details of federal spending and how the tax law works.

In Clive Thompson on How More Info Leads to Less Knowledge, Clive Thompson explores how, despite gains in scientific understanding and growth in the accumulation of facts, ignorance is increasing. Thompson cites Robert Proctor, a historian of science, who focuses on “the study of culturally constructed ignorance.” Proctor even has a word for the study of this phenomenon. It is agnotology. Proctor has concluded that the cause of this ignorance increase is the effort by special interests “to create confusion.” He contends that the information revolution has met the disinformation revolution. His examples include efforts by the oil and automobile industries to “carefully seed doubt about the causes of global warming” and by the tobacco industry to “link lung cancer to baldness, viruses – anything but their product.” Put another way, there are people who want humans to be ignorant. Thompson notes that the recent economic collapse was attributable to the marketing of financial instruments designed to hide their underlying components, blinding investors and crippling financial institutions.

Thompson notes that the journalist Farhad Manjoo distinguishes between arguing about the meaning of facts, which constitutes a debate, and arguing about what the facts are, which is an “agnotological Armageddon.” To me, it seems that those who don’t stand a chance of prevailing when the facts are accepted try to win by twisting, distorting, or hiding the facts, using misinformation as one of their tools. Though the person who started the “five Mondays/Tuesdays/Wednesdays in a month only once every 823 years” or “reverse ATM pin calls police” silliness may have been seeking no more than a practical joke, the folks who deal with serious issues by spreading out-of-context quotations and outright lies, or circulating doctored photographs and altered audio recordings, are dedicated to one thing and one thing only, and that is success through deceit. They belong to a tradition that reaches back a very long time. It started with the words, “You will not die; for God knows that when you eat of it your eyes will be opened, and you will be like God, knowing good and evil.” How did that work out?

Transportation Infrastructure Funding: Tax and Spending Policy Hypocrisy?

On Friday, in How Not To Pay for Transportation Infrastructure, I criticized the proposal made by the Governor of Virginia to shift the cost of transportation infrastructure construction, maintenance, and repair from users to the general public. It turns out that the idea of shifting transportation costs from users to others is not just an idea, but a practice that is rampant across the nation.

Late last week, the Tax Foundation released a report, whose title, “Gasoline Taxes and Tolls Pay for Only a Third of State & Local Road Spending,” pretty much says it all. The report makes the point that “funding transportation out of general revenue makes roads ‘free,’ and consequently, overused or congested – often the precise problem transportation spending programs are meant to solve.”

It is puzzling that the same folks who object to free riders in so-called entitlement programs, even when the beneficiary is not a free rider, object vociferously to doing anything to increase the ever-diminishing share of transportation infrastructure costs borne by the users. Why is it acceptable for transportation infrastructure users to free ride on the highways? Could it be that most anti-entitlement-program and anti-tax people are transportation infrastructure users who delight in letting someone else bear the burden for them? What is so horrible about requiring users of a resource to pay for that use? Considering that doing so would permit reduction of taxes that put revenue into general funds, because transportation infrastructure needs would no longer be pulling money out of those general funds, is it really all that unacceptable to follow the same principles that underlie the objections made to so-called free-riding entitlement program beneficiaries? Is there some hypocrisy at work when it comes to who pays and who benefits?

How Not To Pay for Transportation Infrastructure

The governor of Virginia has presented a plan for funding transportation infrastructure in his state. For those who think that infrastructure users should pay in proportion to their use of transportation facilities, the plan appears to advance the opposite approach.

According to this report, Virginia’s governor wants to eliminate the gasoline tax, increase the general sales tax, and impose a fee on alternative fuel vehicles. He would leave in place the tax on “diesel gas,” which I assume refers to “diesel fuel.”

The message I take from this plan is as follows. If you drive a pollution-reducing, energy-efficient alternative fuel vehicle, you will pay. If you drive a diesel vehicle, you will pay. If you drive a gasoline vehicle, you are off the hook. Then, all residents, whether or not they are drivers, along with people visiting from out-of-state even if they arrive by air or rail, will pay additional taxes on their taxable purchases to fund transportation infrastructure in the state. Though a person who purchases a television has had the benefit of transportation infrastructure because the television was delivered to the store by truck, it is more efficient to impose transportation costs on the users of the infrastructure, who can then pass the cost onto the consumer. In this manner, the person using transportation infrastructure for personal purposes, having no customer onto whom the cost can be shifted, bears the burden of using the roads and bridges. Why should that person’s cost be shifted to someone who is not using those transportation facilities? Why should drivers of diesel-fueled vehicles, which are in many ways more efficient than gasoline-fueled vehicles, bear the burden of both a fuel tax and an increased sales tax? Why should the drivers of alternative-fueled vehicles be hit with a fee and an increase in the sales taxes that they pay? The plan advanced by the governor of Virginia fails from almost every sensible perspective.

The governor’s rationale for subjecting alternative-fueled vehicles to a fee is that they don’t pay gasoline taxes. But if the gasoline tax is repealed, then no one in Virginia would be paying the gasoline tax. So why not impose the fee on all vehicles? Could the fee on alternative-fueled vehicles be intended to squelch the purchase of these vehicles? Surely purchasers of these vehicles are not being exempted from the proposed increase in the general sales tax rate.

The governor’s statement, “But we cannot let another session be lost as each member holds out for their perfect plan,” presumes that all imperfect plans are the same because they all share the quality of not being perfect. Yet there are degrees of imperfection, and the plan with the least amount of imperfection is, of course, the mileage-based road fee. I have been explaining, analyzing, and advocating that fee for more than eight years, in posts such as Tax Meets Technology on the Road, Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, Change, Tax, Mileage-Based Road Fees, and Secrecy, Pennsylvania State Gasoline Tax Increase: The Last Hurrah?, Making Progress with Mileage-Based Road Fees, Mileage-Based Road Fees Gain More Traction, Looking More Closely at Mileage-Based Road Fees, The Mileage-Based Road Fee Lives On, Is the Mileage-Based Road Fee So Terrible?, Defending the Mileage-Based Road Fee, and Liquid Fuels Tax Increases on the Table.

In Liquid Fuels Tax Increases on the Table, I concluded that “If governors and legislators cannot bring themselves to step into the twenty-first century when it comes to maintaining the common weal, then they at least need to summon the courage required to raise the gasoline tax and prevent an ever-increasing parade of catastrophes.” It’s as though Virginia’s governor read that sentence and decided to do the opposite.

Still More Joys of IRC Section 86

More than eight years ago, in The Joys of IRC Section 86, I explained the convoluted manner in which Congress has specified that taxpayers determine how much, if any, of their social security benefits are subject to federal income taxation. A little more than four years ago, in More Joys of IRC Section 86, I explored the impact of state income tax refunds on the section 86 computation, and the additional complexity it layered on an already unnecessarily complicated process.

Now a case decided earlier this month, Brady v. Comr., T.C. Memo 2013-1, provides a glimpse into yet another complicating factor in the computation of social security gross income. The taxpayer developed hip and knee problems and was unable to continue working. He had a disability policy, and in 2005 the insurance company began making payments to the taxpayer under the policy. The payments were properly excluded from gross income. The taxpayer’s contract with the insurance company required the taxpayer to seek Social Security benefits in the event of disability. To the extent the taxpayer received Social Security disability payments, the insurance company would correspondingly reduce the payments it was making to the taxpayer. The taxpayer applied for Social Security benefits, but was denied. He appealed, and again was unsuccessful. By 2008, the taxpayer managed to obtain an administrative hearing, and the judge determined that the taxpayer was disabled. The judge awarded the taxpayer Social Security benefits determined as of the time of his original 2005 appplication. Accordingly, in 2008, the taxpayer received a lump-sum payment of $76,350 for social security disability benefits from June 2005 through June 2008, plus $10,742 in disability payments for the remainder of 2008, for a total of $87,092. In compliance with the insurance company contract, the taxpayer reimbursed the company $73,042 in September 2008.

On the taxpayer’s 2008 federal income tax return, prepared by a professional who was both a lawyer and a CPA, social security benefits of $14,050 were reported. This amount was computed by subtracting the $73,042 reimbursement made to the insurance company from the $87,092 paid to the taxpayer by the Social Security Administration in 2008. The IRS audited the taxpayer’s return and issued a notice of deficiency.

The taxpayer argued that the reimbursement paid to the insurance company in 2008 should reduce the social security benefits received in 2008. However, section 86(d)(2)(A) provides that “[T]he amount of social security benefits received during any taxable year shall be reduced by any repayment made by the taxpayer during the taxable year of a social security benefit previously received by the taxpayer (whether or not such benefit was received during the taxable year).” Repayment made by the taxpayer of a benefit received from a private insurer does not qualify as “repayment made by the taxpayer during the taxable year of a social security benefit previously received by the taxpayer.” In an earlier case, Seaver v. Comr., T.C. Memo 2009-270, the Tax Court had held that a taxpayer required to reimburse an insurance company for tax-free benefits previously received from that company is not allowed to deduct the reimbursement.

The Tax Court in Brady also considered the section 86(e) election. A taxpayer who receives a lump-sum social security payment on account of amounts not received in prior years is permitted to make an election to compute social security gross income by determining the amount by which gross income would have increased in each applicable prior year and adding those increases together. If those increases are less than the amount otherwise includible in the current year’s gross income, the election permits the taxpayer, in effect, to avoid the impact of “bunching” multiple year social security payments into one year. Two obstacles prevented the taxpayer from taking advantage of the election. First, the election must be made when the return is filed, and the taxpayers had not made the election. The Tax Court found not authority for permitting the taxpayers to make the election “so long after filing” the return. Second, the IRS informed the court that it had made the computation that would be made under the election and determined that it would not reduce the amount of social security benefits that must be included in the taxpayer’s 2008 gross income. Although the taxpayer’s tax returns for the prior years had not been introduced into evidence, the taxpayer did not dispute the IRS assertion.

The only good news for the taxpayer was the Tax Court holding that the accuracy-related penalty did not apply because the taxpayer relied on the professional preparer to compute the amount included in gross income. The taxpayer had provided the preparer with the amount of the lump-sum social security payment and the amount of the reimbursement paid to the insurance company. Accordingly, the Tax Court concluded that the taxpayer “made a reasonable and good-faith attempt to comply with the tax laws relating to the Social Security benefits.”

Advocates of tax simplification claim that a “flat tax” would eliminate tax law complexity. Reducing multiple tax rates to one rate would do nothing to make tax compliance easier for recipients of social security benefits. Making the sort of simplification to section 86 that I advocated in in More Joys of IRC Section 86 would ease the complexity but would not eliminate it. The situation presented in the Brady case highlights the significance of timing questions and the time value of money. Simplifying this aspect of the problem poses a complicated challenge. Does anyone think the Congress is up to meeting that challenge? I don’t.

Taxes and Spending: Theory Meets Reality and Questions Go Unanswered

A reader forwarded to me a commentary that showed up on the Tea Party Christian Issues Explained for You web site. Carrying the title Its [sic] Simple to Balance The Budget Without Higher Taxes, it does not identify its author. Confusion arises because Dan Mitchell wrote some commentary with the same title, and although it deals with the same general topic, it is unlikely Mitchell authored the one that was forwarded to me.

The author of the commentary makes several claims. The nation should be concerned that claims of this sort circulate and find believers. The only silver lining in this nonsense is that it proves that the lack of a quality educational system fertilizes ignorance.

The author claims that “Deficits are caused by too much spending.” Though this is the mindset of the hacksaw CEOs who see job cuts as the pathway to higher corporate profits, the wise entrepreneur knows that putting a business in the black requires revenue. Deficits are also caused by foolish, non-productive tax cuts. They are also caused by unfunded war spending, but the author of the commentary makes no reference to that budget busting decision.

The author refers to the current deficit of $1.34 trillion, and then sets forth the so-called solution. According to the author:

we could limit the federal government to the activities authorized by the Constitution. Article 1, Section 8 provides a list, such as national defense, post offices, etc. Nowhere on the list is the Department of Education, Small Business Administration, National Endowment for the Arts, etc. Getting rid of these departments would immediately balance the budget.

Curious, I did a bit of research and determined that in 2011, $136 billion was allotted to the Department of Education. In 2011, the grand total of $19.6 billion was slated for the Small Business Administration. And for the National Endowment for the Arts, the whopping deficit-creating huge total of $155 million. A little arithmetic, and the author has identified $156 billion of spending cuts. The author needs another $1.184 TRILLION of cuts. Perhaps he thinks that “etc.” will cover it.

But what is the “etc.” that supposedly would cut $1.184 trillion from the deficit? Perhaps the author would bless us with the details, but, as usually happens with these wild claims, details aren’t forthcoming. The reason is simple. A little more research would demonstrate that cutting all of the programs so detested by the anti-tax, anti-government crowd would barely make a dent in the deficit.

Three years ago, in Some Insights into the Tax Policy Mess, I warned:

The deficit cannot be eliminated merely by cutting spending, unless Congress wants to strip the military down to pretty much nothing, eliminate Social Security and Medicare, and put an end to a variety of other programs. The nation faces huge deficits not only because tax rates on the wealthy are lower than they need to be, but also because the deficit reflects eight years of taxes that should have been collected but that were forgiven by a Congress anxious to reward the economic elite and ballooning interest payments on the debt undertaken to finance the deficits generated by trying to finance a war while cutting taxes.

Five months later, in June of 2010, I challenged politicians and commentators from every spot on the spending-taxation spectrum to nominate their candidates for program reduction and elimination. In FICA, Medicare, and Payroll Taxes, I wrote:

Advocates of continued and increased spending need to identify the tax increases that will permit that to happen in the absence of a deficit, and it will take more than the return to the pre-2001 rates and the elimination of capital gains preferences that I support. Advocates of tax cutting need to identify the cuts they would make to balance the budget, and if they don’t touch defense, Medicare, Social Security – and they’re stuck with the interest payment on the debt – there’s not enough to cut.

In November of 2010, in The Grand Delusion: Balancing the Federal Budget Without Tax Increases, I shared some arithmetic to show why the “spending cuts are sufficient” fails as a deficit-elimination tool, and to debunk the myth that cutting foreign aid would balance the budget. I questioned how the nation would react to the sort of spending cuts that would be needed to preserve unwise tax cuts:

Social security, Medicare, Medicaid, military operations, and interest on the national debt alone constitute 62 percent of the expenditures. Unless those are cut, then 89 percent of all other expenditures, including veterans’ benefits and health care, the CIA and other intelligence activities, NIH, military retirement, border security, immigration, the FBI, the courts, FEMA, the Coast Guard, federal prisons, and a long list of services that the country surely needs, would need to be axed.

Some might propose cutting Social Security, Medicare, and Medicaid, but that proposal would bring howls of opposition from across the spectrum, with people of all ages and political stripes objecting. There are those who would cut military operations, but again, objections would pour in from those concerned about the consequences. Who would rejoice at cutting almost 90 percent of national intelligence activities, border security, federal highways, and the Coast Guard? How about NASA? Having already had its budget cut, it has cancelled the program to replace the shuttle, which means China, or perhaps Japan or Russia, will put people on the moon, plant their flag, and leave the United States gasping in the wake of these other nations’ successes. Cutting interest on the national debt would destroy the country’s credit, and accelerate the deep spiral into which it already is heading. Note that to reduce interest on the federal debt, the debt must be cut, which means chopping even more expenditures in order to generate a budget surplus that can be used to pay down the debt.

I concluded with this warning:

I find it interesting to consider what would have happened had taxes not been cut, let alone raised, when the nation went to war nine years ago. Imagine the trillions of dollars that would have been collected during that period. Imagine the impact on credit markets. Imagine an economy not bloated with tax cut money and thus not sucked into bubbles that eventually burst. It’s too late to go back and do the right thing that should have been done. It’s politically impossible to collect “back taxes” with interest to compensate for the error in judgment. And until Americans understand the reality, it’s politically impossible to put an end to one of the principal causes of the economic mess in which the country is mired. With 40 percent of the nation’s citizens thinking foreign aid is one of the top two federal expenditures, we have a very long way to go before Americans are cleansed of the lies and misleading sound bites of the extremists and ready to tackle the problem. By then, it will be too late. Unless taxes are raised – and that’s not saying there should be no cutting of expenditures – but, I repeat, unless taxes are raised, America will be a second-order, or perhaps even third-order, nation by the end of this century.

I returned to the spending cut dilemma two years ago in Cutting Taxes + Failing to Identify and Enact Spending Cuts = Default?, warning that the failure to reduce the theoretical “cut spending” cry into practical reality highlighted by specific proposals would prevent the nation from getting out of its death spiral. A month later, when a list of proposed cuts did emerge, I pointed out, in Spending Cuts, Full Disclosures, Hearts, and Voices, that the cuts fell short of making much of a dent in the budget deficit, and pretty much gutted every program designed to preserve the environment, bolster education, improve health care coverage, feed children, and otherwise preserve the common weal. General theories often spawn unrealistic details. That’s because general theories manifested in “cut spending” sound bites reflect something less than thorough and careful research.

So, anonymous author of the the spending-cuts-can-eliminate-the-deficit commentary, what’s in your “etc.”? The nation is eager to learn what’s in that $1.184 trillion of unidentified cuts.

Biting the Taxpayer Hand That Feeds You

When I was a child, I remember asking someone to explain the expression, “Never look a gift horse in the mouth.” I also learned to say “Thank you” when receiving a gift, even if it was, as has happened a few times, a gift that I had already received earlier in the day, or, as has happened more than a few times, a gift of something I probably would not use. The point, I was told, was the thought and the gesture. The value of the gift was not the measure of the generosity. There was probably some reference made to the parable of the widow’s mite.

So it did not surprise me that I was more than annoyed to read the recent news that A.I.G. has been considering joining its shareholders in a lawsuit against the federal government. The lawsuit claims that the federal bailout of the almost-bankrupt A.I.G. was too harsh on the company. The shareholders claim that the bailout “deprived” them of money and violated the Fifth Amendment because it allegedly took private property for “public use, without just compensation.” Nor did it surprise me to read a report that A.I.G. decided not to join the lawsuit.

The shareholder lawsuit was filed, not by shareholders, but by A.I.G.’s former chief executive officer, Maurice Greenberg. He also is a shareholder, and he had been encouraging A.I.G. to join the litigation because he thinks it will compel the federal government to settle the case in favor of the shareholders. Greenberg is a major shareholder, and so he would have done well if he had prevailed.

The litigation demonstrates how pervasive greed has become in our nation, and how terribly it has infected the legal and financial systems. The foolish and perhaps illegal activities of a group of people at A.I.G. caused the company’s finances to fall into disarray. What should have happened was action against those individuals for the damage that they caused. Instead, because they hid behind the corporate veil, the clients of A.I.G. and the nation generally bore the brunt of the risky decisions. Taxpayer money was used to prevent A.I.G. from falling into bankruptcy. Had that happened, it is almost certain that the shareholders would have ended up much worse off than they are now. According to Greenberg, by making payments to A.I.G.’s clients on behalf of A.I.G., the federal government stole A.I.G.’s money and cheated its shareholders. Yet the shareholders, who own A.I.G., ought to be the ones who bear the burden of its bad decisions.

A.I.G.’s board, most of whom were not around when the unwise decisions were made to issue mortgages based on credit-default swaps, faced a difficult decision. By voting to keep A.I.G. out of the litigation, A.I.G. probably will be sued by Greenberg. If Greenberg succeeds in his litigation against the federal government, other shareholders probably will sue A.I.G. If the board had decided to join the litigation, it would have risked not only adverse public relations consequences, but negative reaction in the nation’s capital, but it might have ended up receiving damages. Greenberg and A.I.G., in the meantime, have been immersed in separate litigation arising from the allegations of accounting and other misdeeds during his tenure as chief executive officer.

Once upon a time, people took responsibility for the consequences of their decisions. That principle has eroded over the past thirty years. It has been replaced by the idea that someone else is responsible, an outlook that surely has been reinforced by the cultural attitudes that absolve people of responsibility because it is easier to cast blame on some other person. In a non-dysfunctional system, the architects of the credit-swap mortgage nonsense and the owners of the company that employed them would bear the burden, as would those who supervised them and let them run amok making bad decisions with other people’s money. In a sensible system, A.I.G would have been required to carry insurance to protect against the risks that its employees were taking. Instead, the federal government ended up bailing out A.I.G. and other badly managed companies, although at least in several cases, the government was repaid.

I questioned the wisdom of using taxpayer dollars to bail out private companies and their sketchy employees in a series of posts, including Where Is the Money To Be Found?, Greed, Stupidity, and Fraud: Lessons from Tax Law, and Funding the Bailout. Had I known that those being bailed out would in turn come back to bite the hand of the taxpayers who were lending a hand, my objections would have been orders of magnitude more strenuous.

The problem here isn’t the new A.I.G. board. It was, as explained above, in a tough spot. The problem lies with A.I.G.’s shareholders, particularly Greenberg. Rather than offering thanks that he didn’t lose pretty much all of his stock value in a bankruptcy, he chooses to grab more money. Rather than appreciating that the manner in which the federal government handled the bailout, though not what he would have done, was successful, he acts as though he is more skilled at dealing with these sorts of financial issues even though his company crumbled badly because of bad financial management decisions. As for Greenberg’s attempt to extract more money from the federal government, the answer is simple. The nation’s taxpayers saved A.I.G.’s shareholders billions of dollars. They’ve done enough. They should do no more.

Government Spending v. Government Investment

In an opinion piece on Sunday, George Will made an important point. There is a difference between borrowing to finance investment and borrowing to finance consumption. A person or government who borrows $100 to purchase a $100 asset is neither richer nor poorer. The important issue is whether the asset will be used in a manner that generates income that can be used to pay off the debt and enhance the financial position of the investor. In contrast, a person or government who borrows $100 to fund consumption is $100 poorer, because there is no asset to offset the loan.

Where I differ with Will is in his examples of borrowing to finance investment and borrowing to finance consumption. Will gives two examples of borrowing to finance investment. One is infrastructure. On this example, I agree with Will. Borrowing $100 to build a $100 bridge leaves the nation no richer nor poorer. The same can be said of borrowing $100 to repair a bridge so that its value has increased, arguably, by $100. The issue is if and how that bridge will generate income to repay the debt and to maintain the value of the bridge. Will’s other example of borrowing to finance investment is war. I disagree. A government that borrows $100 to build a bomb that destroys something has consumed $100. In some respects, it has burned a $100 bill. I suppose Will would argue that the $100 is an investment in security or peace, but even from that perspective, investment in war has turned out to be pretty much a waste, with uncountable costs in human lives and materiel and no peace at hand. In contrast, borrowing $100 to build a defense system, such as aircraft carrier groups, anti-missile systems, radar warning devices, whatever, that prevents war is an investment not unlike the purchase of a fence, a lock, or a moat. Perhaps that is what Will meant, by using the term war, though I would prefer he used the word defense.

There is a deeper problem, though, with these examples. The examples assume that a $100 outlay for a bridge or an aircraft carrier brings a $100 asset into the hands of the people through government. It very well may be, and often has been shown to be, different. The bridge or aircraft carrier might be worth $80, with the difference being excess funds winding up in the hands of private contractors. The seriousness of this problem can be debated, with estimates of corruption and overpayments ranging from minimal to significant. Unfortunately, it costs money to ferret out the waste, bribes, and other squandering of taxpayer dollars.

When Will gives examples of borrowing to finance consumption, which he sees as the flaw of the “entitlement state,” he again provides two examples. Again, I differ with his selections. He focuses on Social Security and Medicare. Social Security has not been financed through borrowing. In fact, it has been a source of lending for borrowing to finance other programs. True, without adjustments to reflect increased life expectancies and the resulting lengthening of the average retirement period, Social Security eventually will need to borrow in order to maintain its outlays. But of all federal programs, save a few minor temporary ones, Social Security is the model of how to avoid borrowing. On the other hand, Medicare outlays exceed Medicare premiums, requiring borrowing to “break even.” Is Medicare spending properly classified as consumption? Or is it an investment, an investment in people who, by receiving medical care, live to generate societal benefits?

The same conundrum arise with respect to other spending programs. Is spending on education appropriately tagged as consumption? Or is it an investment in the nation’s future? What about food stamps? Is the borrowing presumably undertaken to finance food stamps borrowing to finance consumption? Or is it borrowing to finance investment in the nation’s future? Put another way, are the people who are saved and nurtured through borrowing to be treated as an asset on society’s balance sheet?

Perhaps the problem is in the measurement of the deficit. Annual deficits are measured by income (tax and other revenue) over expenditures. In typical accounting, only expenses, and thus not the cost of aircraft carriers or bridges, would be included in expenditures. And the result would be called a loss. The cumulative deficit would reflect the excess, if any, of government debt over the value of government assets. If those assets include the value of defense personnel trained by the government, along with physical assets, do not the numbers change?

Ultimately, the worst form of consumption occurs when assets are destroyed. Food is consumed, but is turned into energy that fuels the creativity of the nation’s citizens. When munitions are consumed, they do not create human creativity, nor do they rebuild bridges. This nation has directed a significant amount of borrowed funds into war consumption. To call that a financial investment is, at best, misleading. And if there’s any entitlement in war consumption, perhaps it lies with the defense contractors who have profited mightily from the destruction of assets.

Spinning Taxes and Tax Spinning

As I pointed out on Friday in Fiscal and Tax Irresponsibility, the recently enacted legislation that postpones the impact of the so-called fiscal cliff can be analyzed in different ways. As I noted, “there are ways of spinning the situation so that it appears to put a slight dent in the deficit.” I concluded, as have many others, that the legislation will generate a $3.9 trillion increase in the federal budget deficit over the next ten years.

The legislation cuts taxes. As I pointed out in Fiscal and Tax Irresponsibility, it does so by restoring most of the Bust tax cuts, adjusting the alternative minimum tax, re-establishing tax breaks for the working poor, and enacting or re-enacting special tax breaks for selected individuals and businesses.

According to this report, it did not take long for the anti-tax crowd to issue not only expressions of disappointment, but also warnings of retaliation, for what it considers to be, in the words of a “tea party favorite,” Ted Cruz, “[A] lousy deal.” Why? According to Cruz, “I think it raised taxes by $620 billion.” Really? Here is what happened. The Bush tax cuts expired. More than a decade of bad tax policy, which brought revenue as a percentage of the economy to its lowest level in decades, came to an end. The Congress then decided to re-enact some of the Bush tax cuts. So why is Cruz complaining? His friends in the top income levels, who for more than a decade have increased their collective share of the economy at the expense of everyone else, didn’t get a tax cut. So Cruz, spinner deluxe, decides that a person who does not get a tax cut has been hit with a tax increase. The fallacy of this logic is no less obvious than the claim of someone who does not get a raise during a time of zero inflation that he or she has been inflicted with a pay cut.

If Cruz is concerned about the federal deficit, he ought to stop campaigning for tax cuts. Tax cuts increase the deficit, and do very little for the economy, despite the propaganda that tax cuts for the wealthy create jobs. It is true, though, that as Cruz and others point out, federal spending needs to be corrected. How that can be accomplished is a challenging puzzle, as I discussed in The Howling Void of Taxes and Spending. What he and others will discover is that there isn’t anywhere near the amount of spending cut savings that he and others seem to think that there is. Despite the floating of theoretical spending cut proposals, the reality is that the only way to balance the budget while conferring the tax cuts Cruz and his friends want is to knock most of the nation into poverty and despair. Imagine a nation dealing with substantial cuts in Social Security, Medicare, Medicaid, education assistance, food assistance, and the loss of progress in energy efficiency, the destruction of the environment in the wake of the elimination of the EPA, and the continued deterioration of the nation’s infrastructure.

What’s alarming about the reaction of the anti-tax crowd is not so much that its ringleaders take the position that they do, for it is understandable that those who benefit from their policies would seek implementation of those policies, but that many of those who stand to suffer on account of those policies root for those policies to be adopted. Considering the nonsense I read on web sites, ranging from mainstream media to social networking outlets, it is not surprising that people are being misled and it is inescapably evident that a significant number of Americans would benefit from some careful study of the facts.

Fiscal and Tax Irresponsibility

So we’re told that the nation avoided the fiscal cliff. No, the nation did not. The nation backed away from the cliff, by pushing it two months into the future. The Congress made the cliff steeper, because if the nation goes over the cliff it will be a much longer fall.

The absurdity of the last-minute temporary duct-tape and chewing gum solution is evident from two very significant flaws in the failure of the Congress to meet its responsibility. Instead of tackling the problems long before the deadline, Congress waited and put together a patchwork piece of nonsense. First, as reported in this story, the Congress did not address the fact that the nation reached its debt limit on Monday. Second, the legislation adds to the deficit, making the situation worse, even though, as this report explains, there are ways of spinning the situation so that it appears to put a slight dent in the deficit.

The only sensible way of measuring the impact of the legislation is to compare it to what would have happened had the nation gone over the cliff on January 1. Had the nation gone over the cliff, the deficits for 2013 and subsequent years would have been less than what it is under the legislation. The legislation preserves tax rates that would have increased in the absence of the legislation. That adds to the deficit that otherwise would have existed. The cost of this legislation is a $3.9 trillion increase in the accumulated deficit that otherwise would have existed over the next ten years.

Two pieces of the legislation account for most of the $3.9 trillion. By extending the Bush tax cuts for all taxpayers other than those with incomes of more than $400,000 (or $450,000 for married couples filing jointly), the accumulated ten-year deficit is increased by $1.9 trillion. Fixing the alternative minimum tax adds another $1.8 trillion. Of the rest, $134 billion comes from extending tax breaks for the working poor, and $77 billion comes from extending special tax breaks for businesses and certain individuals.

Interestingly, the legislation does not extend the repeal of the itemized deduction and personal and dependency exemption phase-outs. This crafty way of raising rates ought not to have been enacted in the first place, and it ought not to have been revived. Hiding tax rate increases in this manner makes it more difficult for Americans to understand the issues percolating in the tax and fiscal policy debates. However, by not extending the repeal of phase-outs and by not extending the Bush tax cuts for taxpayers with incomes of more than $400,000 (or $450,000 for married couples filing jointly), the Congress demonstrated that it could abandon pieces of the 2001 and subsequent tax legislation. Why, then, extend special tax breaks for businesses? Why continue spending money on the motorsports industry? Why continue lower taxes for some industries and not others? Whatever can be said in favor of special breaks for the motorsports or other favored industries can be said in favor of every other industry. It is this sort of favoritism that makes the entire legislative process tainted, and that creates an atmosphere in which rational and sensible policy decisions cannot be made.

As icing on this cake of irresponsibility is the postponement of any decision with respect to the spending side of the problem. Though the sort of wholesale spending cuts that the anti-tax, anti-government crowd wants are unrealistic, surely there are programs and activities that can be scaled back. It is not unreasonable to expect that the Congress again will do nothing until hours before the new, delayed deadline. Whatever people may think of their own Senators and Representatives – most of whom they continue to send back to Washington – the Congress as an institution has failed miserably. Until Americans insist on a revamping of how Congress does business, the nation is in for an extended period of tax and fiscal irresponsibility.

The Howling Void of Taxes and Spending

The debacle over the so-called “fiscal cliff” should compel Americans to re-examine the various claims that government spending cuts will solve the nations’ economic problems. A recent article, Why Republicans Can’t Propose Spending Cuts, explains the phenomenon of reality knocking theory down. As Jonathan Chait, the author, puts it, “The Republican understanding of government spending is based on hazy, abstract notions that don’t match reality and can’t be translated into a workable program.” That haziness percolates in the assorted internet and social media postings that claim cutting this or that program will solve the problem.

Almost two years ago, in Americans Still Don’t Grasp Federal Budget Realities, I examined the quandary in which the nation has been placed by blind acceptance of mistruths spewed by those who use “cut government” as a pathway to electoral success but who then fail miserably when it’s time to balance the budget. I reacted to the results of a poll revealing that Americans grossly overestimated the portion of the federal budget devoted to the right’s favorite scapegoats, such as foreign aid, the Corporation for Public Broadcasting, pensions for federal workers. Even military spending was overestimated. If people don’t know the facts, how can they fix the problem?

Apparently, few, if any, of the people coming up with the wrong answers had taken a look at what I had explained six months earlier in The Grand Delusion: Balancing the Federal Budget Without Tax Increases. Examining the proposed 2011 federal budget, I concluded that balancing the budget on spending cuts would require cutting one-third of federal expenditures. I explained that if military spending, Medicare, Social Security, Medicaid, and interest on the federal debt were untouched, “89 percent of all other expenditures, including veterans’ benefits and health care, the CIA and other intelligence activities, NIH, military retirement, border security, immigration, the FBI, the courts, FEMA, the Coast Guard, federal prisons, and a long list of services that the country surely needs, would need to be axed.” I predicted, correctly, that attempts to cut Social Security would encounter widespread “howls of opposition,” as would proposals to cut military operations. I predicted, again correctly, that advances in space exploration would shift to “China, or perhaps Japan or Russia.”

In Why Republicans Can’t Propose Spending Cuts, Chait pinpoints some of the many flaws in the approach taken by the anti-tax, eliminate-government crowd. He describes the approach taken by “the CEO community and their publicists” who want to “cut deeply into entitlement spending” and who claim that “There’s money to be cut everywhere.” Chait, taking a view consistent with mine, posits that “There really isn’t money to be cut anywhere.” He notes that federal spending on social services lags behind other advanced countries, that Social Security benefits are “quite meager,” and that “infrastructure is grossly underfunded.”

Chait is of the opinion that the Bowles-Simpson plan failed because the panel could not reconcile the “gulf between perception and reality.” In other words, there is no way compromise can be made between delusion and sense. Chait provides a window into understanding the dysfunction of Congress. It is, in part, a consequence of the dysfunction of the nation and the delusion of those who believe fantasy rather than facts.

Chait criticizes the Bowles-Simpson plan as one that “simply pretended the federal government could have everybody do a lot more work for less pay.” That’s, of course, the secret of that “CEO community,” which sees cuts everywhere. That’s a community that enriches itself by firing employees and leaving those who remain to do the work of two or three employees, because it worships the short-term bottom line rather than long-term stability. Oddly, that community hides behind the word “prosperity,” but its philosophy has brought misery to far more people than it has brought any sort of confident financial position.

Ultimately, the anti-tax, cut-spending crew objected to the cuts suggested by Bowles-Simpson. Chait mentions Paul Ryan’s approach, which he characterizes as “kick[ing] the crap out of the poor,” and which would work only if “epic levels of suffering on the very poor” were acceptable. They’re not. And even things such as making Medicare needs-based, or fiddling with the CPI component of Social Security generates a drop in the bucket compared to the spending that must be cut to finance the tax cuts for the wealthy that were made ten years ago and that the anti-tax group wants to continue.

Chait concludes that the anti-tax, cut-spending folks don’t disagree with the inability to find spending cuts that don’t “inflict real harm on people with modest incomes” and that don’t “save small amounts of money.” They simply “don’t seem to understand it.” Thus, he concludes, the failure of Republicans to list specific spending cut proposals “is not just a negotiating tactic but a howling void where a specific grasp of the role of government ought to be,” and that “The spending cuts aren’t there because they can’t be found.”

Federal taxes are at the lowest they have been for many decades. Failure to connect that fact with the existence of a huge deficit, and attempting to pin the deficit on needless spending that does not exist demonstrates a howling void in understanding reality.