How Our Current Tax Code Drives The Growing Wealth Gap

Internal_Revenue_Service_logoA common assumption in the debate on the growing wealth disparity in America is that the rich are getting richer as a result of natural forces, and the only thing that can close the gap is the government. What gets overlooked is all the ways in which government policy is driving inequality.  One example is our tax code, but not for the reason that most people think. The widening gap has little to do with the marginal tax rate. Its driven by the ever growing list of deductions and credits that go into play before one’s tax bracket is even decided.

Take our tax code’s treatment of where you live. If you are a homeowner, you get to deduct the interest you pay on your mortgage along with your property taxes, both of which can amount to a substantial amount for pricier homes in affluent areas. Renters on the other hand can’t deduct anything, even though through the monthly rent they are still paying for financing costs and property taxes (if landlords couldn’t pass those expenses through to their tenants, along with a profit, they would not be landlords).

So imagine 2 families that are financially identical, except that for non-financial reasons one decides to buy their house while the other rents the same unit next door. Even if their cost of living in their respective house is about the same, thanks to our tax code the family that owns becomes marginally richer with every passing year. Its important to note that this particular increase in net worth has nothing to do with what happens to house prices or rental rates. Regardless of whether those two factors go up or down, our tax system will always favor the owner.

The tax advantages of owning real estate are even greater for those that invest in residential property to rent out, as they enjoy both the advantages of a landlord mentioned above and the tax advantages of being a business. If for example your landlord decides to renovate the plumbing in your building, he will pass that expense on to you via higher rents in the future, but he will also deduct that expense from his business taxes. Once again both the renter and the landlord enjoy the same result in better plumbing, but one gets to deduct it from their taxes and the other does not.

The most extreme tax advantage of owning rental property is depreciation, or the idea that each year the owner can deduct a little bit of the value of their structure because eventually it will need to be knocked down and replaced. The IRS assumes your building will be worthless in 27.5 years and lets you deduct a portion of that loss every year. But when is the last time you saw a 27 year old building get knocked down just because it was old? In major cities like New York many buildings are still in operation despite being built before World War 2.  That’s because owners will repair a property to extend its life long past the depreciation schedule assumes, all the while deducting the cost of those repairs from their operating income.

In recent years a third layer of tax advantage has entered the fray, thanks to the entrance of hedge funds and private equity funds into the residential real estate space. Falling house prices and low borrowing costs that are disproportionately available to large financial entities have allowed companies like Blackstone to become among the largest landlords in America. Since these funds are structured as investment vehicles, they get to enjoy all of the tax advantages mentioned above, and then pass-off the compensation that the fund’s managers take as investment income, not wage or salary income, and thus enjoy an even lower tax rate.

When talking about the impact of our tax code on the gap between the rich and poor, most people on both sides of the debate focus on what tax rates should be.  It only takes one page of paper to display what our current tax brackets are, but our federal tax code is thousands of pages long. It is within those pages that one finds an endless supply of tax deductions, credits and loopholes that ultimately decide what the effective taxes everyone pays are and thus the true winners and losers. There are many good reasons to decide not to buy a home and to rent instead, but our tax code will punish you anyway. The same goes for decisions of what kind of job to have, how to get health insurance and how to educate your kids.

The existence of all these loopholes make hypocrites out of all of us, because even though we might have strong opinions on how things should be, we can’t help but be impacted by the influence of what is. So individuals who are opposed to the home ownership discrimination take the mortgage interest deduction anyway, billionaires that write op-eds on how their income tax rate should be higher structure their companies in ways that save them millions in corporate taxes, and rich celebrities that campaign for a more progressive tax system buy farms in the middle of nowhere to take advantage of a farm deduction.  If you notice, the more money you make, the more loopholes that are available to you, such as the $7,500 tax credit for buying an electric car. There are no poor people shelling out $70,000 for a Tesla.

Ironically, the toxic nature of these loopholes, both on our behavior and our wealth disparity, mean the best option left for those that want a progressive tax system is a radical simplification of the tax code. Call it a flat tax, or a linear tax or whatever visual description you prefer.  No credits, no deductions. Everyone just adds up how much money they’ve earned and pays a fixed percentage of it to the government. Even a flat tax  structure can be made progressive by making a starting amount of income tax free.  So lets say the first $25,000 of income is not taxed, and the rest is taxed at a flat rate of  20%. If you make $30,000 a year, your effective tax rate is 3.3%.  If you make 3 million dollars, your effective rate is 19.8%. Such a simplified tax code would have the added benefit of eliminating much of the lobbying and special interest campaign finance donations that are rotting our political system. If there are no loopholes or credits to fight for, there is less reason for corporations and the affluent to donate to politicians.

 
 

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