The Tax Man Cometh

by B. Lana Guggenheim


‘Tis the season - tax season, that is. Yours are due April 18th, unless you’ve filed a timely extension.

There is much muttering and moaning about the dreaded tax man, though when pressed, most of us would admit that some level of taxation in return for government services is both fair and necessary. However, today’s tax code is a dizzying labyrinth of laws that seem invented to torture rather than merely tax. It is such exhausting work to navigate that there are entire professions centered around helping people properly file their taxes. Tax laws are so filled with loopholes, it’s as though the system lacks integrity altogether. Unlike individuals, large businesses have the power to gain industry specific tax breaks, and corporate taxes have reduced over time as a result. And the IRS seems to make little effort in tracking down corporate tax law-breakers, resulting in nationwide distrust of this organization.

Why is our tax code such a monstrous mess? Part of the answer is that our tax laws weren’t formulated in a particularly organized matter. Rather, the laws we have evolved and changed in bits and pieces over time, resulting in many layers, some of which are very confusing. In order to collect taxes and administer the Internal Revenue Code, the domestic portion of federal statutory tax, the IRS or Internal Revenue Service was created. Though this name was only made official in 1953, though it was used as early as 1913, the government body collecting taxes has been in place since 1862, when income tax was first levied by President Abraham Lincoln to raise funds to fight the Civil War. By war’s end, the Union had raised 21% of its funds via this tax. At the time, income tax was meant to be a temporary measure, but it continued on to fund the Reconstruction, and was only allowed to expire 7 years after the war’s end. In 1894, the Supreme Court declared income tax unconstitutional (and there was probably much rejoicing, unless you were in the government). In the start of the 20th Century, there was a populist movement for tax reform, ultimately culminating in the ratification of the 16th Amendment in 1913, which essentially stated that the government had the right to tax its citizens without regards to apportionment among the states by population. Since then, income tax has been part of the landscape of the American economy, though less so than it is today. However, even the imposition of a modest income tax caused the IRS a ten-fold jump in their workload, and they fell behind in their duties almost immediately; they were still processing 1917 returns as late as 1919.

The twin pressures of Prohibition and the Great Depression were the next influences on the evolution of American taxes. Prohibition eliminated the income the government received from taxes on the sale of alcohol, and drove an entire economy underground into the hands of a professional class of criminals - gangsters. The financial strain, exacerbated by the onset of the Great Depression, meant that the government sorely needed the income both from taxing alcohol sales as well as from an increased income tax. In 1927, the Supreme Court ruled that illegally obtained income was subject to taxes (and that remains true today, though we would recommend leaving out the specifics of your occupation in such cases), giving the Feds access to money they sorely needed, as well as the legal means to seize some of the gains the gangsters earned from bootlegging. It is this law that ultimately put Al Capone behind bars, when he was nailed and jailed for tax evasion. However, the demise of Prohibition in 1933 did not mean the demise of the income tax, as some had hoped. The New Deal did cut taxes for those earning less than $3,000 a year, but was pretty harsh on the wealthy, who saw their taxes rise. Payroll and quarterly tax withholdings were introduced during WWII, and the marginal tax rates on income at different income levels have fluctuated wildly since then, reaching a height of 92% in 1952 on top individual earners, and down to 28% in 1987. Currently, the top tax bracket hovers at around 35%.

Today, the IRS processes taxes as well as institutes investigations. Some of these investigations are civil tax cases and audits, which are about money owed. If you are subject to an audit, you might end up owing a lot of money, but it is unlikely you will face criminal charges. Most Americans are unlikely to be audited - the odds are somewhere around 1%. If you earn over $200,000, your likelihood of being audited goes up to just under 3%, and if you earn above ten million, or alternatively, if you report no earnings, your chances of being audited go up (approximately 16% and 5%, respectively). So too if you report income from abroad, especially from a place like the Cayman Islands. As the IRS has fewer employees now than it used to (a low in 2012 of  89,000 versus a peak in 1996 of over 116,000), their ability to audit has been impaired, even as the work they have to do has increased. This sounds like good news, but in many cases, audits find that people are owed larger returns than they initially had received, so the inability of the IRS to do its job is more likely to harm than help. This is soon after the IRS had its reputation blackened by the reveal that more than half of its employees willfully violating tax law were not let go, and some were in fact promoted. In such a situation, things don’t look good for either the IRS or the average American.

In addition to audits, some IRS investigations are criminal investigations that center around the violation of specific tax laws. In such cases, even if all the money owed is paid, the case is not likely to be dropped. While the most common crime is tax evasion, other prosecutable ills include money laundering, identity theft, and fraud. The IRS website shows an entertaining list of the top ten biggest such cases in the past fiscal year. But tax-related crimes are a regular occurrence, for the famous, infamous, and average citizen alike. The 1989 case of Leona Helmsley, nicknamed “the queen of greed” by the press, evaded taxes by charging millions she spent in redecorating to her business. She was fined over $7 million and sentenced to four years in prison. Wesley Snipes is estimated to owe the government millions in tax debt, and was eventually convicted in 2008 to three years in prison. The IRS likes to make a big deal of celebrities they catch in tax fraud, hoping to scare the rest of us into being honest on our tax forms, provided we can successfully navigate them, that is.

Where does this money go? Primarily to the military and healthcare, it turns out. Of all the Federal tax revenue, a little under half of the total comes from income taxes, making it the single largest source of federal funds. From there, the budget is divided into discretionary and mandatory spending -- 30% and 64% respectively, the remaining being interest on federal debt. Discretionary spending is decided by Congress through the annual appropriations process, and mandatory spending refers to spending on programs required by law. More than half of discretionary spending is bestowed on the military, about 15% of the total budget, and the majority of mandatory spending is split between healthcare and social security, about 60% of the total budget. Tax breaks, which function as a type of federal spending, outstrip discretionary spending, by about $0.1 trillion - or ten billion dollars. That’s a huge amount of money, but the relative difference isn’t that large - tax breaks account for $1.22 trillion, and discretionary spending for about $1.11 trillion.

All told, untangling the federal budget, the tax law, and our own taxes is a taxing affair.

Works Cited

Brandeisky, Kara. "These Are the People Who Are Most Likely to Get Audited." Time. Time, 14 Apr. 2015. Web. 14 Apr. 2016.

Coleman, James William. "Fraud and Deception: Tax Evasion." The Criminal Elite: Understanding White-collar Crime. New York: Worth, 2002. 31-32. Print.

"Federal Spending: Where Does the Money Go." National Priorities Project. National Priorities Project, 2016. Web. 14 Apr. 2016.

Fishman, Stephen. "What Are the Odds of Being Audited by the IRS? | Nolo.com." Nolo.com. Nolo, 2012. Web. 14 Apr. 2016.

Henchman, Joseph. "How Taxes Enabled Alcohol Prohibition and Also Led to Its Repeal." Tax Foundation. Tax Foundation, 5 Oct. 2011. Web. 14 Apr. 2016.

Henderson, Audrey. "Tax Tips: The IRS Criminal Investigation Process." Optima Tax Relief. Optima Tax Relief, 14 Aug. 2014. Web. 14 Apr. 2016.

"Historical Documents Relating to Alphonse (Al) Capone, Chicago." Internal Revenue Service. Internal Revenue Service, 18 Aug. 2012. Web. 14 Apr. 2016.

"Internal Revenue Service (IRS) 2012 Data Book." The Concise Dictionary of Crime and Justice (n.d.): n. pag. The Internal Revenue Service, 30 Sept. 2012. Web.

"IRS Statistics." Infoplease. Infoplease, 2007. Web. 14 Apr. 2016.

"IRS's Top Ten Identity Theft Prosecutions; Part of Ongoing Efforts to Protect Taxpayers, Prevent Refund Fraud." IRS's Top Ten Identity Theft Prosecutions; Part of Ongoing Efforts to Protect Taxpayers, Prevent Refund Fraud. IRS, 3 Mar. 2015. Web. 14 Apr. 2016.

Okrent, Daniel. "No Closing Time for Income Taxes." The New York Times. The New York Times, 12 June 2010. Web. 14 Apr. 2016.

Prohibition. Dir. Ken Burns and Lynn Novick. Perf. Peter Coyote. PBS, 2011. Documentary Mini-series.

Thomas, Kenneth. "A Big IRS Job and Fewer People to Do It." US News. US News, 30 May 2013. Web. 14 Apr. 2016.

Wood, Robert W. "61% Of IRS Employees Caught Willfully Violating Tax Law Aren't Fired, May Get Promoted." Forbes. Forbes Magazine, 07 May 2015. Web. 14 Apr. 2016.

Do Capitalists Manipulate, Deceive, and Cheat? Not as Much as Politicians Do

by Michael Makovi, Guest Writer

Real-world markets, according to Nobel laureate economist Robert Shiller, are all about manipulation and deception.

So he argues in a New York Times article summarizing his new book, coauthored with fellow Nobel laureate economist George Akerlof: Phishing for Phools: The Economics of Manipulation and Deception. According to Shiller, merchants and vendors regularly “phish for” ignorant consumers who they can mislead into acting less in their own interests and more in those of the phishermen.

Shiller claims that the theoretical defense of the free market depends on consumers being rational and well informed — a condition that doesn’t hold true in the real world. Drawing on behavioral economics, he argues that consumers are often possessed with cognitive biases that allow them to be systematically deceived by unsavory merchants. For this reason, Shiller argues, consumers need government regulation to protect their interests. The internal forces of the market are not sufficient.

Deus ex Nirvana

But government regulation is not an infallible deus ex machina. The question is not whether the market fails, but whether the government is more likely than the market itself to correct those failures. Economist Harold Demsetz coined the term “nirvana fallacy” to make this point: it is not enough to find flaws in the real world; one must prove that some feasible alternative is likely to be less flawed. James Buchanan, one of the fathers of public choice economics, compared advocates of government regulation to the judges of a singing contest who, after hearing an imperfect performance from the first contestant, immediately award the second contestant, reasoning that he must be better.

No, the market is not perfect, and consumers are often ignorant and manipulable. But the real question is this: Will government do any better?

Just because the first singer offered a less-than-perfect performance is no proof that the second singer will be any better. Ironically, Nudge author and former member of the Obama administration Cass Sunstein, no friend of economic freedom, accidentally makes this very point in his positive review of Shiller and Akerlof’s book.

According to Sunstein,

Bad government is itself a product of phishing and phoolishness, for “we are prone to vote for the person who makes us the most comfortable,” even when that person’s decisions are effectively bought by special interests.

So yes, people behave irrationally in their capacities as market participants, but they are no more rational in how they cast their votes than in how they spend their dollars.

Buying What You Don’t Want

The difference is that in a market, there are feedback signals, however attenuated. If a vendor cheats his customer by holding back information about his product, at least the customer will learn about the product’s faults after he purchases it, and he will buy from someone else next time. He will likely warn others, too. The consumer may have cognitive biases, but he has the opportunity to learn from his mistakes, prevent others from making them, and correct them in the future. The deceptive merchant will develop a bad reputation, and paying customers are motivated to learn about merchants’ reputations — especially as 21st-century technology develops ever-more-robust reputation markets, accessible through anyone’s smartphone.

By contrast, there are fewer feedback signals in politics and even fewer opportunities to act on that feedback. One vote barely counts, and each voter must vote not for specific policies, but for politicians with a range of policies. Electoral politics doesn’t really offer a choice so much as it imposes a bundle. A vote for a particular candidate implies endorsement of all the policies in that bundle, when the truth is more likely that the voter has selected the least bad option. In the market, customers can easily split their “dollar votes” to purchase only the specific products they want.

In Freedom and the Law, Bruno Leoni notes that we are all doubly unrepresented by politics: we vote for A, but B defeats A in the election. Then, when B is sitting in the legislature, he is outvoted on a bill by C. So in the end, a person is governed by politician C who beat B, who in turn beat the voter’s preferred choice, A.

When Phoolishness Is Rational

In such a situation, it makes sense for voters to be rationally ignorant of the effects of government policies they are helpless to affect. Politicians are free to peddle shoddy products when they know voters have few opportunities to learn from their mistakes — and even fewer opportunities to correct them.

Meanwhile, markets tend to concentrate benefits and costs on the consumers who use a specific product. This internalization of costs and benefits promotes learning and feedback. In a market, a person must bear the consequences of his or her own actions.

In politics, benefits are concentrated on those whom the politician wishes to favor — such as financial donors and special interests whose attention is narrowly focused — while costs are dispersed among those whose attention is elsewhere, including many who focus on producing wealth instead of transferring it.

The combination of rationally ignorant voters and informed and motivated special interests encourages rent seeking. Private benefit and social cost diverge as the political process encourages the creation of new externalities. While markets tend to internalize the costs, politics encourages externalities.

So yes, consumers are often “irrational” and deceived and make mistakes. But, as Sunstein himself tells us, this is true in both politics and markets. The question is, Which institutional environment is more likely to promote learning from mistakes? And which institution — the market or politics — maximizes a person’s ability to correct those mistakes? Shiller and Akerlof have failed to prove that government regulation will detect or correct mistakes better than the market itself can.

This article was written by guest writer Michael Makovi, and was originally published on the Foundation for Economic Education, and can be seen here.

The Easy Way to Plan Your Financial Future

Americans today are concerned about the lagging global economy & growth prospects of the economy here at home, especially after learning of the relatively flat final quarter of 2015. The US stock markets have lost over $1 trillion of value in the first month of trading this year, partially due to concerns from abroad, but local issues including the interest rate tightening by the Federal Reserve & the almost historic lows in oil prices have also contributed. In these trying financial times, many Americans are looking for safe harbor for their savings so they can accomplish life goals like retiring, putting children or grandchildren through college, or buying a first home. Fortunately, there is a veritable army of financial professionals waiting in the wings to help educate, inform, & make difficult decisions regarding investments & finances. These dedicated professionals are known as Personal Financial Advisors, and they are eager to help put your money to work!

Personal Financial Advisors assess the financial needs of individuals & help them make decisions on investments (like stocks and bonds), tax planning, and insurance. Advisors help clients plan for short and long term goals, including meeting education expenses & saving for retirement with investments.

They invest client funds based on the decisions made by the client. Many advisors also sell insurance products or provide tax advice, but they need special certifications & must be registered properly to offer these services. As of 2014, there were nearly 250,000 personal financial advisors in the US, and the profession is expected to grow at a rate of 30% from 2014 - 2024, which is much faster than the average occupation. Personal financial advisors earn significantly more than the average American, as the mean annual salary for an advisor is $108,090, compared to $47,230 for the average job. That hefty paycheck comes with a good deal of work as well; 30% of advisors worked more that 40 hours per week in 2014, and many go to meetings at night or on weekends to solicit new clients. They also must be well-educated, as advisors require a bachelor's degree, as well as a great deal of on-the-job training. Advisors with higher degrees or certifications like the Certified Financial Planner (CFP) designation can expect to earn more & may gain more clients also.

If you are interested in learning more about Personal Financial Advisors & how they can help you invest wisely, check out our fact-filled infographic below. Also, be sure to check back to our Facebook, Twitter, & Instagram pages all week to find more awesome financial advisor content!

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