If you get a big tax refund, you’re doing it wrong — April 15, 2014

If you get a big tax refund, you’re doing it wrong

This probably gets said to everyone every year, but I feel I need to repeat it: if you get back a big tax refund, it’s not like you’ve outsmarted The Man, or like you’ve gotten a big windfall; it’s just that you paid the government more throughout the year than you needed to, and they’re giving you back what you overpaid.

I really think many people don’t understand what they’re doing when they file their taxes. They’re computing on the one hand how much they should have paid during the previous year, and on the other hand how much they actually *did* pay. Subtract what you did pay from what you were supposed to pay. If the result is a number greater than zero, then you underpaid during the year, and you need to pay to make up the difference; if it’s less than zero, you overpaid, and the IRS owes you back some of your own money.

When you underpay throughout the year, you can take the extra money from every paycheck and put it in a bank account and earn interest, or you can invest it and (if you’re lucky) earn a positive return. Whereas if you overpay, the government doesn’t pay you interest at the end of the year. So by overpaying throughout the year and receiving a refund at the end of the year, you’ve given the Federal government an interest-free loan throughout the year.

The optimal strategy, then, is to do two things:

1. Estimate, early in the year, roughly how much you’re going to owe in taxes.
2. Underpay throughout the year by just enough that the IRS never gets mad.

Actually, 2. isn’t quite right. It’s okay to get them mad, because when they get mad they just charge you money. If you know your tax situation well enough, you can have them charge you just enough money that you still end up ahead. Suppose they charge you $1.05 for every dollar you underpaid. Well, if you can get a 6% return on your money by investing it rather than paying it to the IRS, you should just invest that money, earn 6%, then pay the 5% penalty. You’ll still end up ahead.

But presumably they don’t just charge you some fixed low rate of interest for every dollar by which you underpaid throughout the year. I don’t know, but I would imagine you pass some threshold where your underpayment makes them *really* unhappy (we might say that their response is “nonlinear”). So the optimal strategy would be to underpay such that the marginal dollar of underpayment is just offset by a marginal dollar of fines from the IRS.

I realize this takes all the fun out of why people like tax refunds. They like seeing a nice big check. And I think a lot of people don’t believe they have the self-control to set aside a few dollars with every paycheck; they believe they could handle a windfall better. If that’s how you feel, then go you. Empirically, I wonder if it’s true that people can handle a windfall in their taxes any better than they can handle a small regular payment.

Generally speaking, I don’t understand why people find taxes so vexing. For most of us, it’s simple:

1. Add up all the money you made during the year.
2. Subtract exemptions for yourself and your dependents.
3. Subtract deductions for your house and charitable contributions.
4. Use the tax tables to figure out what you owe.

Some people do have it hard. Small-business owners, I would wager, will find this particularly tricky. If you have lots of complicated financial assets, it’s probably annoying. I’d like to look it up empirically, but here’s a quick observation: most people don’t itemize their deductions. If you take that as a measure of how complicated most people’s returns are, you have your answer: most people’s returns aren’t complicated.

And if the pain of filing your taxes is that you’re sending money to the IRS, you can eliminate this pain by just setting up your withholdings properly throughout the year. Set it up so that you owe nothing, and are owed nothing, at the end of the year. If you’re like 2/3 of Americans, this isn’t hard: you’re not even going to be itemizing the deduction for the home you own.

Indeed, most Americans would be just fine letting the IRS handle their taxes for them, if we had such a thing; we’d be more likely to have such a thing if tax preparers weren’t lobbying against it. Your employer would submit your salary to the IRS; your bank would submit your interest income; your mortgage company would submit any interest payments you made; the IRS would tell you what you owe, and you’d be done with it.

For most people, though, I just don’t see what the big deal is.

Help me learn how to read laws — January 9, 2013

Help me learn how to read laws

I wonder if my dear readers could educate me. Here’s where I got started: my employer’s payroll company, ADP, emailed me to say that as of this year, the mass-transit-pass employer fringe benefit reduces taxable income by as much as the parking-permit fringe benefit; it used to be that you got more for parking. I found this unjust, and was pleased when the injustice was corrected.

So now I want to go find the part of the law that rectifies the injustice. As per that earlier blog post, the relevant section of the tax law appears to be 26 USC 132.

First thing I seem to have discovered: you can’t understand any part of that law until you read all of it. Here’s the first relevant piece:

(f) Qualified transportation fringe
	(1) In general
	For purposes of this section, the term qualified transportation fringe means any of the following provided by an employer to an employee:
		(A) Transportation in a commuter highway vehicle if such transportation is in connection with travel between the employees residence and place of employment.
		(B) Any transit pass.
		(C) Qualified parking.
		(D) Any qualified bicycle commuting reimbursement.
	(2) Limitation on exclusion
		The amount of the fringe benefits which are provided by an employer to any employee and which may be excluded from gross income under subsection (a)(5) shall not exceed
			(A) $100 per month in the case of the aggregate of the benefits described in subparagraphs (A) and (B) of paragraph (1),
			(B) $175 per month in the case of qualified parking, and
In the case of any month beginning on or after the date of the enactment of this sentence and before January 1, 2012, subparagraph (A) shall be applied as if the dollar amount therein were the same as the dollar amount in effect for such month under subparagraph (B).

That final paragraph says “equalize transit passes and parking”. Got it. But two things:

1. ADP says that the benefit is $240 per month, which disagrees with the $175 in (f)(2)(B).
2. The final paragraph says that this equality of benefits ends when 2011 ends, which disagrees with ADP.

So I look around some more and I find two things that address these problems:

1. Section 6(A) in this same law applies an inflation adjustment — hence my statement that you need to read the whole thing to understand the rest. It seems to say that you take the CPI from the preceding calendar year and divide by the CPI for 1992, then multiply by whatever (f)(2)(A) or (f)(2)(B) say.

All right, so we consult the CPI. First of all, I don’t know what ‘the CPI for 1992’ means: does it mean January of 1992? It probably doesn’t much matter which part of 1992 I pick (we’re not Zimbabwe), so I’ll just grab 140.3, the annual average for 1992. Then we get 2012’s CPI, which is about 230. So the multiplier is 1.64. Multiply by the $100 in (f)(2)(A), and I only get $164 — not the $240 that ADP reported.

But again recall that final paragraph, quoted above. It says that mass transit and parking are equal. So let’s assume the pre-inflation-correction benefit is $175 per month, and again apply the 1.64 multiplier. That brings the mass-transit benefit up to $287 — which is now too *high*. So now I’m confused where the $240 came from that ADP mentioned.

2. The American Taxpayer Relief Act of 2012 extended benefit parity until the beginning of 2014, specifically

> (a) IN GENERAL.Paragraph (2) of section 132(f) is amended by striking January 1, 2012 and inserting January 1, 2014.
> (b) EFFECTIVE DATE.The amendment made by this section shall apply to months after December 31, 2011.

The law as it’s archived at Cornell doesn’t seem to reflect this.

So I’m confused on three general points:

1. How do I know that I read all the parts of the bill that modify the particular paragraph I’m interested in? (John E. McDonough’s magisterial [book: Inside National Health Reform] explains very patiently the complicated way in which one needs to read the Affordable Care Act. Do I need a McDonough by my side to read any law? Do I need a Marion Nestle to walk me through the farm bill?)

2. How do I know that I’m looking at the most up-to-date version of a particular section of the law?

3. How do I know that there isn’t another section of the US Code that’s relevant to the particular policy — in this case, commuter fringe benefits — that I care about?

Accounting gripes and the tyranny of trillions (part of an occasional series) — October 16, 2011

Accounting gripes and the tyranny of trillions (part of an occasional series)

Matt Yglesias makes the entirely correct point that We Underinvest In Infrastructure Because We Overinvest In War, Health Care, And Low Taxes, along the way noting the various estimates of how much we need to be spending over the next N years on bridges, roads, and whatever else. Various organizations give us various numbers:

> All of the numbers are so gargantuan large that theyre useless when youre trying to communicate with the public, said Roy Kienitz, undersecretary for policy at the Department of Transportation.
> The American Society of Civil Engineers has estimated that an investment of $1.7 trillion is needed between now and 2020 to rebuild roads, bridges, water lines, sewage systems and dams that are reaching the ends of their planned life cycles. The Urban Institute puts the price tag at $2 trillion.

The fact that these numbers are so gargantuan is exactly why we shouldn’t be talking about them in raw terms. $2 trillion is an essentially unfathomable number. So let’s try it some other ways:

The IRS collected about $2.3 trillion in fiscal year 2009, across personal income taxes, corporate taxes, Social Security taxes, the estate (“death”) tax, Medicare part A, various excise taxes, and so forth. Individual U.S. states collected about $704 billion in 2010, of which 33.5% was income tax and a bit less was sales tax. Federal and state taxes altogether, then, come to about $3 trillion. So our $2 trillion infrastructure investment is about 2/3 of the country’s total tax bill. (The $3 trillion tax bill, to put that in some more perspective, comes out of a $14 trillion GDP. Taxes come to about 21% of GDP, in other words.)

U.S. 10-year Treasurys are available at historically low rates right now — right around 2.5%. So let’s say the government borrowed $2 trillion today, and paid it off at 2.5% over the next ten years. How much would the monthly payment come to? (There is probably a lot of complexity about government financing that I don’t understand, but I’m treating this exactly like a mortgage with a 2.5% interest rate. Feel free to correct me if there’s some important nuance I’m missing.)

The monthly payment, it turns out, would be about $18.8 billion. This is getting more fathomable. And while the various governments’ $3 trillion in receipts come from many classes of tax levied on many different types of people and businesses, let’s just simplify and say that there are 144.1 million taxpayers — which is the number of individual Federal income-tax returns. How much will each of those taxpayers have to pay every month to ensure that our bridges don’t collapse in a decade? The answer: $18.8 billion per month divided by 144.1 million taxpayers, or $130.43 per month.

Now *that* is a number I can understand. The cost of ensuring a non-crumbling infrastructure is $130.43 per person per month. How much of an increase is that over what we pay now? Well, we pay a total of $3 trillion per year, or a quarter-trillion per month, or about $1,731 per return per month. $130.43 is a 7.5% increase over what we pay now.

I can wrap my head around “my tax bill will increase by 7.5%.” The story gets even rosier if you consider that investors are currently willing to lend the Federal government money to be paid off in 30 years for about 3%. That lowers the monthly payment to about $60 per person, which is about a 3.5% increase in overall taxes.

All of this assumes, recall, that every dime of the $2 trillion would be new money — money that we wouldn’t spend anyway. That is obviously false: if a bridge collapses, we’ll presumably repair it. And presumably there’s a lot of roadwork that we’d already be doing. But assuming it’s all new money, the average tax bill would go up by somewhere between 3.5% and 7.5%. I can wrap my head around the concept “my tax bill will increase by 5%,” much more than I can wrap it around “$2 trillion over the next decade.”

Note also that, if we somehow managed to get a lot of high-income people into this country, we could lower the per-person expense even more. What counts as “affordable” depends to a great extent upon how many people live in this country, because “per-person expense” has both a numerator and a denominator. There are two obvious ways to get more high-income people into this country: either (1) allow in any immigrant who has an employer to sponsor him or is looking to get a Ph.D., or (2) encourage native-born Americans to have more babies. Ideas for how to make either (1) or (2) happen will have to occupy another post at another time.

Trillions are unfathomable, so it’s important to find some way to put them in context to make them fathomable. Switching from aggregates to per-capita numbers is one quick way. Switching from “costs over ten years” to “cost per person per month” is another way. Percentages are another good measure: percent of GDP, say, or percent of current tax revenues. Otherwise we get stuck in massive-number fatigue, which helps no one (except maybe the political party which takes terrorizing you over the budget as its reason for being).

How much is the employer health-insurance subsidy worth? (Or, I regurgitate Austin Frakt.) — July 9, 2011

How much is the employer health-insurance subsidy worth? (Or, I regurgitate Austin Frakt.)

I come back to Austin Frakt’s post calculating how much the Federal subsidy for health insurance is worth every few months, and I think I have to re-study it every time. It’s a hugely important post.

Probably a lot of others don’t read wonky health-insurance blogs quite as obsessively as I do, so the background is like so: your employer (if you’re lucky enough to have an employer that supplies health insurance) doesn’t pay taxes on the health-insurance fringe benefit. When they pay you a dollar in wages, they have to pay their part of Medicare and Social Security taxes. Once they’ve paid their taxes and passed your wages on to you, you have to pay taxes on them. Health insurance isn’t like that: your employer doesn’t pay taxes on health benefits, and neither do you. So one dollar in health insurance is worth more than one dollar in wages to you and to your employer.

Turns out that the subsidy is really distorting. Professor Frakt’s exercise may already be clear to everyone, but I don’t think it was clear to me for a while. So in bullet form, trying to make it as clear as possible (to myself as much as to everyone else) it’s like so:

  • For every dollar an employer pays out in wages, a certain fraction of that dollar goes to taxes (employer pays Medicare and Social Security). Call that fraction T.
  • So for every dollar in wages that the employee receives, the employer pays $(1+T).
  • Flip that around: for every dollar in wages that the employer pays, the employee receives $1/(1+T).
  • Now the employee has his dollar in wages. Of that, a certain fraction goes to taxes (Medicare, Social Security, federal, state). Call that tax fraction E.
  • So the employee is left with $(1-E) of his dollar.
  • But his dollar was already $1/(1+T) of what the employer spent.
  • So of every dollar the employer spends on wages, what ends up in the employee’s pocket is $(1-E)/(1+T). Call this F, for “Final amount in the employee’s pocket.”
  • This means that $(1-F) goes to taxes, for every dollar the employer spends on wages.
  • Put another way: a dollar spent on health insurance, which no one pays taxes on, loses the government $(1-F). 1-F is called the “tax price.” Professor Frakt links here to a paper by the omnipresent Jon Gruber, an MIT professor who was central to building Massachusetts’ universal-coverage system, and who advised President Obama on the Affordable Care Act. The paper — “The Impact of the Tax System on Health Insurance Coverage” — sounds interesting.

To put some flesh on the numbers:

  • when the employer pays you a dollar (in wages, but not in health insurance), it spends 6.2 cents on Social Security and 1.45 cents on Medicare Part A. So T = .062 + .0145 = 0.0765.
  • you pay Social Security and Medicare Part A (same percentages as your employer), plus your Federal marginal tax rate (I’m in the 28% bracket), plus your state marginal rate (Massachusetts’ is 5.3%). So my marginal rate is 40.95%, whence E = .4095.
  • So when my employer spends a dollar on health insurance rather than on wages, the government loses 45 cents that it would have picked up in taxes. (Professor Frakt ends up with 37 cents using more-conservative assumptions, namely that the state tax rate is 5% and that my Federal marginal rate is 20%.)

This distorts the labor market — encouraging employers to buy more-expensive health-insurance plans — and costs the government money that it could be spending on other valuable things.

And it’s regressive: if you’re in the top (35%) bracket, you’re getting more of a benefit from the health-insurance subsidy than is someone in the 28% bracket. Same goes for the mortgage-interest deduction, and it may be even worse there: not only do higher-income people get more off their taxes for every dollar they spend on mortgage interest than do lower-income people, but the more you spend on a house, the more you can take off your taxes. Assuming Bill Gates’s house cost the $97 million that some random web page says it did, that he put 20% down, and that he financed it with a 2%, 30-year fixed-rate mortgage, he’ll be able to use the mortgage-interest deduction to avoid paying taxes on $26,345,019.10 in income over the life of the mortgage. Assuming he’s in the 35% bracket, that’s $9,220,756.69 that the mortgage-interest deduction saved him. Whereas if you’re in the 28% bracket and finance a $350,000 home the same way, you’ll save $33,270.77 over those same 30 years.

These “tax expenditures” cost the government money in the same way that buying a bomber or building a road costs it money. But tax expenditures haven’t, until recently, appeared on the radar in the same way that a $500 toilet seat does. We may well be paying for Bill Gates’ $500 toilet seat, but it hasn’t had the same visceral effect.

Accounting fictions, cutting off your nose to spite your face, pound-foolishness, and other metaphors besides — February 19, 2011

Accounting fictions, cutting off your nose to spite your face, pound-foolishness, and other metaphors besides

The reporting on budget cuts is just all wrong. The [newspaper: Times] reports that the House is set to cut $60 billion, but doesn’t really go into detail on what those cuts include.

Among the cuts that it does describe are an amendment to deny funds to Planned Parenthood. Now, this is really stupid. As of 2008, only 3% of Planned Parenthood’s expenses went toward abortion; about 13 times that much went to contraception, and 9 times more toward STD treatment.

So what does a “smaller budget” in the Planned Parenthood context mean? It means more unplanned pregnancies. This may or may not increase expenses in the future (you can imagine scenarios under which it increases, and others under which it decreases), but you miss the entire picture if you focus narrowly on how much avoids going into the budget today.

Or take the IRS, everyone’s favorite bad guy. The GOP is predictably going after it. But we know what happens: cut from the IRS budget, and more people avoid paying the taxes that the law requires them to pay. If you think the tax burden is onerous, fine; then change the law so that it’s less so. But if you want to enforce the tax law, that enforcement costs money. The IRS budget pays to enforce the tax law. If you think that a marginal dollar of IRS expense leads to less than a dollar in taxes recouped from cheats, then suggest ways to improve the ratio. The way the press talks about the budget, however, avoids discussing benefits, and the GOP is in no rush to debate the merits of a marginal dollar in IRS expenditures. (Far be it for me to suggest that the *very point* of cutting the IRS’s budget is to make it easier for wealthy people, the GOP’s natural constituency, to cheat on their taxes.)

Or take the $131 million the GOP wants to cut from the Securities and Exchange Commission’s budget. Greater SEC oversight might have prevented the financial crisis that we’re just now digging out of. That would have saved us trillions of dollars in bailout money. If a marginal dollar of spending on the SEC yields more than a dollar of savings, we should spend that dollar; if it doesn’t, we shouldn’t. But narrowly focusing on expenses without focusing on results is the essence of foolishness.

Everyone loves to attack regulation of the sort that the SEC engages in. And yes, it confers costs on businesses. When the EPA fines firms for dumping toxic waste into the water, that’s regulation too, and that’s an expense. But it also saves money: keeping toxic waste out of the water keeps people safer, lets them live longer lives, keeps them in productive economic activity for more hours every day, etc.

The SEC’s and the EPA’s budgets are visible costs: the numbers are written down in a book and debated. Their benefits — birth defects prevented, financial crises averted — are longer-term, and the connection is not always visible. In fact, if government is working well, we often don’t notice the regulation’s benefits. Had the SEC been working perfectly, we might have avoided a financial crisis altogether. When FEMA fell apart under the Bush administration and New Orleans drowned, we noticed that failure; had FEMA done its job, there would have been nothing to notice. We had 30 or 40 years of financial stability after the Great Depression, in no small part because banks were kept highly regulated and boring. I suspect this invited people to think that regulation was unnecessary, because the world seemed to do fine without it. But that doesn’t mean the regulation went away; it just means the regulation was invisible.

Invisible, properly-functioning regulation — from FEMA, from the SEC, from the EPA — means invisible benefits: cities that don’t flood, financial crises that don’t drive us into recession, rivers that we can swim in without thinking of the agencies that made it possible. The costs, though, are there for everyone to see in the budget books every year.

To every decision there are costs and benefits, but somehow government policies are treated as though they conferred costs and never benefits. This same refusal to see the forest for the trees came up when the Affordable Care Act was being debated. Democrats insisted on keeping the cost of the bill below an arbitrary limit of $1 trillion over 10 years. But don’t focus on “how much the government spends on health care”; focus on “how much the average taxpayer is spending on health care”; whether the taxpayer’s expense comes out of taxes or from his wallet is largely immaterial. Presumably when the government spends $1 trillion on health reform, that’s going to lower the amount that we consumers have to spend out of pocket. So it’s just transferring expenses from one bucket (out-of-pocket health-care expenses) to another (taxes). Does a dollar taken from taxes reduce out-of-pocket expenses by more than a dollar? If so, there’s a good argument that we should spend that dollar; if not, there’s less of a good argument.

Granted, you could argue that government expenses are *always* worse than personal expenses, no matter the ratio. This is an argument from principle, which you get from dyed-in-the-wool libertarians, and it’s crazy. I think most Americans would reject it out of hand, and it absolutely wouldn’t sell. Suppose a dollar of government health-care expense, or a dollar spent regulating the private insurance industry, saved $10 off the average American’s out-of-pocket health expenses. Would you be willing to let the government handle this and charge you your dollar of tax? I know I would; I hope you would too.

Sometimes what government gives us for our taxes is something that the private market just couldn’t provide. Medicare provides insurance for old people, which they *couldn’t get at any price beforehand*. Here it’s not even a question of how much it costs the government to provide something that the market also provides; it’s the government creating a functioning market where none existed before.

Again: to every policy there are costs and there are benefits. We live in a time when government policies are assumed to consist solely of costs with nary a benefit. Republicans rejoice in this assumption, which allows them to talk about “cutting $60 billion” without having to answer the question: are they also cutting more than $60 billion in benefits?

We need to stop considering government expenses in their own separate bucket. At the very least, we need two expense buckets: out-of-pocket expenses and tax expenses. We simply cannot view the federal budget in isolation from the rest of the economy.