Reuters Money

Tax deductions are popular, but penalties may work better

When making tax policy, there’s a choice between carrots or sticks: Does the government give taxpayers credits or deductions for doing the right thing (buying their homes, giving money to charity, not emitting greenhouse cases) or penalize them for doing the wrong thing?

Brian Galle, who is on leave as an assistant professor at Boston College Law School and currently a fellow at the Urban Institute in Washington, DC, has been analyzing those choices, and come to a surprising conclusion: Expenditures may be politically expedient, but penalties would often be preferable for fiscal policy.

In his forthcoming paper in the Stanford Law Review, called “The Tragedy of the Carrots,” Galle argues that carrots are overproduced and often misguided, costing the Treasury funds that would be better spent elsewhere in an effort to nudge people towards the behavior it hopes to reward.

“The problem with tax expenditures is not that they are in the tax code, but that they are expenditures,” Galle explains in a recent telephone interview.

As Washington debates tax policy and budget cuts, Galle’s ideas are particularly relevant. Tax expenditures — those credits and deductions that favor some taxpayers over others — have grown dramatically over the years, and their cost to the Treasury is over $1 trillion dollars.

Last year, when the national deficit commission, co-chaired by Alan Simpson and Erskine Bowles, released its bold tax proposals, one of them called for eliminating all the expenditures and lowering marginal tax rates to 8 percent, 14 percent and 23 percent. The commission’s ideas went nowhere, and today the congressional supercommittee is hashing out its plan for budget cuts and tax reform.

Galle’s theory goes one step further in thinking about rewards versus penalties. Economists consider carrots and sticks pretty much indistinguishable. There’s not much difference, as Galle points out, between taxing someone a dollar for each cigarette smoked, versus giving someone a dollar for each cigarette thrown in the trash. Either way, smoking is penalized, and the cost to you (whether explicitly in the tax or implicitly in the foregone reward) is one buck.

What next for long-term care after CLASS act folds?

The federal government threw in the towel on creating a public option for long-term care coverage last week, and that would seem to be definitive for now.

In defeat, Health and Human Services (HHS) Secretary Kathleen Sebelius was doing the right thing in admitting the concept’s flaws and cutting the government’s losses of the proposal, which was a lesser-known component of the new health reform law. It was an attempt to expand the number of Americans with long-term care coverage by providing a basic, inexpensive LTC option deployed mainly through the workplace as an opt-out choice in benefit plans.

Republicans were overjoyed with the decision, obviously, since they have always seen CLASS as a budget trick to pump up the health law’s revenue and make the law seem less expensive than it is. (CLASS had been projected to generated $86 billion in revenue in the early years from premium payments made by policy holders whose coverage had not yet vested.)

But there is still the problem to solve about how we’ll care for our frail elderly in the years ahead, and it’s unclear what the path to a solution will be. After the shouting subsidies, we’re still left with an inadequate, patchwork system for funding long-term care in the U.S.

The Center for Retirement Research at Boston College (CRR) says about one-third of Americans turning 65 this year will need at least three months of nursing home care sometime during their lives.

Medicare covers only a small portion of long-term care needs, and the cost of a semi-private room averages $79,000 per year. CRR calculates that the mean lifetime exposure to long-term care costs for a 65-year-old couple is $260,000, with a five percent risk of a $570,000 expense.

Meanwhile, Medicaid remains the nation’s largest LTC funder, paying for more than 40 percent of all care. And the market for private LTC insurance continues to limp along, the victim of collective national denial and expensive policies.

Occupy colleges? How to shut down student debt

One of the more compelling issues to emerge from the Occupy Wall Street movement is subject of crushing student debt.

College financing has gotten to be too onerous and complicated, so it’s difficult for families to negotiate the process and, as a result, it’s hobbling graduates’ attempts to live normal lives. Congress has largely ignored these Americans, though, as it focuses on the national debt and the Tea Party agenda.

There’s been a sharp uptick in student loan defaults — the highest rate in a decade — as more students come out of college an average $24,000 in debt, yet can’t find jobs.

Part of the psychology embedded in a college education is that the diploma should enable you to get a living-wage job, pay off debts and live a prosperous life. That was the big selling point of a high-cost diploma. That isn’t happening now for most graduates.

When the debt bubble burst three years ago, did students and their parents really expect to be saddled with onerous debts and face a lousy job market when they signed up for expensive degrees?

If we can bail out the banks, we can certainly find long-term solutions to student debt. My colleague, Linda Stern, recently outlined some of the basic money-management approaches to reducing student debt in her weekly column. It’s all good advice on a personal level — from creative payment strategies to loan consolidation to what to do if you simply can’t pay at all.

How cuts to Social Security Administration will hurt you

“Starving the beast” is a favorite conservative strategy for forcing cuts in federal spending. The idea is to deprive the government of revenue in order to force spending cuts – and resistance to new taxes is a central feature of the current Super Committee deliberations in Washington.

Advocates for older Americans are watching closely to see how the committee’s work might lead to retirement benefit cuts via a higher Social Security retirement age, smaller cost-of-living adjustments or higher Medicare eligibility ages. Meanwhile, a separate starve-the-beast exercise goes mostly unnoticed: a big squeeze on the administrative budget of the Social Security Administration (SSA).

The SSA is funded through the same Federal Insurance Contributions Act (FICA) tax that pays benefits, so it doesn’t compete for general revenue to meet its costs. But Congressional appropriators — who oversee its budget — have been squeezing the agency anyway.

In fiscal 2011, Congress provided the SSA with about $1 billion less than requested by President Obama. Those cuts forced the agency to make cuts that beneficiaries have noticed. It suspended mailing of the annual statement of benefits, and it shelved plans to open eight new hearing offices to handle the backlog of disability claims, which has soared during the recession.

SSA had planned to restore the statement mailings in fiscal 2012 to people over age 60 not yet receiving benefits  – but that won’t happen “if Congress doesn’t provide adequate support,” says SSA spokesman Mark Hinkle. (The agency currently is operating under the second continuing budget resolution for FY 2012, which expires Nov. 18.)

This may sound insignificant, but it’s not. The benefit statement provides a valuable annual reminder of what you can expect to receive and how benefits are calculated – and it prompts us all to make Social Security part of our long-range retirement plans. For now, the alternative is to use the SSA’s online Retirement Estimator, which gives you a personalized projection of future benefits.

Hinkle says the SSA also has responded to the tight budget by reducing employee overtime by 80 percent. That has cut into the amount of time available to help people who come into SSA local field offices for face-to-face services. The agency also lost about 1,600 workers last year who can’t be replaced due to a hiring freeze.

Margaret Atwood on debt and consequences

What might be most surprising about the myriad economic problems around the globe right now is how many major world economies seem to have been taken by surprise by the concept of debt. Maybe they should have been reading more Margaret Atwood.

Atwood isn’t only one of the world’s premier novelists, she’s also the author of the nonfiction “Payback: Debt and the Shadow Side of Wealth,” which hit the presses just as the financial crisis arrived in the fall of 2008 (timing that one review described as “freakishly prescient”).

Atwood is currently releasing her new essay collection about science fiction, “In Other Worlds,” and  sat down with Reuters Money for coffee in Manhattan. We chatted about how debt has been dominating the headlines – and, perhaps, reshaping our sense of self.

Reuters Money: How did the issue of money and debt come to interest you?

Margaret Atwood: I came to this subject through studying literature. Money is everywhere. Charles Dickens, for instance, is completely obsessed with debt. His father went bankrupt, and was thrown into debtor’s prison. As a child, Dickens had to go off and work in the factory, and he never forgot it.

You’ve said that the current debt crisis was entirely predictable. How so?

MA: I’m always sorry when I’m right. It really is true that you can go back through history and trace the influence of money on crises. If you look at conditions right before the French Revolution, you’ll see that they were having a lot of money problems. They kept firing finance ministers and coming up with one new scheme after another, but those at the top wanted to keep everything for themselves. Conditions were top-heavy, with a lot of debt, the price of food going up, and many out of work — which all sounds very familiar right now.

Debt deal puts off tax decisions for another day

The legislation to lift the debt ceiling gives the country a framework for more than $2 trillion in budget cuts over 10 years and avoids default. But it also puts off discussion of taxes for another day — and it’s unlikely that we’ll see any movement on tax reform or significant tax changes until 2012.

“If I were at a roulette table in Vegas, I would put almost all my chips on a square marked ‘Lame Duck,’” says Clint Stretch, managing principal of tax policy in Deloitte Tax’s national office in Washington, D.C. “I see nothing that Congress will regard as a ‘must do’ in the tax area before a lame-duck session in 2012.”

In the second stage of the deficit reduction, a new Congressional super-committee will have a mandate to come up with some $1.5 trillion of savings by late-November. But while taxes could be part of that discussion, there are many obstacles: The two sides are very far apart, the timetable for the super-committee to do its work is very short (especially in tax terms), and the Republican victory on getting taxes off the table in the current deal makes it likely they’ll stay off a few months hence.

The tax reform efforts of 1986, 1993 and 2001 were all debated during their respective Presidential elections, and that’s likely to be the case today, too. While there have begun to be tax-reform proposals bandied about — from the Gang of Six, among others — these remain preliminary. “We have not begun a serious conversation about tax reform,” Stretch says. “It’s going to be the discussion of the next election. The President will eventually have a tax proposal, and the Republicans will have their competing proposal. Then we’ll have a bloody fight over it.”

At stake are key issues surrounding who should pay for the government to do its work, and at what level — issues of fairness and of complexity. What are the right tax rates, and should they be higher or lower than today? Should the wealthy pay higher rates? Should investment income be taxed like wages or at a lower level? Should homeowners continue to benefit from the mortgage interest deduction? Should taxpayers still be allowed to write off state and local taxes? And what about the Alternative Minimum Tax, the complicated alternate tax system? And those are just some of the questions for individual taxpayers.

In the meantime, of course, the Bush tax cuts are slated to expire at the end of next year, when the two-year extension they received last year runs out. Republicans favor continuing those cuts, while the Obama Administration had hoped to eliminate them for high-income taxpayers. Deloitte’s Stretch argues that as tax reform gets pushed off, the Bush tax cuts are likely to get another one-year extension and come up for discussion as part of broader tax-reform.

Also set to expire at the end of 2012 — though barely discussed during the recent deficit discussions — are the changes to the federal estate tax, which increased the exemption amount to $5 million and lowered the tax rate due.

Fractional ownership is on the rise, so power up that corporate jet

Despite the fact that President Obama has started taking aim at tax breaks, fractional ownership is gaining steam post-financial crisis, offering affluent consumers an efficient use of their dollars and time. So if you thought owning a piece of a private jet or Italian villa was just for the Cannes crowd, think again.

Private aviation, in particular, has taken a tongue lashing as of late, thanks to Obama’s proposal to augment tax breaks for corporate jet owners in an effort to fill the country’s coffers.

At issue is a proposed extension of asset depreciation time lines for corporate jets, which would see the expense written off over seven years, as opposed to the current five years, and will likely funnel an extra $3 billion back into the cash-strapped Treasury over the next decade.

To partially repeal the obscure advantage over commercial aviation will do nothing to deter corporate jet business, says Walter Stewart, chairman of the Stewart Organization. Stewart’s company owns 40 fractional shares in two Learjets and a Challenger 300, while Stewart personally holds a share in a Challenger 300 jet with private aviation company Flexjet.

“What they’re proposing to do is simply change the depreciation method of the airplane. Overall, it will have a tiny affect and will certainly not be a consideration for us at all,” he says. Private aviation is integral to his company’s operations, Stewart says, adding the use of a private jet has been “a game changer.”

“I’ve gotten old enough that my time is the most important thing to me. I couldn’t do everything that I do at my age and do it with commercial aviation,” he says.

Despite the political posturing, Fred Reid, president of Flexjet, says the private aviation industry will continue to grow. New business for Flexjet — which offers whole aircraft ownership, fractional ownership and charter flights — is 45 percent higher than in 2009 with the first quarter of this year up 64 percent over the same period last year.

The tax rate you should care about most

We talk a lot about tax rates here, and about whether they might go up in the future and for whom. But to think intelligently about tax policy — not to mention your own tax strategy — it pays to stop and ask: Which tax rate do you mean? And what tax rate matters most to you?

When most people talk about tax rates these days, what they’re really talking about are marginal tax rates. Your marginal tax rate is the percent you’ll pay on the last dollar of income you bring in. Today, those federal marginal tax rates range from 10 percent to 35 percent; under the terms of last year’s tax agreement, they’ll expire next year and the one thing you can count on is another big debate over what tax policy should look like.

But looking at marginal tax rates is only one way of looking at taxes. When I talk with friends about taxes (yes, I’m geeky enough to do this), I find that a lot of people are confused about what their marginal rate is and what percentage of their income they’re actually paying to the government. The latter number is a mix of tax rates applied to income that’s likely been reduced by various deductions, for home mortgage interest, say, or for charitable contributions.

No matter how much money you bring home, you get to take advantage of the 10 percent rate on your first $17,000 of taxable income if you’re married (or the first $8,500 of taxable income if you’re single). Then, as marginal rates pile one atop another, as your income rises, a slice of it gets taxed at the next highest rate, and so on, and so on, on up to the 35 percent tax bracket if you make more than $379,150.

The actual rates that people pay as a percent of their income are substantially lower than those marginal tax rates because of the combination of rate layering and deductions. The effective federal tax rate, including Social Security taxes and other individual taxes, for all households was 20.4 percent  in 2007 (the most recent year for which data is available), according to data from the Tax Policy Center. That’s below the 21.6 percent rate that applied two decades ago. And, today, middle-income taxpayers (that is, the middle quintile) paid 14.3 percent, while the wealthiest taxpayers (that is, the top 10 percent) paid 26.7 percent. Those numbers, too, are below what they were in 1987.

An even broader way to look at tax rates is to simply divide total federal revenues by the gross domestic product. Bruce Bartlett, a top  policy adviser under both Presidents Ronald Reagan and George H.W. Bush called the Republican party to task for arguing that tax rates are high in a piece in Tuesday’s New York Times:

By this measure, federal taxes are at their lowest level in more than 60 years. The Congressional Budget Office estimated that federal taxes would consume just 14.8 percent of G.D.P. this year. The last year in which revenues were lower was 1950, according to the Office of Management and Budget … The truth of the matter is that federal taxes in the United States are very low. There is no reason to believe that reducing them further will do anything to raise growth or reduce unemployment.

Considering divorce? File your taxes like you’re already single

The following is a guest post from Nancy R. Mandell. She is the former Managing Editor of Wealth Manager and OnWallStreet magazines, as well as the newsletter Securities Week. For the past decade, she has specialized in stories concerning women in finance and women’s relationship to money and investing. The opinions expressed are her own.

Maybe the “D” word hasn’t come up yet, but somewhere in the back of your mind is a nagging concern that your marriage is on its last legs.

Now — before we move one day closer to tax filing deadline day, April 18 — may be a good time to consider an option that could help preserve your financial security if your marriage ends this year.

If you’re considering divorce, consider filing a separate federal income tax return for the year 2010. This readily available, but poorly understood, option for married couples may save neither spouse any money — and in fact, could cost a few thousand dollars more — but it can save days and months of heartache. More importantly, the procedure can absolve you of  financial liabilities incurred by a spouse who has been under reporting income or taking improper deductions.

Wait a minute! Isn’t filing a joint return and taking advantage of a double deduction one of the perks of married life? Yes and no. Actually, for most of the history of the income tax, marriage incurred a tax penalty on couples whose dual earnings were roughly equal, a situation that has become more common in recent years. In such cases, couples — catapulted into a higher tax bracket together than they occupied alone — found themselves paying higher taxes than they would have as single filers.

A “marriage penalty” fix was a major part of the original Bush tax cut, according to a study by the Washington, DC-based Tax Foundation, a non-partisan educational organization. But after estimating the substantial effect of the fix, they postponed marriage penalty relief until 2005 — even then scheduling a slow phase-in so the full effect wouldn’t have been felt until 2009.

When cynics began referring to the phenomenon as the “sin subsidy” rather than a marriage penalty, “Congress thought better of that long delay,” the study found, “and at the President’s suggestion, they ‘accelerated’ the marriage penalty relief, making the maximum benefit that would have occurred in 2009 effective in 2003 and 2004.”

Will a VAT turn America into a Greek-style welfare state?

Daniel J. Mitchell is an expert on tax reform and supply-side tax policy. He is a senior fellow at the CATO Institute. The opinions expressed here are his own.

This post is part of an ongoing series on tax reform ideas. Where do you stand? Come back regularly to be a part of the national debate.

Many Washington insiders are claiming that America needs a value-added tax (VAT) to get rid of red ink. Proponents even claim that this European-style national sales tax is good for growth. Some of them say the imposition of a VAT would modernize our tax system, whatever that means. Others argue a VAT could be used to finance pro-growth tax reforms. And President Obama says that a VAT is “something that has worked for other countries.”

Every single one of these assertions is demonstrably false.

But one thing that everyone acknowledges is that the VAT is capable of raising enormous amounts of tax revenue. The tax is imposed on consumption, which accounts for about two-thirds of America’s nearly $15-trillion gross domestic product. So even a low tax rate of five percent theoretically would generate as much as $500 billion for the politicians to spend. In practice, though, politicians usually insert loopholes in exchange for campaign cash, so the actual amount of revenue would be lower.

It does not matter, however, how much revenue a VAT generates with a five-percent rate. One of the many problems with a VAT is that it is a hidden levy. Unlike a regular sales tax, which is imposed at the cash register, VATs are imposed at each stage of the production process and thus get embedded in the price of goods. And because the VAT is hidden from consumers, politicians find they are an easy source of new revenue – which is one reason why the average VAT rate in Europe is now more than 20 percent!

You probably won’t be surprised to learn, though, that all the additional tax revenue from a VAT has not resulted in deficit reduction. Western European nations first began imposing VATs about 40 years ago, and the result has been bigger government, permanent deficits and more debt. According to the Economist Intelligence Unit, public debt is equal to 74 percent of GDP in Western Europe, compared to 64 percent of GDP in the United States (and the gap was much bigger before the Bush-Obama spending spree doubled America’s debt burden).