Tax code invisibility / tax code simplification / tax code fairness

Most people can agree that the tax code should provide good visibility.

Using the word visibility in the financial arena has become commonplace in the last decade. If a CEO says there that his or her businesses has good visibility, that means that the CEO feels like he or she can look into the future and feel reasonably assured of what the future holds in the near-term and how business will be. So good visibility means I can see the future, and I can predict it well.

Now, most folks believe that the tax code should provide good visibility -- that the common Joe and the common Sue out there should be able to know that, if I do this, then my taxes will be $x.

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The federal tax code we all live with has provided less and less visibility since Bush became president.

One example appeared in today's SF Chron, where Kathleen Pender, one of that paper's financial columnists, wrote about the tax implications of the $3 per share dividend Microsoft is about to pay to people who owned the stock as of close of business yesterday (the ex-dividend date).

So let's say that Joe and Sue own MSFT shares. Lots of people do -- it's one of the most widely owned stocks in the world, and, by most measures, is the most wealth-generating stock in the history of the world. So a lot of non-wealthy people own shares in MSFT -- the sort who might not have a CPA and might not know that much about the tax code.

So how visible is the tax code for Joe and Sue MSFT shareholders? How well can they predict what will happen if they do various things with their MSFT shares?

Well, the tax code is there for Joe and Sue to see, so, in a strict sense, the tax code is visible to Joe and Sue, but it is way way way complex -- so complex, in fact, that it is tantamount to being invisible to all but those most well-versed in the multi- multi-volume book called the Internal Revenue Code (which, unlike the 9/11 Commission Report, has never been nominated for a great book award).

How complex is it?

Well, for one instance, according to the article, if Joe gets the MSFT dividend but sells his MSFT stock before a certain date in January calculated using a 61-day holding period (why 61?), then Joe does not get the favorable tax treatment afforded to the good kind of dividends. Instead, he gets socked with taxes on that MSFT dividend at the same rate that applies to his wages and whatnot, which for most people will be double or more the other rate.

And there's another odd, seemingly impermeable twist: if Sue (a) bought her MSFT shares, say, six months ago, and (b) sells those shares, say, next February at a loss, and (c) if the MSFT dividend she receives exceeds 10 percent of what she paid for the stock (factually an impossibility, because MSFT hasn't been above $30 in a long long time), then she gets to treat the loss on the sale as a long term capital loss, while if there had been no dividend then she would have to treat the sale as a short-term capital loss.

Gobbledy-goop, eh?

And that's the point: just how visible is all that to Joe and Sue? Is it visible at all?

To paraphrase Gretchen Wilson, she of the biker-mama aura, she being the big-deal country music start-up star of the year, hell no!

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The Alternative Minimum Tax, usually called the AMT, is among the most complex, least visible provisions of the tax code. You will never see a CPA "eyeball" an AMT question. So if you have a CPA (most people do not) and if you say to him or her something like, will this have AMT ramifications?, the normal response will be, I'll tell you once I go boot up the software and punch in the numbers.

That, right there, is as good a definition of tax code invisibility at the lay person level as any. If a CPA has no visibility for a certain part of the tax code absent a computer, you better believe that none of us does. And if we can't understand it without asking a CPA to run the numbers, that means that we all either need to talk to CPAs often, or we all need to become the equivalent of one.

Or simply fess up to the fact that we will fall into traps for the unwary., which is a term lawyers use for something bad that happens to anyone who isn't paying attention.

Now a trap for the unwary in the tax code is something that most everyone falls into, because most everyone is unwary when it comes to the tax code, if for no other reason than they have been stupified by it every time they tried to understand it, and have therefore given up trying.

Someone selling MSFT before mid-January is falling into a trap for the unwary; if they wait until the end of January they'll pay tax on their dividend at a 15% rate, but if they do it in early January they'll pay double that.

You better believe that a ton of tons of people will do just that (that's 4 million pounds and, at 150 pounds a person on average, that's 26,667 people falling in to this mighty mighty big trap).

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Bush's tax changes have added a lot of invisibility to the tax code, primarily through the lathering on of sunsetting, which is the term used to describe what happens when tax code changes expire as a matter of course.

In getting his tax cuts through Congress Bush used the sunsetting technique more than anyone had in the past. He did so because the tax cuts he wanted to give to people were bigger than were permissible under a ten-year budgetary law that Congress had passed during the Clinton years (remember those?). That budgetary law said that, in any ten-year period, projected budget deficits couldn't exceed a certain level. Well, the tax cuts Bush wanted to give to people far exceeded that deficit level over the ten-year period, but, hey, look at that: if the tax cuts went away after, say, seven years, then the three years of reversion back to the pre-tax cut tax code saved the tax cuts from being against the 10-year law.

So that's what Bush did: he put tax cuts through that, but for their sunset provisions, wouldn't have been legal. Sunsetting, then, allowed him to take the figurative governor of the tax cut engine, hot wire it, so to speak, with the hope that he would then be able to make them permanent later on.

When an opponent does it, you call it smoke and mirrors. If you do it, you call it sound budgetary discipline.

Among the sunsetting changes Bush put through in the past four years were (a) the 15% maximum capital gains rate, (b) the 15% dividend tax rate, (c) the tax forgiveness on distributions of 529 Plan earnings when those earnings are used to pay for college, and (d) significant increases to the amount of a dead person's estate that could be given to heirs free of estate tax.

Those sunset provisions clouded visibility for the past four years. Were those tax goodies for the wealthy and the quite comfortable going to sunset or not? Who was to know? And that made it hard to plan, because you just didn't know what the rules were going to be. So chalk up a good deal more invisibility

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Bush never couched his past tax changes in terms of simplification. He didn't need to because the un-spun truth behind his tax cuts was just fine and was exactly what a lot of people wanted to hear the government say: less for us, more for you!

But now he's talking about simplification.

Reagan talked about it too. One of his tax-simplifications was to increase the limited martial deduction for estate taxes to an unlimited deduction. People of most any persuasion would say that that was an OK thing to do -- spouses should be able to leave everything to their surviving spouse without the government first coming in and taking dibs and shortstops and such.

Another of Reagan's simplifications was getting rid of -- clobbering really -- the real estate tax shelters that were so ubiquitous back then as well. Sheesh, did he ever shoot those in the head. A lot of people never saw it coming, and, brother and sister, come it did, and with quite a wallop.

But he also got rid of income averaging, which many people feel was a step away from fairness. Without income averaging people who had lumpy income streams (e.g., lots of income one year, non-existent income the next, OK income the next year, non-existent income the next) were taxed like the rich one year and taxed like the destitute the next, with the overall result being that they were taxed like upper-middle class or lower-upper middle class people even though they were solildly middle class. Income averaging, then, allowed them to average out their lumps over a handful of years, so that they were taxed in keeping with their average income over those years.

Getting rid of income averaging made things simpler -- taking alternatives out of the mix is, by definition, a simplification, yes? -- but was it a step towards fairness?

Hell no!

If you had lumpy income back then and still have it today, because you've chosen to make your economic way through the world outside of the W-2 world, you know that it was more complex before but also more fair. True, the difference in tax rates for the rich and the middle-class is miniscule these days, so not having income averaging is less of a big deal, but all during the 1990s when the difference was fairly significant you were paying more than your fair share simply because you had lumpy income.

And that's the point: sometimes to treat people fairly you have to add some complexity into things because of the infinite variety of ways that people make their way in this world.

Treating everyone as if that is not the case will, inevitably then, treat like things differently and different things likely.

And that means that flat-taxing everyone or simplifying the tax code might be treating everyone alike at one level, but vastly differently at another.

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So there's a very real, very irreconcilable tension between simplification and fairness.

Adding more visibility into the tax code is a good thing. It will make it easier for all us to be financially healthy because we won't need to study the tax code quite so much or be talking to our CPAs quite so much or simply falling into traps for the unwary repeatedly. So kudos to those who succeed in doing so.

Getting rid of sunsetting , in and of itself, would be a good thing (though making budget-busting tax cuts permanent would not be -- see yesterday's piece). And getting rid of the AMT would be a good thing too because it is just way too complicated.

But most of us should be afraid -- very afraid -- because we might lose fairness as we gain simplicity.

We saw some of that with Reagan, and we can expect more of it from Bush. In fact, dollars to doughnuts, any simplification coming at us will also poke a bit of finger into our eyes because, when interests collide -- and when it comes to economics, they always do -- we all know which interests have had the upper hand the last four years, and those interests ain't us.

That means that we are likely to get some shifting of the tax burden along with tax simplification.

So picture this: Joe and Sue, you and me, and all of our parents and relatives, kids and grandkids, all getting taxed exactly the same as Donald Trump or Bill Gates or Rupert Murdoch, all in the name of simplification.

It would add visibility, but would it be fair?