U.S. tax system: Why do the rich just keep on getting richer?

Editor’s Note: Edward J. McCaffery is Robert C. Packard trustee chair in law and a professor of law, economics and political science at the University of Southern California. He is the author of “Fair Not Flat: How to Make the Tax System Better and Simpler.” The opinions expressed in this commentary are solely those of the author.

Story highlights

Hilary Clinton has proposed raising tax rates on those earning over $5 million a year by 4%

Edward McCaffery: The wealthy are actually saving billions in our current tax system

CNN  — 

It’s silly season for tax policy again: a presidential election year. Hillary Clinton, under pressure to do or say something about income inequality, has proposed raising tax rates on those earning over $5 million a year by 4%.

The plan is reminiscent of the tax policy of Franklin D. Roosevelt, who instituted a 79% tax bracket during the Depression in which, legend has it, a single person – John D. Rockefeller – resided. (“Because he can afford it,” FDR was said to have quipped.)

Clinton’s proposal would fall on a few thousand households, perhaps, but it is hardly going to make things in America equal. After all, it is only going to fall on people with reported incomes – mainly high wage-earners – and not so much on capitalists like Warren Buffet, who not coincidentally is supporting Clinton.

Edward J. McCaffery

Let’s back up a few weeks. Just before the new year, The New York Times gave us two articles about the state of tax in America. The first was titled: “For the Wealthiest, a Private Tax System that Saves Them Billions.”

The second, published the very next day, seems to contradict the first with its headline: “Thanks, Obama: Highest Earners’ Tax Rates Rose Sharply in 2013.”

Yet both stories are each perfectly accurate. Neither tells us anything we should not already have known. And of course neither story addresses the 800-pound gorilla in the room – just like Clinton’s proposal or those New Year’s resolutions that rarely go after our deepest, darkest problems.

Let’s consider five simple points to ponder this year.

1. The American tax system is mainly a wage tax

This is clearly true of the payroll tax, the Social Security and Medicare “contribution” system that for over 80% of Americans is the major tax they pay. But it is also true of the “income” tax, which does a fairly good job at taxing labor, or wages – mainly because employers tell the government how much each employee makes on those W-2 forms. But the same system does a very poor job at taxing the gains to capital – the other source of wealth.

2. Our governments need lots of money

Because federal and local governments keep spending more than they take in, they turn to wage taxes. Trying to actually tax capital – which only the rich have in any significant amount (rather by definition), is highly mobile and easy to hide and comes with much political and economic power – is hard. And it takes time. Who has that?

So, instead, the U.S. has been increasing its wage taxes, a far easier thing to do, as the government can count on employers to collect and remit the tax (another FDR-era tax policy innovation). The government can increase taxes by raising rates and/or by closing down “loopholes” available to wage earners. (Hence, the near constant chatter about repealing personal deductions like charitable contributions and mortgage interest).

The Obama administration has shepherded some of each tactic through a sometimes cantankerous Congress. As the second Times article points out, the effective tax rates on America’s 400 wealthiest families, which had fallen from 26.4% to 16.7% from the 1990s to 2012, rose to 22.9% in 2013, the first year that the Obama tax increases were in play. This is the same high-end crowd that Clinton is targeting.

3. Really high wage-earners find ways to avoid really high taxes

The percentages being discussed are percentages of reported income. The rich don’t report all of their goodies as “income.” The first Times article does not go into details of the techniques involved, but it is clear that they are being used by high wage earners, such as hedge fund managers, who find ways to have their incomes taxed at lower capital gains rates, and others who take advantage of offshore trusts and elaborate entities to hide the income altogether. Nothing new here – and expect more of the same if Clinton’s plan becomes law.

Journalist David Cay Johnston published a book over a decade ago titled “Perfectly Legal: The Covert Campaign to Rig Our Tax System to Benefit the Super Rich – and Cheat Everybody Else.”

Johnston helped to illustrate that the tax games of the rich are a constant – among other things, they make enough money to make complex avoidance strategies worthwhile. A deeper problem with wage taxes is that rates cannot get all that high, or people stop working or leave the jurisdiction, as Phil Mickelson threatened to do.

So we end up with a wage tax at fairly (but not extremely) high rates, virtually inescapable for the vast middle classes with their W-2s but still encouraging games to be played by wealthy wage-earners.

4. Really high wage-earners do not have to go far or think hard to save on taxes

It is not that the wealthy are necessarily smarter about taxes than the rest of us. The games come to them.

Suppose someone is making $10 million a year, such that he should be paying about $4 million a year in taxes at today’s rates – $4.2 million under Clinton’s proposal. Some well-credentialed professional explains that she can reduce that tax bill to $2 million. That kind of tax savings leaves plenty of money to share with the professional, who thus has plenty of reasons to make her own market by seeking out the high wage-earner.

This is all Capitalism 101 – where there’s a profit to be had, there will be profiteers to be found. Which brings us at last to the ultimate point.

5. None of this is relevant to the truly rich, such as Bill Gates or Warren Buffet

The truly rich don’t live off salaries. They live off their capital, the other great factor of production in a capitalist economy.

If you already have wealth, you need never pay tax – any tax – in America again. You can play what I call Tax Planning 101 and, unlike high wage earners, you don’t have to pay any professional much or do anything too fancy at all. You simply buy and hold assets, borrow against their value to finance your lifestyle, and then die, as we all do. Only when the really rich die, their assets go to their heirs with no income tax consequences.

President Obama made a sensible proposal in his 2015 State of the Union speech to change this absurdity, by requiring capital gains – the difference between an asset’s value and its tax “basis” (typically cost) – to be taxed on death. That proposal was declared dead on arrival. No serious presidential candidate, including Clinton, has embraced it.

So there you have it. Wage earners are being increasingly taxed. High wage earners are trying to avoid the taxes, aided by a well-heeled industry of professional tax advisers. Politicians like Clinton or FDR may make a big splash by attempting to raise tax rates on these high wage-earners, and the advisers will come running to the rich to help them plan around the increased taxes. All the while the 800-pound gorilla – the fact that the U.S. tax system is highly ineffective at getting at capital or wealth other than wages – keeps getting ignored.

Nothing really changes. Capital wins. It need not go on a diet like the rest of us with standard New Year’s resolutions, and it stays safe from the grasp of politicians who want headlines but don’t want to antagonize their donors. And so stay tuned for more silly proposals that make big headlines but promise little real change.

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