Today, President Bush signed into law a new tax law that puts in place a three year exclusion from income of mortgage debt forgiveness. Currently, individuals who receive forgiveness of their mortgage must claim the forgiveness as income on their IRS tax forms. This change in tax law is bad tax policy for two reasons. First, it's temporary. If mortgage debt forgiveness should not be taxable income, then why should somebody who is in financial trouble in 2008 be more deserving of somebody who is in financial trouble in 2012? Such a provision defies logic and basically shows that the politicians are just trying to appease the short-run concern of voters, void of any true principle.
But then again, tax policy in Washington is rarely driven by principle. And that brings us to the second reason why this is bad tax policy mortgage debt forgiveness is income and should be taxed under an income tax. There is a reason that the IRS lawyers have ruled that this type of mortgage debt forgiveness should be treated as ordinary income.
Under a pure income tax, a house would be treated as an investment that pays annual dividends (in the form of imputed rental income) and which can have capital gains or losses which are realized upon sale. But for political reasons, we have decided that not only should imputed rental income not be taxed and capital gains on primary housing non taxed, but that homeowners should be able to deduct the mortgage interest that they pay. (It really is bizarre policy when you think about MID allowing people to deduct mortgage interest against income that they don't have to claim.)
Now on the issue of debt forgiveness, if an individual seeks to purchase a $450,000 home and needs to borrow $450,000 to do so, the interest expenses should be deductible under the pure income tax assuming the imputed rental income is taxed. For simplicity, however, assume there was a zero percent interest rate. Suppose one year later, the value of the home now falls to $200,000 given the market and the bank forgives the remainder of the loan. $15,000 has been paid off, but the bank now forgives the person of the remaining $435,000 and takes the home. Should that $435,000 be taxed?
From a Haig-Simons perspective, the person's change in net wealth is zero relative to the starting point (before the investment). Ignoring the imputed rental income (the consumption portion of HSI), the person would be forced to claim the forgiveness as income but also be allowed to deduct from income the huge capital loss as a result of the house depreciation. However, the U.S. tax system does not tax the capital gains from housing nor does it allow for housing-related capital losses to be deducted against income. Therefore, the forgiveness should still be treated as income and the person should have a positive tax liability.
Finally, it is worth noting that this will cost $1 billion. So how do we pay for that? Raise taxes on somebody else of course. Bloomberg News reports that "the $1 billion cost of the bill will be offset by raising penalties on partnerships and small businesses that fail to file tax returns." That is not sound tax policy either. The penalties on partnerships and small businesses for not filing tax returns should be set in order to ensure proper compliance, and should not be increased merely because politicians want to raise revenue to pay for something else. (Same principle as Virginia drivers' fees and cigarette taxes.) There is an optimal fine amount, which is independent of the need to raise money to help bailout homeowners who happen to be struggling when others are struggling.
It has been a common theme recently for elected officials to go after cigarettes for a tax hike to pay for some spending program that is supposed to provide general public benefits. What is the justification of this type of policy from the perspective of sound public finance? Unless one wants to argue for an across-the-board switch to Ramsey Rule taxation, there is none. It's pure democratic politics: use the coercive power of the state to take from an unpopular minority to finance a majority's wishes.
The latest two examples come from California and South Carolina. Gov. Schwarzenegger (yes, the same man who used to loathe socialist policies in Free to Choose videos) wants to use the revenue to pay for universal healthcare in California. Gov. Sanford wants to raise the South Carolina cigarette tax to pay for a flat tax in his state.
Neither has justified higher cigarette taxes on the grounds of empirical evidence on their negative externalities. They just want the revenue. It's kind of scary that in a supposedly free country a politician with the political support of a majority could raise taxes on an arbitrarily selected minority to finance a program that benefits the majority.
Our recommended holiday reading for these politicians: Federalist Paper No. 10 by James Madison
(Caution: May contain words not used often in everyday readings or talk such as "liberty.")
There's a lot of talk of silly tax policy now-in-days. Every politician seems to have some funny gimmick that will tax some group to pay for a program for some other group. So with the holidays upon us, here's a list of new taxes we wouldn't be surprised (for better or usually for worse) to see proposed:
Egg nog and Christmas cookie "fat" tax
They are staples of the holiday diet, but they're also the cause of the ever-expanding American waistline. Therefore, it's time to tax these holiday favorites into oblivion.
Christmas Tree Global Warming Tax
Deforestation is certainly a cause of global warming, so expect that evergreen to cost a bit more green next year.
Menorah Candle Carbon Offset Fee
Burning candles is one quick way to increase your carbon emissions, so prepare to give one night's worth of presents to the tax man.
The Gift of the Magi Sales Tax Holiday
Perhaps with a bit of incentive from the taxman Jim and Della could have afforded that watch chain and hairbrush outright (though that doesn't solve the question about the income they gained from pawning the watch and her locks of hair - maybe next year).
Holiday Lights Carbon Tax
Electricity runs on coal and coal equals carbon, so plug in Frosty on the front lawn and prepare to pay.
Ebenezer Scrooge Charitable Donation Deduction
Maybe old Scrooge would have abandoned his miserly ways a bit sooner if he'd had a bigger tax incentive to do so. Maybe Tiny Tim will have the holiday the feast he always wanted after all.
Snow Shovel Tax Credit
Tax policy isn't just about penalizing "bad" behavior. This year, we'll reward those who buy a shovel instead of firing up the ol' snow blower. After all, there will be no more white Christmases for them if they keep up their gas-powered ways.
Coal in the Stocking Carbon Tax
Well, duh. What else would you expect after a year of being bad but an added tax?
New Years Eve Champagne Liquor Tax
Booze is always a favorite target for special taxation, so why not up the ante on the biggest celebration of the year. You're going to pay for popping that cork this year.
New Years Cigar Tobacco Tax
Tobacco is another easy target, so there's no reason to leave them out of this holiday tax-and-spend-a-palooza. Puffing on that stogie will mean paying the piper this go around.
and finally...
The Broken Resolutions Fee
You promised to lose weight, you promised to spend more time at home, you promised to go out and volunteer... and broke every single one of those resolutions. You got away with it last year, but not this go around. Break your word and pay the price. After all, if the tax man isn't watching out for you, who is?
Happy holidays!
Inflation adjustments for tax brackets, exemptions, and deductions will mean that your first paycheck in 2008 will be slightly higher than your last paycheck of 2007, even if your salary remains the same. While the increase this January will not be nearly as large as last January, it will still be noticeable.
For a single person earning $50,000 per year (assume all wages/salaries and no adjustments), his federal individual income tax bill under 2007 tax parameters would be calculated as follows:
AGI = $50,000
Taxable Income = AGI less Standard Deduction ($5,350) and Personal Exemptions ($3,400) = $50,000 - $5,350 - $3,400 = $41,250
Income Tax Before Credits = Tax Paid at 10% Rate + Tax Paid at 15% Rate + Tax Paid at 25% Rate = (($41,250 - $31,850) * .25) + (($31,850 - $7,825) * .15) + ($7,825 - 0) * .10) = $2,350 + $3,603.75 + $782.50 = $6,736.25
Credits = 0 (we assume no credits)
Income Tax After Credits for 2007 tax law = $6,736.25
Now for a person earning $50,000 under the 2008 tax parameters:
AGI = $50,000
Taxable Income = AGI less Standard Deduction ($5,450) and Personal Exemptions ($3,500) = $50,000 - $5,450 - $3,500 = $41,050
Income Tax Before Credits = Tax Paid at 10% Rate + Tax Paid at 15% Rate + Tax Paid at 25% Rate = (($41,050 - $32,550) * .25) + (($32,550 - $8,025) * .15) + ($7,825 - 0) * .10) = $2,125 + $3,678.75 + $802.50 = $6,606.25
Credits = 0 (we assume no credits)
Income Tax After Credits for 2007 tax law = $6,606.25
The person would save $130 on the year assuming no pay change, which would be about a $5.42 pay increase per pay period (assuming two per month).
Note also that inflation adjustments do reduce somewhat any growing income gap between those whose real incomes did not grow as fast as others as higher exemptions and deductions make the tax system more progressive.
Finally, a pay raise will not apply to some of those who live in Maryland as paychecks for high-income Marylanders are set to shrink significantly starting Jan. 1, 2008 thanks to the recent tax hike approved by the legislature and Gov. O'Malley. Those not high income in Maryland may see higher paychecks thanks to a slight increase in the exemption amount, but they will see higher taxes when they shop as the sales tax is going from 5 percent to 6 percent effective January 3rd.
Since taking office, Governor Mark Sanford of South Carolina has sought to cut his state's income tax, which tops out at a 7 percent rate. Yesterday, he unveiled a proposal to offer residents the option of sticking with the current code, or paying a 3.4 percent flat tax, with no exemptions or deductions.
He estimates the revenue loss would be $107 million, which he proposes to make up by increasing the state tax on cigarettes from 7 cents to 37 cents. According to the Governor, it's a step to increase South Carolina's competitiveness and bring about sound tax policy:
This is about beginning a long-overdue conversation in South Carolina about the way we tax and about the need to simplify our tax structure. To that end, we're making this proposal as a way of starting that conversation and as a way to take a meaningful step in that direction.
Sanford has tried reforming the state income tax several times since taking office:
In 2003 Sanford supported raising the cigarette tax to cover Medicaid costs, while advocating gradual reductions in the top income tax rate from 7 percent to 6.5 percent in the first five years, and then to 5 percent over the next 10 years. In 2004 he supported a proposal to reduce the income tax rate to 4.75 percent over 10 years. The proposal passed the House, but was killed by a seven-hour filibuster by Senate Democrats. A similar measure approved by the House in 2005 was scaled down by the Senate to a reduction in small business taxes, which Sanford signed, while vowing to return the next year "asking for what the Senate ultimately didn't give you this year."
In 2006 Sanford proposed an income tax rebate and limiting state spending to population growth plus inflation with a referendum similar to Colorado's Taxpayer Bill of Rights, also known as Amendment 1. But lawmakers were more interested in property tax relief that year, and Sanford ultimately signed a bill raising the sales tax by 1 percentage point to pay for a partial property tax exemption for owner-occupied homes and a reduction in the tax on groceries.
While we've criticized (most recently yesterday) the soundness of raising cigarette taxes for general revenue needs, the flat tax plan is an intriguing one, and hopefully it will generate a good discussion about tax policy in the Palmetto State.
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