WahooTide

Fewer Withholdings do not a Tax Cut Make

Obama Talks Tax Cuts, Cutting $1.3 Trillion Deficit in Half - Gothamist: New York City News, Food, Arts & Events

“In his weekly address, President Obama discussed the economy (of course) and made two points: First, that 95% of Americans will get a tax cut, because employers will withhold less taxes …”

WahooTide’s take: As a tax lawyer, I have to go on a geek rant for a minute and throw up my hands at Obama’s continued mischaracterization of the defintion of “tax cut.” A tax cut is technically defined as (and presumed to be by the average American taxpayer, I would submit) a reduction in the applicable rate of tax for a given bracket of income or other applicable tax base.

For example, when the highest income tax bracket rate was reduced from 39.6% to 35% by the EGTRRA act in 2001 (known commonly as “the Bush Tax Cuts”), THAT qualifies as a true tax cut — at the end of the year, the rate on which your yearly income was taxed was lower, resulting in a lower overall liability or “tax due” by you the taxpayer to the IRS.

First, some background. Our Income taxation system is characterized by academics as a “voluntary compliance” system because the entire system hinges on individuals “voluntarily” and accurately submitting the amount of income they earned on their form 1040s at the end of the year. Although it may seem ridiculous to most Americans to call any system that is required by law “voluntary,” the truth is that out of necessity the IRS must take most tax returns at face value. The Service is woefully understaffed & its employees underpaid; there’s simply no way they can begin to verify even a small portion of the over 150 Million tax returns filed each year. Indeed, although there’s a frightening social stigma attached to the dreaded “audit” process, by its own admission in a 2006 report the IRS estimated that it only aduits around 0.7% of all returns each year. As such, our government’s revenue system relies heavily on voluntary compliance.

Withholdings, as we all know, are one of the IRS’s enforcement mechanisms to ensure that people participate at least partially in our voluntary compliance system by requiring employers to send to the government a portion from an individual’s paycheck based on an estimated year end total income, and thus, on an estimate of what rate bracket the taxpayer will be in at year end. However, because these withholdings are only an estimate, taxpayer’s actual end-of-year income figure (and thus income tax liability) can vary wildly from the mere sum of these withholdings.

For example, the taxpayer might have investment income from their personal portfolio of stock/bonds/etc. that wouldn’t be factored into their employment withholdings (causing an underestimation in their total liability used to determine withholdings thus resulting in net tax still due by the taxpayer at year end). Conversely, they might end their employment before year end and have no further income (resulting in overestimation of total year-end income used to determine their withholdings therefore resulting in a REFUND due to the taxpayer by the government for overpayment of tax).

The point is that the withholdings are a mere proxy, a guess, at the TP’s year-end tax liability, used by the IRS as both a method of keeping taxpayers honest in a voluntary compliance system AND as a way for the government to even out their income stream over the course of the year rather than as a huge lump sum that rolls in every April.

Merely withholding less out of taxpayers’ paychecks each month without correspondingly lowering the rates for their income brackets is therefore not a true tax cut, since when taxes are calculated at year end their liability (read: tax due based on total year-end income earned) will be the same as it would’ve been regardless of any change in withholdings from paychecks. As such, in many cases the fact that actual tax due hasn’t changed coupled with the fact that less money was withheld from paychecks will likely result a higher net balance still being owed to the IRS by the taxpayer at year end, which means that at that point the taxpayer will have to come up with the money from somewhere in their own funds to send a check to the government for the amount still due.

To be sure, there is some advantage from a theoretical economic standpoint in withholding less from taxpayers — assuming they actually save or invest the additional money they receive from their paycheck each month, they’ll earn interest they otherwise wouldn’t have been entitled to (this is an oversimplification, but in economics this is known as the “time value of money” - I’d rather have a dollar today than the promise of getting a dollar tomorrow, because I can invest it today and start earning interest right away). The problem is that in this economy, those who stand to benefit the most from those few extra dollars a month will likely have to spend them immediately, either to pay their mortgage/rent, groceries, other debts, and so forth. They won’t be saving or investing these dollars; they’ll scramble to spend them to keep their head above water & save their homes.

As a result, when the end of the year roles around and they still owe net tax to the government becuase the RATE of tax hasn’t changed, they won’t have the money that would’ve otherwise been withheld (and thus credited to their “tax due” based over the course of the year) because they’ll have spent it trying to pay down their other bills. Where then will the balance due to the government come from?

Don’t get me wrong. Allowing those in need to have a few more dollars to help cover their payments is a fantastic idea and a noble goal. But this particular implimentation does disservice to this good ideal by not lowering the overall rate of tax (i.e., implimenting a true tax cut). Instead, for those taxpayers who are in the throws of financial hardship (read: everyone) they are merely swapping one problem for another: instead of owing the bank, they’ll merely owe the government the dollars released from their withholdings, albeit on a delayed basis.

Ultimately, this could put such taxpayers in a worse position than they are right now — if you fail to pay your income taxes, the government, by law, has what’s known as a “super-priority” income tax lien at its disposal. This lien can attach to any and all property of the taxpayer and, just like other liens (mortgages or car loans, for example) allows the lienholder to reposses and sell off the taxpayer’s assets to satisfy the taxpayer’s obligation to the lienholder. In plain English, this means the government can repo the taxpayer’s house or car (or whatever else) to satisfy their past due income taxes. In contrast, with other liens such as a mortgage the borrower’s liability is typically limited to only the asset which the funds were used to purchase — i.e., if you default on your mortgage the bank can only foreclose your house to satisfy the debt, they can’t typically go after your car unless you agree to such provision in the mortgage.

In sum, in my own opinion the government is setting itself up for failure here by calling these reduced withholding amounts “tax cuts” because the average American will assume they don’t owe as much tax and are free to spend the dollars released on their pressing needs. While in the short term this will probably help stabilize the credit and housing markets to a very small (perhaps even neglible) degree by allowing the released dollars to go towards payments which may stave off some defaults & foreclosures, I believe long-term it will create confusion and even more heartache for those at whom this action is most targeted.

Simply put, if you don’t lower tax rates and thereby their overall tax liabilty but still call something a tax cut, most non-lawyerly (read: sane) people will assume they can spend the money without later owing tax on it. But by not lowering rates, unbeknownst to the taxpayer they’re still liable for tax, and thus you’re setting them up for failure by encouraging them to spend the money they get in the short term becuase it won’t be around when the tax bill arrives.

It may seem like semantics to most, but to me this misuse of the phrase “tax cut” is going to be nothing but a disater to those who rely on the common-sensical definition of that phrase and assume their extra dollars each month are theirs and not the government’s.

If you’ve made it this far, thanks for reading!