The Bear’s Lair: Destructive effects of the charitable tax deduction

President Trump’s tax plan removes the deduction for state and local taxes, but leaves in place a much worse policy, the charitable tax deduction. As tax policy, the charitable tax deduction is execrable, targeted primarily at the very rich and enabling such atrocities as the Clinton Foundation. However, it has a subtler undermining effect: it allows the very rich to get away without paying the taxes the rest of us suffer. This exemption from tax is why the rich now vote Left, betraying what should be their class interests. It needs to go – now.

Fifty years ago, you could more or less tell what a person would vote from his economic status. This made sense; top rates of income tax were set at very high rates, while there wasn’t much visible tax on the working class (sales tax and social security payments took a chunk of his paycheck, as they do now, but sales taxes are unnoticeable while social security payments were supposed to buy him a comfortable retirement.) There were loopholes by which the rich could avoid paying their full whack of tax, but they still paid a lot, and suffered considerably higher marginal and average tax rates than the poor.

This resulted in most rich people being politically conservative. The same was true in Britain at that time – a top marginal tax rate of 98% and very few loopholes (and 135% in one magic year of 1968) will sour the liberal sympathies of most people. There were a few exceptions – trust fund kids, living off capital, could afford to be liberal because their net income was relatively unimportant to them. But in general, especially among those who earned most of their wealth, such as bankers and businessmen, support for the free market system that produced their wealth was strong and there was a general agreement that government needed to be smaller and less uppity.

Politics was thus healthy and balanced. Conservative rich people had all the money and a lot of the political power, but poor liberals had the numbers and the instinct for collective action. Hence political leadership alternated between the two parties, and most business was done in the middle. Quirks of the system, such as the tendency of southern Democrats to vote with conservatives even though they were generally relatively poor, modified this picture but did not fundamentally alter it. One important advantage of it was that a small-government, low-tax system was the most open to new talent, so rich conservatives were forced to remain fairly open to new entrants, in the interests of self-preservation.

Had this tax system and wealth structure remained intact, we would now be living in a political Nirvana. The theory and practice of collectivism collapsed spectacularly in 1989-91, so even the relatively impoverished would have realized that a free market gave them the best chance of improving living standards. They would still have favored a fair amount of redistributive taxation, and would favor a higher level of government provision than the rich, but they would generally have bought into the argument that the market enables optimal resource allocation, so therefore maximizes society’s wealth for a given technological frontier.

But of course, that is more or less the current blue-collar belief system. They have a deep suspicion of all the new quick money that has been made out of zero interest rates and the tech boom, and rightly so. They have a deep suspicion of all the outsourcing to emerging markets, that has deprived them of their well-paid jobs – and rightly so. They have a deep suspicion of immigration policies that have been appallingly badly enforced at the low-skill end and appallingly badly fiddled at the high-skill end – and rightly so. But other than that, they are admirably capitalist and free market oriented, as they should be.

It is the rich who have gone off the rails. At about the time when the intelligentsia were almost universally proclaiming the death of communism and the triumph of capitalism, the rich began to desert the economic system that had made them or their ancestors wealthy. Initially, this appeared to be merely an eccentric minority movement, by the likes of George Soros, who spent billions in Eastern Europe dedicated to ensuring that nothing much changed after the Berlin Wall’s collapse. However, more recently the disdain for capitalism has spread to a majority of the very wealthy and even of the well-off. They spout continuing support for “liberalism” but the liberalism they support has nothing whatever to do with nineteenth century liberalism, instead including a morass of socialist property expropriation and state controls, all exerted in the names of environmentalism, “climate control” and sheer political correctness.

There are several economic factors that could explain the change. The tax system has been roughly stable since the admirable 1986 tax reform, with the top rate of income tax only creeping up and capital gains tax declining. If the state is only taxing you at around 50% (including state tax) and political decisions result in only modest moves up or down in that rate, the economic incentive to favor the low-tax party is more modest than if tax rates are 70-98%.

A second factor is undoubtedly the prevalence for the last decade of ultra-low interest rates, and real interest rates little above zero for a decade before that, with the policy change in the U.S. coming in 1995. The rich can borrow more money than the middle class, at lower interest rates, and they have access to a wider range of investment opportunities. Moreover, the inexorable increase in house prices, especially in major international centers, has disproportionately benefited them. Why support capitalism and the difficult task of building a business, when socialism and funny money make you richer more quickly and with less effort?

However, it is likely that an even greater factor in the collapse of the wealthy’s support for capitalism has been the charitable tax deduction. This allows the wealthy to shelter a large portion of their income while feeling a moral superiority in doing so. While the total of tax-deducted charitable tax deductions has increased only modestly (from 1.28% of personal income in 1984 to 1.41% of personal income in 2014), more than 30% of those deductions, $63 billion in amount, are non-cash in nature.

At first sight, you’d think this is not a problem; taxpayers may be giving real estate or stocks, thereby avoiding capital gains tax but still giving something of genuine ascertainable value. However, in 2010, according to a 2103 Joint Committee on Taxation study, 58% by value of those gifts were food, clothing and accessories, and another 30% were electronics and household items, while only 2% was land or stocks.

Combine that with the statistic that those with incomes over $10 million, the highest bracket, gave only $18.1 billion in cash contributions but $22.5 billion in non-cash contributions, $2.9 million per taxpayer, and you can see that this entire item is a gigantic scam. (At $2.9 million per taxpayer, it’s not just underwear; the tax reduction from a $10,000 designer dress, lightly used and valued at $9,000 for tax purposes by an enterprising accountant, is $4,986 for a California taxpayer in the highest bracket).

Like Bill Clinton tax-deducting his used underwear, the ultra-rich are giving away their used electronic junk, clothes, spoiled food and discarded costume jewelry, doubtless overvaluing it for tax purposes, and taking a tax deduction based on the overvaluation. Doubtless many of the “charities” to which they give the cash portion of their deductions are useless dreck like the Clinton Foundation, which can be used to pay infinite amounts of jet-setting expenses, 40% of which are then reimbursed by other taxpayers.

Of course, the rich are moving left. Their tax rates are lower than in the 1980s, they have infinite tax-free capital gains on their urban real estate, which they can finance at funny-money sub-zero real interest rates, and they can get a warm altruistic glow by charitable deductions that result in a massive tax write-off without significant economic cost to them. The system is as corrupt as is Russia under Vladimir Putin, and more corrupt than the Soviet Union under Communism.

President Trump, you have two reforms on the economic front that are absolutely essential, above all else. Fire Janet Yellen, and replace her with a Fed Chairman who will keep interest rates at proper levels, above the inflation rate. It will cause economic pain, but the long-term benefits will far outweigh it. Equally important, eliminate the charitable income tax deduction. First, that will cause you short term joy, in the screams of anguish from your most dedicated opponents and those who fund them. Second, it will cause long-term economic benefit, in sharply cutting back the parasitic charitable sector of the economy. Finally, it will cause long-term political benefits, in returning the rich to a proper sense of where their interests lie and which economic system is good for the country and the world.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)