Following is an excerpt from
Marylin vos Savant,
The Power of Logical Thinking

The Tax Cut in Arkansas?

"Clinton brags that the 91 [Arkansas] legislative session cut taxes for lower-income and middle-class taxpayers."
January 20, 1992

Almost certainly, there's nothing that citizens find more infuriating about government than taxes. Perhaps we can forgive politicians their endless windy rhetoric, their trash heap of broken promises, their outward assumption of moral superiority even as they pursue wine, women, and wealthy backers, and their penchant for putting their own re-election before any other cause-but when they reach into our pockets for the funds with which to gain votes and wield power, we react as though we're being robbed.

So it isn't surprising that politicians so often offer tax cuts for certain groups of citizens. Put plainly, that's where the votes are. Although voter turnout tends to increase as income goes up, the majority of votes still come from the lower-income and lower-middle-income citizens. For this reason, politicians advertise tax cuts for them, but in order to avoid cutting spending, which also maintains large blocks of votes, they can't cut taxes on all voters. So they target their promises of tax cuts and government spending directly to the lower-income and lower-middle-income citizens in particular, gradually eliminating the payoff as they go up the income ladder and its dwindling number of voters. The votes of upper-middleincome citizens are still significant, but the votes of upper-income citizens are virtually worthless at the polls.

The money has to come from somewhere, and it comes from the small amount paid by a large number of citizens in the lower brackets and the large amount paid by a small number of citizens in the higher brackets. In this last excerpt, Clinton claimed a cut for Arkansas' lower-income and middle-income taxpayers. This makes vote-getting sense, but he didn't finish painting the picture. The total tax burden for the residents of Arkansas actually became larger, not smaller. The per capita state tax burden for Arkansas (not including local and federal taxes) went from $962 in 1990 to $998 in 1991. Lower-income taxes (and some middle-income taxes) went down, and spending went up.

It's a classic political ploy, but it can't be supported for long. That's because the rest of the middle-income residents and the upper-income residents saw their taxes go up, and as there simply aren't enough of them (especially in Arkansas, the fourth-poorest state in the Union in terms of personal income) to support this election tactic time and time again, taxes creep in everywhere else. In the case of Arkansas, this meant simultaneous increases in the general sales tax and in taxes on such items as gasoline and beer. In all, the total tax burden on the citizens of Arkansas increased to $272.6 million in 1991-an addition that amounted to 11.7 percent of the entire state revenues.

Helping the Rich at the Expense of the Poor?

"Mr. Bush proposed cutting the capital gains tax by half. Democrats have called this helping the rich at the expense of the poor."
The New York Times
op/ed by Williarn Safire
February 27, 1992

A capital gain is money earned through the sale of an asset such as a farm, a home, a business, or stocks. As part of the 1986 Tax Reform Act, the taxation on capital gains was increased, making them subject to the same tax rate as other income. At that point, the effective capital gains tax rate jumped from 20 percent to 28 percent, an increase of 40 percent. Bush tried repeatedly to get this reduced, but as the quote above indicates, his political opponents routinely portrayed such a reduction as one that would benefit only the rich.

Let's look at the numbers and the logic to see if this is so. The spirit of the 1986 raise in capital gains taxes would appear to be that of making the rich pay more taxes. Did it work? The year before the capital gains hike went into effect, the government collected $213 billion in revenue from it. By 1991, this amount had gone down to $108 billion.

What happened? Even if the spirit of the tax hike simply had been to bring in more revenue, clearly that didn't work. It's counter-intuitive, but raising tax rates doesn't necessarily increase revenues from those taxes. In this example, when capital gains taxes are raised, citizens avoid taxes by not earning capital gains. If we don't want to give the government 28 percent of the profit from selling our home-especially when the "profit" came from simple inflation, and the house isn't actually worth any more than it ever was-we simply stay put.

At the time of the tax increase, the Congressional Budget Office (CBO) predicted that the revenue from capital gains taxes would reach $269 billion by 1991. It only reached $108 billion. This means that revenues from capital gains taxes in 199 1 -five years after the tax hike-amounted to only half what they were in 1985-the year before the tax hike.

At least partially because of this serious predictive error by the CBO, the national debt unexpectedly ballooned by an extra $ 1 00 billion between 1989 and 1991. Static assumptions are a common problem in predictive statistics. In this case, the CBO didn't realize that when taxes change, people change, too. Behavior that is taxed is discouraged; behavior that is not taxed is encouraged (which is the principle behind "sin" taxes, such as increasing the tax on tobacco products). This shouldn't have been a surprise. From a historical perspective, every lowering of capital gains taxes has resulted (counter-intuitively) in increased revenue from them, and every rise has resulted in decreased revenue.

The taxes themselves have economically debilitating consequences, but the error of assuming that rising rates bring rising revenues adds further weakening effects. By causing people to freeze the selling of old assets-and, other things being equal, the buying of new ones-economic dynamism is stymied, and capital is frozen into old investments instead of becoming available for new ones. That is, money stops changing hands. As an example of just one possible result in this case, between the time the 1986 capital gains tax hike went into effect and 199 1, the amount of money in the United States going into venture capital for small businesses fell by two-thirds.

So does this mean that the rich managed to evade the tax man? Not at all. (Per capita, the rich pay an astonishing amount of taxes.) According to Internal Revenue Service data from 1987, 10.3 million tax returns listed capital gains. About two-thirds of them were from taxpayers with gross incomes below $50,000, and about half of this under-$50,000 group had gross incomes below $25,000.

Moreover, capital gains often represent a sudden, one-time addition to a person's net financial worth that may never be repeated. If we sell our house and retire into an apartment, yes, our tax return this year might yield a snapshot of a somewhat wealthy individual. But what did we actually gain? We may have the money, but we no longer have the house. (We have even less after we pay the tax.) And we're not going to repeat this sale year after year after year. But this same snapshot, multiplied all over the country at tax time every April, continues to provide a provocative and genuinely misleading picture of bloated plutocrats perennially at leisure while their money piles up in the bank.

Let's look at the income of taxpayers who reported capital gains, but let's subtract the capital gains itself. Data from the Joint Committee on Taxation show that of taxpayers reporting capital gains in 1985 and 1986 (before and after the capital gains tax increase) the percentage of capital gains accruing to taxpayers earning $200,000 or more fell from 45.3 percent to 25.4 percent. Similarly, the percentage of capital gains accruing to taxpayers earning $30,000 or less jumped from 12.9 percent to 26.5 percent.

Far from being the Bill Gates’ of this world-and there are only a handful of them-the capital gains crowd is mainly Mom and Dad and you and I. Internal Revenue Service data from 1979 to 1983 show that only 16 percent of capital gains-claiming taxpayers claimed them every year, and 44 percent claimed them only once throughout that entire five-year period.

Another consideration is also warranted, first mentioned in the case of selling a house at a "profit" when the house isn't actually worth any more (compared to other houses) than it ever was. Capital gains are not adjusted for inflation. This means that an item (like a house) that was purchased, say, decades ago may very well be sold at a price that, when adjusted for inflation, is only equal to (or even less than) what it cost in the first place. (This is a very common situation with houses.)

Today's dollar is not quite the same as yesterday's, has less relationship to the dollar of three years ago, and is only remotely akin to the dollar of three decades ago. What gives a dollar value is our ability to exchange it for goods or services, and the amount of goods or services that we can buy with a dollar shrinks steadily with inflation. So you may have bought a house for $20,000 that inflated in value to $70,000 over the years, but so did the price of bread and milk and everything else. When you sell it to retire to an apartment, you gain nothing at all, but you'll have to pay capital gains tax on the $50,000 "profit" anyway. Such is the world of the "wealthy."

Economists adjust for inflation by multiplying the dollar of any given year in the past by the percentage rise in the Consumer Price Index (CPI), but the technique is far from comprehensive. The CPI is calculated by choosing a set "market basket" of items whose changes in price are measured over time; these changes are then assumed to represent the change in the purchasing power of the consumer's entire budget. Calculating inflation is an inherently loose procedure. One problem with the CPI is the assumption that any one basket of goods could reasonably represent a useful measure of the standard of living of so vastly varying a populace as 250 million people. (Fax machines affect some of us very significantly; they don't affect others at all.)

Another problem is that there is no numerical way (for this very numerical of concepts) to measure changes in the quality of goods, which is an essential key to our standard of living. (Consider the difference between the icebox of yesterday and the refrigerator of today.) A third problem is that there is no way to account for changes in desire, which is not the frivolous consideration that it may seem at first. (Early in this century, our great-grandparents had little desire for electricity; today they desire it very much.)

And what about the concept of need? Does any human animal really need fax machines, modern refrigerators, or even electricity? Obviously not. But we'd surely call anyone who lacked electricity in his home "needy." When my mother grew up, her mother cooked everything from scratch and made her own clothing. Her family also felt blessed that they had everything they needed, and everyone was content. The only luxury afforded the children was a chocolate bar once a week, and that was greatly appreciated. But imagine the reception we would get from the poorest segment of our population if we were to cut welfare back to a small fraction of its current budget and instead truck people an abundance of free supplies like milk, flour, sugar, and bolts of cloth.

Another problem with the CPI is that inflation occurs in different parts of the market at different times; prices don't join forces and march up together the way the CPI implies. Many necessities (such as water) remain incredibly cheap while many luxuries (such as soda) have soared by comparison. Also, relative prices in high-tech areas of the economy are highly misleading over time. For example, this year's top-performance computer costs a small fortune. But if you buy last year's top-performance computer, it costs a small fraction of that. And while last year's model may cost the same as a top-performance computer of five years ago, the newer model may perform ten times as many functions ten times as fast. The BLS does make an effort to account for this sort of component with estimates that it calls "hedonic quality adjustments" (which we might define as the pleasure factor"), but such attempts are understandably weak.

Occasionally, the BLS recognizes such great flaws in the CPI that they actually make a change in the method of measurement. (Although an appropriate step, this change then creates a whole new source of confusion and error.) One such change, in 1983, makes any previous poverty or inflation measure suspect, including new measurements with old numbers.

Before 1983, in order to reflect month-to-month changes in the price of housing, the CPI reflected month-to-month changes in the special onetime costs incurred when buying a house-even though no one buys a new house every month. By switching to reflect month-to-month changes in the cost of rental housing instead (for the same household budget), the amount of inflation turned out to be lower than it was thought before. Thus, any comparative cost-of-living analysis that uses (unadjusted) pre1983 CPI data overstates inflation.

In 1994, the BLS again considered changing its method of calculating the CPI, an additional indication that the figure can't yet be relied upon to give a true picture and indeed may never do so, considering its inherent weaknesses. This is of major importance because flaws in the CPI translate into flaws in nearly every aggregation of economic variables for comparison over time; an accurate adjustment for inflation is imperative for such analysis.

Specifically, the BLS suspects that the CPI may overstate inflation by as much as 0.6 percentage points every year. Part of the problem, the Bureau acknowledges, is with the conceptual difficulty of assuming that a market basket set back in the years 1982 to 1984 adequately reflects the buying patterns of people a decade later. (Note that buying patterns have little to do with acquiring the basic necessities of life. In this country, those necessities are both inexpensive and plentiful.)

Another part of the problem is a mathematical misconstruction that dramatically affects inflation calculations when a price fluctuates up and down. For example, a rise in the price of a commodity from $1 to $1.25 registers as a 25 percent increase because the 25@ rise is 25 percent of $1. But if the $1.25 price then drops back down to $1, it registers as only a 20 percent decrease because the 25,t drop is only 20 percent of $1.25. The 5 percent increase (the 25 percent increase minus the 20 percent decrease) stays in the CPI even though the price is exactly the same as it was before.

But regardless of the obvious flaws of the CPI, capital gains taxation that is not adjusted for inflation is even more flawed. Not only do you find yourself taxed on a "gain" that doesn't exist, you may even find yourself taxed on a loss. (And plenty of us do; it's a common scenario.) Suppose you bought a house for $20,000 that inflated in value to $70,000 over the years, but you're only able to sell it for $60,000. You have a $ 1 0,000 loss, but you'll have to pay capital gains tax on a $40,000 profit, instead. The world of the wealthy can be a hostile one, indeed.


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