If You Want To Make More Money - Pay Less Tax

It’s the American Way

What’s The History of Taxation?

You make money, you pay taxes, and you keep what’s left over. If you want to keep more, pay less tax.

Tax was first levied in 1861 to pay for the costs of the Civil War. It was repealed in 1872, but the idea didn’t go away.

Tax as we know it today came into existence in 1913 and has been with us ever since.

People are passionate about taxes because they don’t like the feeling of the government having its hand in their pockets: they prefer to hang on to the money they earn.

They are prepared to hand it over if they trust the government will spend in ways consistent with their values and views on how the social safety net should be funded.

Everyone wants to keep more. But people are afraid that avoiding taxes is a criminal act. Sometimes it is: that’s called tax evasion.

People also want all the stuff taxes pay for, such as roads, bridges, defense, and social programs. That’s Federal tax.

There’s a local tax on local roads, schools, trash pickup, fire, police, and ambulance—all things people think they are entitled to.

Governments pass taxes because, without it, they have no revenue and can’t function.

Politicians love to promise things to get elected, bribing voters. Then, they have to figure out how to pay for it.

There are three choices:

1. Raise more taxes - voters don’t love that

2. Cut expenditures - no way the US is cutting defense or entitlements right now

3. Borrow money - also known as kicking the can down the road

My Personal History With Taxation

Over twenty years of my professional career have been in structured finance. For many people, if that means anything at all, it means securitization: chopping up debt into pieces, repackaging it, and selling it.

That was the kind of thing that Margot Robbie explained in The Big Short

That is not what I did. I helped structure deals that tip-toed between different parts of the tax code to allow corporations to optimize their tax outcomes: get value from their losses, get credit for foreign tax paid that was packaged inside a company that was sold from one country to another equity.

One sentence and it’s unclear what I did. It’s not worth trying to explain. It was not—is not—a good cocktail party conversation.

See what I mean? I did this because it was a job that I wandered into somewhat randomly, and it paid well.

And suddenly, after the GFC (great financial crisis), it was shamed out of existence because firms such as AIG Financial Products and Barclays Capital got into huge trouble and, in the case of AIG, were bailed out so that all sorts of financial institutions tangled up with them - Goldman Sachs - didn’t go bust.

Game over. Now, structured finance has morphed into renewable energy, which you can definitely get loved talking about at cocktail parties.

How Great Are Government Incentives?

The bad thing about structured finance, as I knew it, was that you were working, to some large extent, against what the government/IRS wanted.

If the citizenry is to get tax benefits, the government wants to be the one doling them out.

Let’s list a few:

1. Low-income housing tax credits(LIHTC)

2. Employee retention credits (ERC)

3. Energy credits - some based on the amount invested (ITC); other on the amount of energy produced (PTC)

4. Research and Development credits

5. Earned income tax credit (EITC)

6. Credits for electric vehicles (EV Credits)

7. Credits for clean, energy-efficient buildings

All the energy and clean vehicle/building credits were added up and projected over ten years when the Inflation Reduction Act (IRA) was passed and scored at $389B.

The government loves to try to put its thumb on the scale of economic activity that is aligned with its industrial policy. It believes it can influence behavior with tax incentives. It is right: it can.

Various analyst reports estimate the $389B may be over $1T. It could have been a lot more.

The IRA started life as Build Back Better. That bill was ‘scored’ at $3.5T. Thank goodness Senator Joe Manchin (West Virginia) managed to hold the Biden Administration hostage until the stimulus amount was reduced to $780B (including the $389B for renewables).

Imagine how inflation might have been with Build Back Better in full force!

How Does The Tax Picture Look for the US?

You really have to love America.

We live in a country where you can insult your political leaders and burn the flag without going to jail.

We also live in a country where the IRS publishes copious amounts of information about taxes paid, and organizations such as The Tax Foundation put together reports and nice charts explaining what is happening.

While we hear a lot about how the highest-income taxpayers are running circles around the IRS and the poor are paying all the taxes, we can examine the data.

And we can see that the top 1% started paying proportionately more under…the Trump Administration.

It came from capital gains, as investments performed well

Because most of the investments are owned by the top 1%. So, no surprise.

In fact, under Trump, who, being transparent, I have never voted for and don’t plan to, the data show that the bottom 50% have done better.

The bottom 50% had taken a clear hit from the de-industrialization that happened after China entered the WTO (World Trade Organization).

It was clear to the bottom 50% of those who were hit after the GFC that they were not the ones being bailed out. It was corporations and banks.

What happened was the Tax Cuts and Jobs Act 2017 (TCJA).

This reduced corporate taxes but also individual taxes. Importantly—and this was progressive (it had a greater impact on poorer people)—it limited the amount of deductions that individuals could offset against taxes.

This meant that people with high mortgage interest, property, and state taxes could deduct no more than $10,000 against their taxes—the so-called SALT (State and Local Tax) deduction.

This was a direct hit on high-income taxpayers living in predominantly blue states like New York and California, which have high property values and high state income taxes.

What About The TCJA and The IRA?

A number of the individual tax provisions and tax cuts embedded in the TCJA are supposed to end after 2025.

Since 2025 is going to be a big year legislatively, whoever wins in November—the first year is where a lot of legislation gets passed because it gives the incumbent administration a ‘win’ before the mid-terms two years after the general election—something is going to happen with these provisions.

It is very difficult to assess the possible impact of each candidate’s tax proposals this early in the election process, especially given Kamala Harris’s relatively unknown policy plans.

Four things remain true:

1. Both candidates will promise ‘stuff’ to various demographics

2. The US will continue to run an increasing budget deficit

3. Tax cuts or increases will be promised and delivered

4. More debt will be issued to cash the cheques promised by candidates that taxes cannot fulfill

Corporate and individual taxes will be on the table in thinking about this. What makes this really interesting is that the distribution of corporate taxes paid has shifted:

Over 50% of corporate taxes are now paid by pass-through companies—LLCs, partnerships, or S-Corporations—where corporate income shows up on individual tax returns.

So, business and individual taxation is becoming more and more intertwined.

Because tax breaks such as the energy credits promoted by the IRA have historically been focused on corporations, the question arises of whether individuals can also use them.

The answer is “yes”, but…

It’s All About Passive Income

Individuals can use all the IRA credits provided they have passive income.

When we think of passive income, we first think of income that is NOT wages or business income.

We think of income from our investment portfolios, but the IRS considers passive income differently.

The IRS thinks of passive income as income derived from:

1. Trade of business activities in which an individual does not materially participate;

2. Interests in partnerships, S-corporations, and limited liability companies that conduct such activities in which a taxpayer does not participate;

3. Equipment leasing;

4. Rental real estate.

Income from stock investments, dividends, interest, and capital gains is not considered passive income.

The IRS defines this as "portfolio" income that cannot be offset by purchased tax credits.

According to IRS data - the latest available is from individual 2021 tax returns, there were:

• $62B in passive income from rental and real estate.

• $143B in passive income through partnerships

• An average tax rate of 26% for the top 1% of taxpayers suggests $53B in tax that renewable energy tax credits could offset.

Here is the summary data:

Takeaways

1. Like death, taxes are not going away.

2. The government pass taxes and gives out tax benefits.

3. They are giving away too much and raising too little.

4. This isn’t likely to change.

5. We will continue to issue debt to make up for the shortfall.

6. Individual and corporate taxation has become mixed up as pass-through companies pay more tax on individual tax returns.

7. If individuals want to take advantage of government tax credits, they need to pay attention to how much passive income they have.

8. There is plenty of passive income in the US, but it just needs to be matched with the available tax credits

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9. The IRA has made this matching easier.