Tax Deductions vs Subsidy

The recent attempt by TIME magazine as a SuperPAC to "SwiftBoat" (promulgate political lies) in favor of their candidate got me to thinking. My father told me (confirmed multiple times in my own experience) that "Those who can, do; those who cannot, teach" [or write magazine editorials masquerading as teaching]. So it seems possible that author Michael Grunwald and his editors really do have Clue Deficit Disorder -- they're stumping for the Democrats, aren't they? That should be proof enough that they are (in the words of fellow left-wing journalists) "poor, uneducated, and easy to lead."

The purpose of this essay is to explore the nature of the American tax system to see to what extent it qualifies as "subsidy", as compared to how much of it is smoke and mirrors designed to bamboozle taxpayers and journalists alike.


First, we need to understand what exactly constitutes a "subsidy." Taxes fairly collected are generally not subsidies. Taxes not collected when not due are also not subsidies, they are just the tax system at work. Lower taxes across the board on poor people and higher taxes uniformly laid on rich people are not subsidies, they are merely a just imposition of taxes on those people best able to pay them.

When the Federal government chooses to exempt from income tax the salary of Federal judges, that is not a subsidy, it is the reasonable interpretation of the Constitutional provision that Federal judges shall not have their salary "diminished" by Congress. Taxation does diminish income.

When the Federal government chooses to exempt from income tax the interest earned on munincipal bonds, that is a subsidy, but it is effectively granted, not to the investor who buys such bonds, but to the cities and counties that offer them on the bond market. How is that so? The investor who has money to invest, will put it out to interest or gain at the best possible rates he can get for the risk level of that instrument in his investment portfolio. If his combined (State+Federal) income tax bracket is 40% then $4 out of every $10 he earns on taxable bonds must be paid in income tax, but he pays no tax on the muni bonds. The bond market people know this, so if a taxable bond offers 10% interest, a corresponding muni bond can offer only 6%, and the investor makes exactly the same amount on his money, after tax. The only difference is whether or not the borrower pays a higher interest rate, which the IRS (and state) immediately takes in taxes. It's a wash for the investor, but the cities get to borrow at a lower interest rate. The subsidy is effectively paid to the cities, not to the rich investor, even though it looks like he is paying less in taxes, because the investor is not making any money at government expense, the city is. There are slight variations in tax rates and interest rates, which are designed to balance out so the lenders get the best interest, and the borrowers get the money they need at the lowest possible rates. The market works that way, and it works well.

When the Federal government chooses to tax at a lower rate money which is invested in making businesses grow, then more businesses will have capital to grow, and they create more wealth for all of us to share. The stock market inserts a degree of separation between the investor and the businesses he owns a part of, and that is good, because it makes more money available for businesses to grow and create wealth in this country. "The rising tide lifts all boats," and we all benefit from the creation of wealth. And yes, some people make more money out of the stock market than others, because they (or their grandparents) worked harder, or were more lucky, or took bigger risks, or some combination of those. It is a mathematical principle that bigger risk must yield bigger profits. Taxing long-term capital gains at a lower rate is kind of like a subsidy, to encourage investors to invest as Warren Buffett does (for the long term), which is better for everybody. If the government didn't do that, there would be less money invested, and less wealth created, and fewer jobs, and we would all be poorer. How that wealth trickles down to the rest of us is a little complicated, perhaps best left for another essay.

Sometimes a city or state will offer reductions in other kinds of taxes, or guaranteed loans (which therefore cost less on the bond market because of the reduced risk) to a business to bring a large employer into their area. This is a subsidy, which increases the profitability of the company thus enticed, with the expectation that the people they hire will pay more in income taxes and sales taxes and property taxes than the city or state is losing in tax abatement subsidies. Mostly it works, or they wouldn't do these things.

Except sometimes a greenhorn President who has never run a business himself, and who has surrounded himself with greenhorn politicians who also know nothing about business, might offer subsidies to otherwise unprofitable or poorly managed companies for political purposes, and then when they fail as the rest of the business community knew they would, he just says "Oops!" and tries to tell you lies about other things that are not subsidies.

Tax Deductions

Next, we all need to understand that (with few exceptions, notably Social Security, the new Conscience Penalty Tax, and maybe sales taxes) the American tax system is reasonable and equitable. The poor people pay no income tax, which is reasonable, because they don't have much income to pay it from. The rich people (by the world's standards, which is mostly middle-income in America) pay more in taxes than the not-so-rich (but not really poor) people because they can afford it. And the very, very rich (Warren Buffett, Bill Gates, Barack Obama, etc) pay less in taxes if and only if they invest their wealth in ways that build more wealth in America. And we want them to do that, because it improves life for all of us. There aren't that many of them, so the lost revenue in taxes isn't that big a bite out of the national economy, and it gets made up by all the extra taxes the rest of us pay by being rich and not poor. And we are happy to pay those extra taxes, because it means we are making a lot more money than those poor folks who pay even less in taxes than Warren Buffett and Bill Gates and Barack Obama. Be happy. High taxes means you are well off. You could be like me, with no gainful employment.

Social Security is not an equitable tax. It falls most heavily on the poor and middle-income people. Rich and very rich people pay a much smaller percentage of their income in Social Security taxes. The new Conscience Penalty Tax (also know as ObamaCare) falls even more heavily on the poor and less on the rich. Both of these taxes were invented by the political party which pretends to want to "tax the rich." It's a lie, but then so is the name of their party.

Sales tax falls more heavily on the people who buy stuff, than on the people who sock their money away in investments that make America wealthy. So it's kind of like a subsidy on investment. That's not a bad thing, but it could be better. Enough said, that's not my purpose today.

What are "deductions"?

Have you looked at the tax code lately? It's huge. Mostly it's big because it tries to make sure everybody's income gets taxed exactly once, while closing up loopholes which enable shysters to get away without paying tax on their income. The biggest complications come from determining what is a reasonable cost of earning money, which is therefore not income. Some examples:

You go to the grocery store and pay $5 for a hunk of steak. That's "gross income" to the grocery store, but it's not profit. The actual profit on that $5 is probably closer to a dime. You took that steak to the checkout counter, and the checker spent one minute beeping it through her scanner and putting it into a plastic bag and accepting your $5 bill and handing you a receipt. She is paid maybe $12/hour, so that minute of her time cost the store 20 cents, plus another 30 cents in health insurance, payroll taxes, and the time she was just standing there waiting for you to come to the checkout, a total of 50 cents. The butcher who cut the steak from a slab of beef is more skilled, so he is paid more for the one minute it took him to cut it and wrap plastic around it, and place it in the meat display case, probably a whole dollar. The store bought the slab of beef from their warehouse for maybe $2/pound, but half of that slab is bones and fat and stuff they can't sell, or maybe they can get only $1/pound for it. The effect is that the good beef cuts cost the store $3.50/pound. They also must pay for the electricity to keep the display case cold, and the manager's salary, and the property taxes on the building and parking lot, and the mortgage on the store building. Amortized over all the beef and bread and lettuce and soap, these things come to a few pennies, but it adds up. It's the cost of doing business. What's left over after subtracting off these costs is a "gross profit" of $0.10 on that $5 steak. That's what the grocer earned from your purchase, and that's what he pays taxes on. The other $4.90 are expenses and costs, which the grocer never gets to take home to buy his family's food and clothing.

That warehouse bought the steer from the cattle barn from the farmer for maybe $800 to $1000, about a $1/pound, give or take. They have to slaughter the animal, throw away the guts and stuff nobody wants to eat, properly age it, and cut it into slabs to sell to the grocer. He has labor and a mortgage and fuel to take the steer from the cattle barn to his slaughterhouse, and from there to the grodery store. He probably only makes a quarter on that $5 steak you bought, the rest is cost of doing business. He pays income tax on that 25 cents, not on the whole $2 the grocer paid him for the pound of flesh.

The farmer might birth his own calves, but he must feed them and call the vet in when they get sick, and pay his own mortgage on his farm land, and buy feed when bad weather destroys his hay. Most of the farmers in this part of the country do not make enough money on their farming to feed their own families, they also hold a day job in the city. They work hard, and their kids work on the farm (for free). It's a tough life, but they like it. I guess they consider it more fun than taking a vacation in the Bahamas. The farmer didn't get much profit from that steer from whose rump that $5 steak came from, because it cost so much to raise and feed it, maybe he earned a dime, or maybe this year he actually lost money. Farms are like that. The tax system recognizes that some years farmers don't make much, and that they have special costs, and there are special forms (Schedule F) for reporting their income. If he earned a dime, he pays tax on that dime; if he lost money, it comes out of the next (or last) year's taxes, so on the average -- so long as there is a long-term profit -- the farmer pays taxes on the money he earns over the long haul.

The whole point of the "deductions" part of figuring your taxes is to determine what part of the $5 the grocer took in at the register is labor and wholesale cost of goods and overhead, so as not to make the grocer pay taxes on the cost of running his business, but still pay taxes on the money he takes home and uses to buy clothes for his wife and kids. Deductions are not taxable income, they are merely part of the calculation to determine what is taxable income. Every business has legitimate costs in running that business, and those are "deducted" from the gross income before the tax rate is applied to the remaining "taxable income." Nobody ever attempted to tax the cost of doing business, they only tax the profits.

Unfortunately, the human heart is deceitful above all things and desperately wicked. People like myself and author Michael Grunwald really don't need to buy much stuff to turn our thoughts into pixels on the screen, which we get paid for. So he and I and others like us do not have a lot of legitimate expenses to deduct against out income. It is tempting -- and Grunwald almost admits to it -- to buy books we want to read and call them "deductable business expenses" and who's to know? It is tempting to allocate a room of the house as a home office, and deduct the expenses of that part of the house as business expenses, and who's to know? Grunwald did that for one room (apparently out of six). The IRS does not have time to hassle every taxpayer to determine if their deductions are legitimate business expenses or tax fraud.

Time-Shifting Taxes

Some deductions only move taxes paid from one year to another. Maybe the tax rate might be higher that year, maybe lower, but the taxes will be paid. Short-sighted greedy people might suppose they are getting out of paying taxes, but it's not true. Take Grunwald's home-office deduction, for example. These are only guesses, but you get the idea; let's suppose he bought his house for $240,000, and pays $1,000 each month in mortgage, maybe $800 of it as interest. The IRS lets him deduct that $800 from his income before figuring his taxes. Grunwald called it a "subsidy" but it's not. He's still going to pay tax on that interest, but it will happen later in his life, after his tax rate is higher. It will be higher in the future, because he's stumping for the Democrats. He's not very smart, but those who are smart enough to actually create wealth do so; those with less elevator, write magazine articles. How does he pay tax on that interest? When he sells his house, maybe five or ten years from now, after the housing market recovers, and he gets double what he paid. That's $240,000 that he must pay capital gains tax on. Don't forget, the Democrats are trying to raise the capital gains tax to be the same as income tax. If Grunwald had not deducted the interest on his income tax today, he could count it as part of the "basis" = the cost of buying the house, and his profit would be much smaller, for a much lower capital gains tax. Pay the taxman now, or pay him later, you will pay.

Grunwald also deducts 17% of the cost of his house (one room out of six) as a home office expense. The biggest piece of that is the mortgage interest, but that's a wash because he has already deducted it; he cannot deduct it twice (that would be tax fraud, and the IRS does not take kindly to fraud) so it has a minimal effect on his taxes -- today. But it hangs him out to dry on his own petard when he goes to sell his house. By deducting 17% of his homeowner expenses as a business deduction, he is effectively selling one-sixth of his house to his business. When he gets around to selling it, perhaps to move into a bigger, nicer house, that 17% that his business owns must pay capital gains taxes immediately; it cannot be rolled over into the new home. Furthermore, if he sells it when he retires, he gets a one-time exclusion of $250,000 on personal capital gains on his primary dwelling, but that 17% is office space, not primary dwelling, so it is excluded from the exclusion. In other words, he must pay taxes only on the 17% he deducted as office space today. Like I said, he's a Democrat, he can't be expected to be very smart about money. Most likely the IRS won't notice, and he will get away with tax fraud -- unless the IRS gets more diligent with middle-income tax cheats because the economy is still so bad from what Grunwald's favorite political party is doing to it today.

Another Grunwald deduction is his 401(k) retirement account. That's also not a subsidy, he still will pay taxes on all that money that is being deducted today, and like his mortgage interest, it will be at the higher tax rate of tomorrow (when he retires) instead of today's rates. If he dies before he pulls it out, it will be taxed at the maximum estate tax rate, which his favorite political party is trying to raise on middle-income people like Grunwald. Did I mention, he's not very smart? He hasn't improved.

Grunwald mentioned another tax deduction, for charity donations. Like the others, he calls it a "subsidy" and like the others, it's not -- at least not to Grunwald. Sure, he doesn't pay income tax on the money he gives to qualified non-profit organizations, but he doesn't get to keep that money. (Still assuming a combined tax bracket of 40%) he must give away $100 for every $40 he takes off his taxes. Basically he's out $60. If there's a subsidy involved, it's to the charity, because they get a donation of $100 for every $60 it cost their donors. But that sounds too much like government giving to religious organizations, so nobody talks about it that way. Instead we recognize that the First Amendment tells government "Hands off of religions," which especially includes taxing them. So like the Federal judges above, the religious organizations are not taxed at all; the deduction that Grunwald might take if he actually gave to charity (people in his tax bracket generally don't give much to charity) is a way of the government not taxing the income of the charity. Furthermore, most charities return back to their communities far more in public services than they cost in tax deductions. Government-funded public schools cost the most per pupil and turn out the worst-educated; private schools do much better. Church-run soup kitchens feed more people at lower cost with less waste than government programs. It makes sense for the government to just get out of the way and let people who know what they are doing do it. Now the Democrats think they can do better, so they try to impede the religious organizations from doing what they do best, but that leads to "fraud, waste, and abuse" which the politicians and union honchos are good at siphoning off, leading to bigger deficits and lower quality services.

So if you go through Grunwald's SwiftBoat piece, and look at all those deductions he calls "subsidies," you find they aren't subsidies at all, they are just taxes he must pay some time in the future at possibly higher tax rates. Maybe he will save a few bucks over the long haul, maybe it will cost him  a few bucks. What the deductions mostly have done is make his life complicated, so he must pay an expensive tax attorney to do his taxes every year from now until he dies, instead of filling out a simple 1040 short form in 20 minutes. And you call that a subsidy? I don't.

Tom Pittman
First Draft, 2012 September 14


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