Feb 12, 2024
Taxation, often seen as unavoidable, is more an art form than a mere financial obligation. It is a delicate balance between funding government operations and not overburdening the taxpayers.
“The art of taxation is the art of plucking the goose so as to get the most feathers with the least hissing.” Jean-Baptiste Colbert
This concept was famously summed up by Jean-Baptiste Colbert, who knew that taxation was the art of collecting the most taxes while minimizing the complaints over taxation.1 This analogy is more relevant today than ever, especially when considering the U.S. tax system’s complexity and its relationship with citizens.
The challenge lies in the inherent tension between the need for the government to collect taxes to fund public services and the natural desire of individuals and businesses to minimize their tax liabilities. Tax policies must be designed to be fair, efficient, and effective, encouraging compliance while discouraging evasion and avoidance. This balance is precarious, and tipping too far in one direction can lead to dissatisfaction, economic distortion, or both.
The Challenge of Taxation
How to solve Unlimited Wants with Finite Means
Jean-Baptiste Colbert, serving as the Finance Minister under King Louis XIV of France, revolutionized the way we think about taxation.1 His philosophy emphasized the importance of a tax system that is as painless as possible for the taxpayer while still being effective in meeting the needs of the state. His approach underlines today’s tax policies, aiming for a system that extracts necessary resources without stifling economic growth or public contentment.
US Tax Code
The U.S. tax code, a labyrinth of rules and regulations, is a testament to the complexity and intricacy of modern taxation. It is akin to a vast, sprawling metropolis, where every street, building, and alleyway has been meticulously planned, yet can still confound those navigating it without a map. This complexity arises from the need to address a multitude of scenarios, ensuring fairness across diverse economic situations.
Taxation in the U.S. embodies a symbiotic relationship between the government and its citizens. As with the ebb and flow of a river, so goes our taxes. Over various periods of time we have expected our government to provide more or less services and that balance of what the government provides, and what individuals provide creates the basis for the Social Contract (See our article: Social Contract). It is a partnership where individuals and businesses give up some of their freedoms and liberties to live in a society fueled by their taxes that provide the public services everyone relies on, from roads and schools to national defense and social welfare programs. This relationship requires trust and transparency, where taxpayers comply with their obligations, believing in the effective use of their contributions.
The Art of Taxation
The “art” of taxation, therefore, lies in crafting policies that achieve the delicate balance of maximizing revenue without discouraging economic activity or provoking widespread discontent. It is about understanding the psychology of taxpayers, employing strategies that encourage voluntary compliance, and designing a tax system that is perceived by citizens as fair and just.
A Model used by economists called the Laffer Curve2 is a U-shaped curve that shows the relationship between tax rate and tax revenue. If you tax someone nothing and move the tax up to 1% people will continue to work and revenue will rise. As rates on taxes rise, revenue continues to rise until the rates reach a point where rates are too high. The curve begins to bend before plateauing and people begin actively avoiding paying taxes (through legal and illegal means). After it plateaus, revenue begins to drop and people are both actively avoiding taxes, and at a certain point dropping out of the workforce as it is no longer worthwhile. For example, if you were taxed at 100%, would you work? Obviously not, as there would be no reward for your labor, and the model reflects that knowing that people will stop working well before 100%.
The art of taxation is akin to weaving a complex tapestry, where each thread represents a different tax rule or policy, and the goal is to create a harmonious and functional whole. It requires a deep understanding of economics, sociology, and human psychology, like Colbert’s approach centuries ago, proving that while the tools and context may have evolved, the underlying principles of effective taxation remain timeless.
Citations
- Brittannica Jean Baptiste Colbert
https://www.britannica.com/biography/Jean-Baptiste-Colbert - Laffer Curve
https://en.wikipedia.org/wiki/Laffer_curve
Feb 12, 2024
1969. A year of moon landings, Woodstock, Tie Dye, the Summer of Love, Vietnam War protests, and less glamorously, the birth of the Alternative Minimum Tax (AMT). What began as a narrow measure to prevent a handful of very wealthy individuals from exploiting tax loopholes has morphed into a complex beast, ensnaring millions of taxpayers, including the middle class.
Born from Inequality
Imagine a world where billionaires could legally reduce their taxable income to zero – that is what sparked the AMT’s creation (Sound familiar?6). Congress, alarmed by reports of such tactics (In 1969!), devised this parallel tax system with stricter deductions and exemptions, aiming to ensure high earners paid their “fair share.”
A Modest Beginning
Back then, the AMT targeted a tiny fraction of taxpayers – just 155 individuals in its first year1 making over $200,00 a year.4 It collected a mere $85 million, a drop in the ocean of federal revenue. Yet, it served its purpose, preventing blatant tax avoidance by the ultra-rich.
The Unintended Creep
Fast forward to today. The AMT’s net has widened significantly, instead of the handful of extremely rich it is netting roughly 5 million taxpayers and is projected to catch 7 million by 2026 (See TCJA update). The culprit? Inflation and a lack of indexing. Unlike regular tax brackets, the AMT’s exemptions have not been adjusted for inflation, meaning increasingly middle-class Americans get swept up as their incomes rise with the cost of living. In 1969 when Congress passed AMT to today the Consumer Price Index from the Bureau of Labor and statistics based on annual inflation has risen a cumulative 900%. Which means a dollar in 1969 would be worth $9 today2.
The Price of “Fairness”
This unforeseen expansion creates a paradox. While the AMT still catches some high earners who game the system (or just follow what the law allows depending on your perspective), it now also burdens many individuals simply earning a decent living, and while well off, most do not consider themselves rich. For example, in contrast to those it was intended in 1969 making over $200K or over $1 million in current dollars, a family of 4 in San Francisco or New York making $250,000, while in the top 20th percentile of income, is by no means “rich” based on the cost of living in these areas and nowhere near the 1969 equivalent. This is especially true as many caught in AMT are wage earners that do not derive most of their income from investments, capital gains, or have businesses that have significant write offs. They face unexpected tax bills, negating deductions, and credits they otherwise may have relied on. This “invisible tax” can be financially devastating, pushing families into debt, and causing hardship for many in the middle class, and depriving them of wealth creation that can help them in their later years.
Overhead
While it did “catch” the very wealthy, it trapped what has become middle income (if upper middle) taxpayers in a much wider net. While roughly 5M million users are subject to AMT, 9.7M must calculate it even if they are not subjected to it.2 For these taxpayers they must calculate their taxes twice, once for their normal taxes and a second time for the AMT to determine the higher of the two. The Tax Foundation has estimated that this burden adds up to $4.6 billion on compliance overhead. 5
A Call for Reform
The unintended consequences of the AMT have ignited a debate. Critics argue it has become a regressive tax, disproportionately impacting the middle class for which it was never intended and undermining its original purpose of catching the very wealthy who were paying nothing. Some advocate for complete repeal, while others propose indexing adjustments and raising exemption levels. Members of both sides of the aisle including Bernie Sanders, and Ted Cruz have called for the complete elimination, while members like Hillary Clinton have proposed raising the limit significantly and adding a 2nd tier she refers to as the Buffet Rule for the Uber wealthy based on Warren Buffets calls for higher taxes on the very wealthy3. Many question the basic premise of AMT to begin with, the whole reason AMT exists is because of the maze of deductions in the Tax Code, especially available to business owners and higher net worth individuals. Congress enacted these for beneficial reasons, like economic incentives for growth or other areas the government wanted to incentivize. Having an alternate parallel tax system seems to defeat many of those incentives and calls into question why have all the incentives and complexity if you just turn around and create another level of complexity on top of it defeating the original purpose. Some might suggest this seems to be a fight between congress and itself.
Update: Tax Cuts and Jobs Act of 2017
Well, amazingly after almost 50 years, major changes to the AMT and good news came in 2017. Prior to the implementation of the Tax Cuts and Jobs Act of 2017 (TCJA), approximately 5 million taxpayers were impacted by AMT. The TCJA increased the AMT’s exemption and exemption phaseout through 2025, reducing the number of taxpayers subject to the AMT, to an estimated 200,000.3 While this has been great news, it is set to expire next year and if so, we will be right back where we started. Hopefully, congress will correct this and make it permanent before it expires next year.
Citation
1. Bureau of Labor and Statistics (BLS) – Consumer Price Index (CPI) – annual inflation rate
https://www.bls.gov/cpi
2. Tax Foundation – Taxpayers subject to AMT
https://taxfoundation.org/blog/taxpayers-subject-alternative-minimum-tax/
3. Tax Foundation – AMT Glossary
https://taxfoundation.org/taxedu/glossary/alternative-minimum-tax-amt/
4. Tax Foundation – Background Individual AMT
https://taxfoundation.org/research/all/federal/backgrounder-individual-alternative-minimum-tax-amt/
5. Tax Foundation – The Tax Cuts and Jobs Act Simplified the Tax Filing Process for Millions of Households https://taxfoundation.org/research/all/federal/the-tax-cuts-and-jobs-act-simplified-the-tax-filing-process-for-millions-of-americans/https://taxfoundation.org/research/all/federal/the-tax-cuts-and-jobs-act-simplified-the-tax-filing-process-for-millions-of-americans/
6. Business Insider – Billionaires avoiding paying federal income tax
https://www.businessinsider.com/how-billionaires-avoid-paying-federal-income-tax-2021-6?op=1
