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The Strange World of Tax Deductions

Javi Calderon

The Strange World of Tax Deductions 

As the race for the GOP nomination heats up, its becoming increasingly clear that this Presidential election is on a collision course with the growing storm of tax reform, which seems poised to become the hot-button issue of the upcoming election. 

It’s no secret that the United States is saddled with a massive national debt, while receiving little help from an economy that is recovering at an excruciatingly slow pace. In the meantime, the Obama Administration is overturning every rock in search of some extra cash to either pay down the debt or reinvest into economic recovery – while hoping to stumble upon a secret elixir to fix both.

On an individual level this is like having to choose between paying off utility bills or making necessary car repairs. Without the car, the commute to work is slow, and frustrating. On the other hand, living without utilities isn’t really an option. Unfortunately, it looks like this person has to carpool, or use public transportation to get to work until they can pay off their utilities, and then fix the car. In other words, we may just have to wait and be patient while the tedious process of economic recovery happens organically, and then we can worry about paying down the debt.

When it comes to government, Americans have high expectations and are not that patient. We expect Obama to somehow get the economy rolling and cut down our debt simultaneously, while we know from our personal lives that money just doesn’t work that way.

Fortunately, the government has a few more financial tricks and resources up their sleeves. Our bureaucrats smell blood in the water, an inefficient tax system that is bleeding money. We have an alternative minimum tax that is choking the high middle class, while allowing the most wealthy off the hook; and we have a system of tax cuts that allowed billionaires like Mitt Romney and Warren Buffet pay 14 and 17% respectively on billions of dollars of yearly earnings. 

Obama showed his cards during his State of the Union address, he wants a 30% income tax on millionaires with no exceptions. Contrite, humble and unconventional, Warren Buffet agrees. But, how to make it work?

Many experts feel that the answer is twofold: fixing the AMT and tweaking some tax deductions that are used primarily by the very wealthy. 

Neither step is simple; the rich have been avoiding AMT tax for decades by shifting their wealth around to take advantage of certain deductions and tax rates. Changing the AMT system could have unexpected results, like further hampering the middle class, while creating new cracks for the rich to slip through. Changing tax rates on things like dividends and capital gains (the main money makers for the wealthy) would be an ideal solution, but some experts fear that this approach could reduce the incentive to invest and thus hamper economic growth. 

In order to secure their low income tax rates, the wealthy also avoid earning a salary wage (which carries a tax much higher than dividends or capital gains) and make large charitable donations which they are then allowed to deduct against the AMT. 

Well, in the same speech where Obama announced his plan to hold millionaires to a 30% tax rate, he also assured that he intends to keep the deductions for charitable contributions as is – presumably out of concern that eliminating the incentives to donate will deal a crippling blow to charities who get billions of dollars from the wealthy. He may also fear that taxing the donation would make the government seem sinister and money hungry. 

How most donations work, however, allow the wealthy to rack up some incredible savings. In fact, if the donation is made in the form of stock shares, they get an initial deduction for the donation as well as an exemption for the taxes they would have paid on the increased value of those shares. Closing off one of these avenues would go a long way towards bringing millionaires up to the 30% rate, while maintaining the incentive to make donations.   

Another suggestion involves changing the status of tax-exempt municipal bonds for investors who make more than $1 million. Cities, states, and even the federal government, sell these bonds for the purpose of funding public projects. In some cases, interest earned from these bonds is exempt from taxation.

In all of these instances, the fear of raising the tax rate for millionaires on these investment products is that it reduces their incentive to invest. Obviously, millionaires are putting a lot of money into our economy, our charities and our companies. We are in a vulnerable time as our economy attempts to gather momentum post recession, and having billions of dollars taken away from these efforts could be a stunning blow. 

Whatever the Obama Administration does, they must be incredibly careful. Fix the loopholes and issues with the AMT first, without making the system more complex and multilayered. Then start tinkering with tax rates in order to get the rich up to 30%. 

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