This is part 2 of my review of the top 10 individual tax loopholes. You can find part 1 here.

Name	Amount	Credit or Deduction
Employer paid health insurance	$659 billion	Deduction
Mortgage interest	$484 billion	Deduction
Lower rates for capital gains	$403 billion	Neither
Contributions to employer paid pensions	$303 billion	Deduction
Earned Income Credit	$269 billion	Credit
State and local taxes	$237 billion	Deduction
Contributions to defined benefit plans	$212 billion	Deduction
Step-up in basis of assets at death	$212 billion	Neither
Charitable contributions	$182 billion	Deduction
Untaxed Social Security benefits	$173 billion	Neither

Look at #3. Is it fair to tax capital gains and dividends at a lower rate than salaries and wages?

Over at ControlYourCash.com we spend a lot of time explaining the connection between self-employment and wealth.  Most Americans derive their income via salary, so why is the tax code written to benefit the minority who own businesses or invest in other people’s?

People who receive income from capital gains and/or dividends can just as easily invest their money outside the US. The average wage slave relies on those same investors to invest (and thus keep jobs) here.  The current tax code reflects a global investment market.  Throw off the shackles of employment, create something, raise some capital, take a risk and you too can pay less in taxes.

The deductability of contributions to pension and retirement plans is a perfect example of how your elected representatives play with budget numbers.

When your employer contributes to your pension or 401(k), he gets to deduct that contribution from his income for that year.  But when you start to take distributions from your pension or 401(k), you’re taxed at ordinary tax rates. Even though your employer isn’t paying taxes on this money today, you’ll be paying taxes on it when you you start to draw income from that same retirement plan.

While it’s not the only example of double taxation on our list, calling the deduction for state and local taxes a loophole might be the most egregious.  If you earn $1 and pay your home state 25¢ in taxes, should you pay federal tax on $1 or on 75¢?

You’re supposed to work hard, make money, pay your taxes and leave a little something to your kids.  But even once you’re done, the IRS isn’t. Thus the step-up in the basis of an asset at death.

Basis refers to what you originally paid for an asset. Accountants use it to determine how much taxes you owe when you sell that asset.  Stepping up means replacing the basis with the asset’s current market value:

Say you bought 500 shares of Apple at $22 during its initial public offering in 1980, kept them, and died last week. Your tax basis would be $11,000, even though the shares are now worth $1,496,200. That’s an unrealized long-term capital gain of $1,485,200, which is taxed at 15%, which would mean a $222,780 bill had you sold.

Instead, your heirs have to calculate the net worth of your estate and pay 35% on anything over $5 million.  The IRS makes them ”step up” the basis of your stock, thus the shares would have a basis of $1,496,200. If your heirs sell, there’s no capital gain.  This made sense in 2001 when the estate tax was 55% and the individual exemption was $675,000.  It makes less sense today.  I would get rid of the estate tax and let each asset retain its basis and tax character (e.g. long-term or short-term gain).

Social Security retirement benefits used to be non-taxable, because the amount withheld from your paycheck was calculated with respect to your gross salary. In other words, you paid the taxes when you earned the paycheck.

Recent changes mean that retirees earning as little as $25,000 per year might be taxed doubly  on benefits.  The tax schedules aren’t indexed for inflation, so more people will be doubly taxed each year.
Why is this even a US budget item anyway?  The Social Security trust fund should be separate from the general fund, so that we can better measure Social Security’s viability and benefits.

Of the 10 biggest loopholes, you only disagree with one?  How will we ever balance the budget and get rid of the deficit?

Reduce spending.

Stay tuned as I go through the top 10 expenses of the federal budget and see if there’s something to get rid of.  Spoiler alert: There’ll be more than one.

“Government always finds a need for whatever money it gets”.
Ronald Reagan

*Who, in turn, dug the numbers out of here: Estimates of Federal Tax Expenditures for Fiscal Years 2010-2014 written by the staff of the joint committee on Taxation.

**This article is featured in the Tax Carnival #91-Taxtoberfest 2011**

We’re broke, we spend too much money, and no one in Washington is willing to shred the government credit card. The debt ceiling extension was the equivalent of you realizing your credit card debt is overwhelming, getting a new card with an introductory rate of 0% for the first 6 months, transferring your balances, and then going on a spending spree with the new card because you felt so good about “getting rid of” that debt hanging over your head.  The politicians in Washington make Becky Bloomwood, the credit card statement-hiding heroine of Sophie Kinsella’s Shopoholic series, look responsible.  Washington’s answer to our debt and overspending problems?  More taxes.  If they only had a little more of your money, they could cure cancer, make every child an “A” student and create a utopian society where no one ever went hungry, went homeless, or had to face the indignity or being called “gay” or “retarded”.  But even the most liberal of Democrats knows that raising taxes during a depression recession is stupid. So politicians have to figure out how to get more money from you without you noticing. Enter the newest stratagem: closing tax loopholes.

Loopholes in the tax code allows you to either: a) reduce the taxes you owe (tax credit), or b) reduce your taxable income (income deduction).

According to Forbes.com*, these are the 10 loopholes projected to have the highest fiscal impact for 2010-2014:

Name	Amount	Credit or Deduction
Employer paid health insurance	$659 billion	Deduction
Mortgage interest	$484 billion	Deduction
Lower rates for capital gains	$403 billion	Neither
Contributions to employer paid pensions	$303 billion	Deduction
Earned Income Credit	$269 billion	Credit
State and local taxes	$237 billion	Deduction
Contributions to defined benefit plans	$212 billion	Deduction
Step-up in basis of assets at death	$212 billion	Neither
Charitable contributions	$182 billion	Deduction
Untaxed Social Security benefits	$173 billion	Neither

These items aren’t exclusive to multimillionaires.  They’re available to almost any productive member of society.

For any basic task that a sentient human being should be able to perform – feeding herself, finding a job, taking her kids to the doctor – there’s a taxpayer-funded government program to do it if you can’t be bothered to. These programs are obviously popular among their beneficiaries – why pay for something if you don’t have to? – but no one in Washington seems to remember that the money to bankroll these programs comes from the toil of other people. Even if these programs were originally intended as temporary fixes, they’re anything but. The more people there are who are aware that they can get necessities courtesy of their fellow Americans, the more people will. Which means these programs require greater budgets every year. It never ends.

Take item #2 above, the mortgage interest deduction:

When you can deduct your mortgage interest payments from your taxable income, you’re more likely to afford a home, and more likely to exercise the care and diligence that comes with owning private property. With the deduction, politicians argue that they’ll receive less revenue. Revenue that will be used to subsidize public housing programs, such as Section 8.

Every neighborhood, city and state is better off with homeowners instead of renters, especially renters whom the government forces taxpayers to subsidize. Yes, when homeowners can deduct mortgage interest from their taxable income, that lowers tax revenue in the short term. But it increases property values, and thus property taxes. And it encourages stable homeowners who have a stake in their community.

We can make the same analysis with charitable deductions:

 In FY 2012, your elected representatives have budgeted $598 billion of your money for food stamps, unemployment compensation, child nutrition and tax credits, and supplemental social security for the disabled. These programs are rife with fraud. Even when the benefits are legitimate, the government’s definition of disabled can be pretty inclusive  Do you want to pay higher taxes to support someone who’s on disability because of a reckless personal choice? Although Social Security’s Supplemental Security Income program is almost insolvent, the ranks of the disabled grow.  We should be able to choose which programs to support, and get a tax deduction for doing so.  If you feel passionately about Head Start, you should be able to direct your financial support to it.  Can’t imagine a world without NPR? Send them a check.  Or, maybe even just support your own family so that they’re not a drain on the taxpayers.  If every organization getting government money was forced to answer to you and me before we’d pay the bills, fraud would decrease and accountability rise.  Choice is a good thing in ice cream, schools and charitable services.

The Earned Income Credit is a welfare program in disguise. It should be terminated:

From Gateway Pundit:

A married couple with three children and $40,000 in income can take a $9,700 standard deduction and $15,500 in personal exemptions, bringing their taxable income down to $14,800. They would owe $1,505 in taxes.
But with three children, they would get $3,000 in child credits, leaving them with no taxes owed – and a $1,495 refund check.

You just gave Mr. & Mrs. Freeloader $1,495 (via the government) for breathing.  The rationale for the EIC is to offset the Social Security and Medicare taxes the government deducted from Mr. & Mrs. F’s paychecks and didn’t refund to them.  However, Mr. & Mrs. F will still receive Social Security and Medicare benefits when they retire.

Did everyone serving in Congress go to public school?

The best thing to do would be to destroy our current tax code and replace it with a flat or fair tax.  Barring that, here’s what I’d change:

Let people deduct their health insurance premia.  Separating health care insurance from employment will increase competition in the health insurance market, and give people with pre-existing conditions  control of their insurance instead of leaving them at the mercy of their employers.  I’d also loosen the regulatory schemes, letting health insurers sell policies across state lines. That would open up the market to more companies, which would offer more policies.

Eliminate the passive loss rule.  Passed in 1986, this rule forbids you from deducting more than $25,000** in investment real estate losses per year, unless you’re an active real estate agent.  You do get to accumulate your losses and apply them to any gain when you ultimately sell the property, but offsetting ordinary income with real estate losses would benefit many real estate investors right now.  It would also entice new investors, which would help the economy.

*Who, in turn, dug the numbers out of here: Estimates of Federal Tax Expenditures for Fiscal Years 2010-2014 written by the staff of the joint committee on Taxation.

**Up to $100,000 of adjusted gross income . This deduction is gradually phased out for taxpayers with adjusted gross incomes from $100,001-$150,000.

**This article is featured in the Tax Carnival #91-Taxtoberfest 2011**