Bear Left!

Follow the Money
Tim Francis-Wright
1 April 2001

In the film All the President's Men, Bob Woodward's confidential source urged him to "follow the money." Three aspects of current tax policy show the benefits of this sort of approach. All three benefit the rich at the expense of everyone else. They are preferential treatment for capital gains; the social security payroll tax; and the trust system, especially in states like Florida and Ohio.

Capital Gains

Capital gains have a huge advantage over wages, which most taxpayers rely on, as well as dividends and interest, which many middle-class retirees rely on. For well-off taxpayers, most income is taxed at 28%, 31%, 36%, or 39.6%, depending on one's definition of "well-off." As long as capital assets like stocks are held for at least a year and a day, the maximum tax rate is 20%. If everyone shared in the wealth of the stock market, then this advantage would have merit, but following the money shows just who benefits from capital gains.

(This table has data for 1998, the latest year with available statistics. Click here for the data source.) The table shows that taxpayers with the most income benefit disproportionately from the lower taxation of capital gains. Americans with over $1,000,000 of income in 1998 were responsible for reporting over half of reported capital gains. While capital gains represented less than nine percent of total adjusted gross income for all taxpayers, for one-year millionaires, net capital gains were over 41% of their income.

Only this year did taxpayers in the 15% tax bracket get any sort of capital gains tax break, to a 10% level. The working poor who benefit from the earned income tax credit have a disincentive to earn capital gains, even if they have any money to invest. Unearned income of over $2,400 makes a family ineligible for the earned income tax credit, regardless of how low its total income is.

The rationale for the preferred treatment for capital gains takes several forms. One rationale is that long-term capital gains are inherently long-term, so the gains realized should take inflation into account. Indexing capital gains for inflation would be tricky, but reasonable, but only if dividends and interest got a similar treatment. Bonds or bank accounts pay interest in exchange for the use of money over time, yet Republicans do not clamor for a tax cut specifically on this sort of income. In my opinion, because there is no tax on unrealized capital gains, large stockholders get far more than a fair tradeoff. According to one study, over half of the assets in very large estates (over $10,000,000) are unrealized capital gains, which the government does not tax except as part of the estate tax. This fact is one reason that the Republicans are so eager to throw out the estate tax: it would make some of their very rich donors able to avoid any and all taxation on much of their wealth.

A more common rationale for the preferred treatment of capital gains is to reward investors for plowing money into the economy. To the extent that capital gains reflect gains on venture capital, or gains on the sale of businesses by the original proprietors, then this call has merit. But this rationale is a better rationale for rewarding investments in savings banks than for rewarding investments in the stock markets. A typical bank uses its deposits to make loans in its community. A typical stock purchase is a speculative investment that depends on one person (the original seller) being myopic enough to sell at the wrong time, and another one (the buyer) being presbyopic enough to sell at the right time.

For the top officers of large corporations, the capital gains that they earn do not even come from a bet that you or I could make. If a company grants its top officers thousands--or millions-- of options that cost pennies per share, it is easy for those officers to wait long enough to sell to get long-term capital gain treatment one year and one day later. Although what they have earned is wages by another name, their tax rate on it will be no more than 20%. (Even if they are subject to the alternative minimum tax, their rate cannot exceed 26%, far below the 39.6% that a lottery-winner would need to pay.)

Payroll Taxes

The lower rate for capital gains is only one way for the rich to avoid paying their share of taxes. The cutoff for the 6.2% social security payroll tax is $80,400 in 2001. Above that amount of salary, workers pay only a Medicare tax of 1.45% of earnings. Employers pay a matching amount. This is a widespread tax that affects most workers. It is also a rarity in that it becomes less onerous as one earns more money.

The inequity of the current system provides an opportunity for the new Congress to make a serious effort to help American workers. It could seize the day by reducing the payroll tax rate below the current 6.2% level and removing the cap on earnings. Low-wage earners would benefit from the lowered taxes. The merely affluent would generally break even, because all of their earnings would be taxed at a lower rate, not just some of their earnings at a higher rate. The rich would pay somewhat more. The Republicans have called long and hard for a flat tax, but they have not supported efforts to make social security taxes more equitable. Wasn't a flat tax supposed to be a good idea?

Trusts

Trusts are an issue that I cannot lay at the feet of the current administration. The Rule against Perpetuities is part of English and American common law that limits the length of a trust to the lifetime of a living beneficiary plus 21 years. Its original purpose was to limit the length of time that land could be out of circulation. Its effects nowadays are limited, because most trusts are tools of the richest Americans.

The past few years have shown a trend to repeal or emasculate this rule. By my count, eleven states have effectively repealed it. In South Dakota, for example, the rule is null and void. In Florida, a similar rule remains, but the maximum length of a Florida trust is 360 years. To put that in perspective, 183 years ago, Florida was still a possession of Spain. The effect in these states is to the rich, and to the rich alone. A married couple can make a one-time contribution of money or stocks worth $2,060,000--the limit to avoid a federal tax called the generation skipping tax--into a "dynasty trust" and let it grow (presumably) forever. They can also donate $20,000 per year per beneficiary into the trust. The trust must pay tax on its current undistributed income, and the beneficiary must recognize any distributions as income, the donors avoid any transfer taxes altogether, regardless of how large the trust becomes.

While I have sympathy for state lawmakers who thought that a dynasty trust structure would help preserve family farms and small businesses, the proper way to benefit specific businesses or farms is to make special provision for them. Instead, these trusts will benefit the descendants of the truly rich at the expense of the state treasuries that would have collected taxes from those estates. In recent years, upwards of 97% of estates were exempt from the federal estate tax. Anyone whose taxable estate will be less than $675,000 does not need a trust of any sort to avoid all taxation on the estate. Over the next several years, existing law will raise this limit to $1,000,000.

Nothing in the federal tax code prevents a dynasty trust. Instead, federal law provides for a tax on generation-skipping transfers of property or money. Historically, states have restricted the maximum term of a trust either to the common-law length or to some reasonably long term, like 90 years. The proponents of dynasty trusts--advisors to the rich--are not bothered too much by the societal reasons for the Rule against Perpetuities. A few critics worry about how powerful trust companies and banks could become if more and more property could be held in trust for generations and generations. But accountancy and estate law do not attract the most liberal or radical of practitioners, so most of the commentary on this issue is skewed far to the right.

The changes to trusts in many states are such a complete sop to the rich that it may make the debate on the estate tax moot. It is amazing that repeal of the Rule against Perpetuities has happened so stealthily, given how much that rich can benefit.