“Deductions are Expensive” and Other Mistakes in the News

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I recently watched a video by VOX called, “How tax breaks help the rich.” In the video, they discuss wealth inequality (something we’ve written a whole series about) and claim that one of the biggest drivers of inequality is the tax code. Here’s their executive summary:

The gap between the rich and the poor in America looks more like developing countries than other Western nations. Trump and the GOP have proposed tax plans that will give massive tax breaks to the wealthy while it remains unclear if the middle class will get a tax benefit. Deductions give a greater proportion of tax breaks to people with higher incomes.

The same charitable contribution from two different incomes will benefit the higher wage earner, because deductions give tax breaks in proportion with tax brackets. Other countries have eliminated certain tax deductions in favor of tax credits. Credits give breaks in proportion to the amount you give, not the amount you owe.

There are two kinds of income in the US. We tax wage income at a higher rate than income earned in stocks and bonds. That means people who get their income from capital gains and stock market interest pay fewer taxes than the same income of someone who works for a paycheck.

There’s a lot in this video which can be commented on.

Having all methods of reducing your tax bill be tax credits is a fine idea. This is one step towards a flatter tax and away from our progressive tax code.

However, our tax code is progressive. Tax rates hurts those with higher incomes more, so it makes sense that the deductions help those with higher incomes more. The rates and deductions are both progressive. It does not make sense to change the deductions to be a flat tax while keeping the rates progressive.

In the video, if Steve did not receive a higher deduction, he could end up personally worse for earning extra money just to give it to charity. Imagine the law was changed so that Steve only received a 15% tax credit. Steve decides to earn an extra $100,000 to and give all the extra earnings to charity. Under the video’s proposal he would owe an extra $39,600 in federal taxes but only receive a $15,000 tax credit. Although Steve keeps none of his additional earnings, he would be $24,600 worse off for his good deed.

Additionally, the video implies that Dan and Steve are giving the same amount to their church. But even the video’s own statistics suggest that Steve is giving $1,060 for every $100 of Dan’s. “People who make 100K or more make 57% of the charitable contributions.” But at the time of the study that the video quotes, only about 5% of the population earned over 100K. If 5% of people gives 57% of the charitable donations, they are giving about 10.6 times as much per person. As an example of how the media fails to report such generosity accurately, see our analysis of Mitt Romney’s 2011 tax return.

Even outside these issues, there is a fundamental flaw in the perspective of this video which is revealed in the way they use and misuse basic words and definitions.

There seems to be a bias in many people that investors don’t deserve the money they make. In the video (5:52) this Vox reporter shows that bias by saying, “Unearned income means guys who trade paper” while showing pictures of suited men watching TV monitors or reclined at their desks. Furthermore, they imply that “people who get their income from capital gains and stock market interest” have no or little overlap to “someone who works for a paycheck” in their executive summary.

“Unearned income” is such an odd phrase because it feels like saying “undeserved income,” making it an easy target for critique. Most people don’t understand unearned income. They also don’t understand investing. They especially don’t understand capital gains.

There should be no capital gains tax. Most capital appreciation is just inflation. The part that is more than inflation is often from expenditures.

Corporations retain earnings, pay the tax on that income, and then use what remains after taxes for capital expenditures such as the purchase of a new store or factory. These expenditures cause the price of the business or stock to appreciate, making the stock price increase. That stock price increase is called a capital gain, and the government levies a second capital gains tax on the sale of that stock.

Another example is a woman flipping houses. After buying a run down home, she retains some of her earnings, pays the tax on that income, and then uses some of the remainder for home improvement expenditures. These expenditures cause the value of the home to appreciate, making her sale price higher than the purchase price. This increased purchase price is called a capital gain, and the government levies a second capital gains tax on the sale of that house.

The increased value as a result of inflation or retained earnings should not be called “income” at all. Taxing inflation and retained earnings at a lower rate is unfair not because the rate is lower but because the rate should be zero.

Capital gains are the result of spending the income that remains after paying taxes in a manner that produces more value in the world.

A similar example would be if you made $20,000. Then five years later, after diligently saving some of your after-tax money, you went back to school and learned computer programming. After improving your worth to employers you earn $50,000 the next year. The government taxes you on your income, but it also taxes you on $30,000 of “capital gain” because now you are worth more. It is a silly fabrication.

There should be no capital gains tax. It represents double taxation.

Before currency, the product of my labor was the only way I could acquire the product of your labor. In a barter system, I trade my chicken or the promise of my chicken for your stew. If I don’t have any goods or services you want, I can’t acquire the rights to your stew.

However, in today’s monetary system of trade, instead of getting an inherently valuable good as a reward for my labor, I get money. This money is just a placeholder. So long as my payment remains in currency, my labor is still unrewarded.

Spending money is where I finally receive my labor’s true compensation.

Saving money (including loaning or investing) is deferring that compensation.

Giving money away is offering the fruit of my labor to another.

Stealing my money is forcing me to labor for the thief.

Taxation is the government confiscating some of my earnings and requiring that I labor for them. They confiscate my labor (my income) directly from me each day. With the burden of paying for government evenly distributed throughout the year, the government costs us 2 hours and 33 minutes every day.

And when the government taxes my capital gains or my retirement distributions, they are taking my deferred compensation and taxing the reward of my prior labor (my savings).

Combined, these taxes require both my present and past selves to labor for the government.

Given this understanding, many of the statements by Vox in this video do not make sense. For example, in the video Vox says:

The charitable deduction is really expensive. The US spends $70 billion on the deduction.

The United States cannot “spend” money on a deduction.

Spending is where labor’s true compensation is finally received. So to say that the United States “spends” money on a deduction is to imply that they are giving the fruit of its labor to the tax payers. But the government doesn’t labor and produce any fruit. In fact there is no such entity as a government, merely collections of people whose labor is being confiscated to a greater or lesser degree. Governments cannot labor for the people. People can labor for the government.

Thus, deductions are not a government expense but rather are the tax payers getting to retain ownership of their just rewards. Having my money taken from me is forcing me into labor for the thief. Deductions are a mechanism by which money is retained by the people instead of being confiscated.

In his inaugural address in 1801, Thomas Jefferson described that in order to be “a happy and a prosperous people” we needed “a wise and frugal government, which shall restrain men from injuring one another, shall leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned.”

To Jefferson, happiness depended on the government protecting freedom and then leaving us and our prosperity alone. A worker is worthy of his wage. But the income taxes that we have now are taking “from the mouth of labor the bread it has earned.” The just rewards of labor are taken.

Vox talks of a pittance the robber leaves behind as though it were an expense to the robber. Language like this matters. To talk about this thievery as if the reward was never the laborers to keep gives claims of ownership to the thief and not the worker. It assumes that any amount the thief leaves to the one being robber is an expense to the thief. It assumes that the state owns all of the fruits of all our labor.

Unfortunately, when property rights are weakened in this way and the ownership of someone’s wealth or goods is debatable, people can gain more by trying to appropriate that wealth than by producing themselves. This behavior is called rent-seeking.

Rent-seeking doesn’t add any national value. It is coerced trade and benefits only one side. It is especially detrimental when it comes in the form of a tax code.

We have a slanted progressive tax code which means there are artificial groups of Americans from whom more tax is taken. Then we also have targeted itemized deductions, exemptions, and credits which create yet more artificial groups of Americans who pay less tax.

How these rules work and who gets to retain versus forfeit their income is the product of rent seeking.

Simpler and broader methods of taxing are fairer than highly targeted taxes. The “let’s tax that guy” mentality slips into systemic oppression and incentivizes rent seeking. That’s one of the lessons we learn from the Whiskey Rebellion: Anything more complex than a head tax in which everyone owes the same amount pits one faction against another and incites rebellion.

Is the charitable deduction fair? Of course not. Nothing about our tax code is objectively fair.

The federal government has revenue demands to meet its expenditures. It would be easy to calculate an equal share for every person. That would be fair. Instead, we have lobbyists who fight aggressively to win specialized treatment for their constituents.

Follow Megan Russell:

Chief Operating Officer, CFP®, APMA®

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.