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Tax fairness and the wealthy

By Ray D. Madoff,

Ray D. Madoff is a professor at Boston College Law School and the author of “Immortality and the Law: The Rising Power of the American Dead.

A central question for leaders confronting our fiscal crisis is fairness in the tax system — in particular, whether the wealthiest Americans are paying their fair share. While there appears — or, at least, appeared — to be some agreement between President Obama and House Speaker John Boehner that taxes on the wealthy must go up, the amount of the increase remains undecided. Many argue that the wealthy are already paying a disproportionate share of taxes, a view that new data from the Internal Revenue Service appear to support. Missing from the conversation, however, is an appreciation of the way these data fail to accurately describe the true income of the wealthiest Americans.

The IRS recently released its analysis of 2010 tax returns, which shows the allocation of taxes over different income groups. This information is both informative and misleading. According to these latest figures, in 2010 the top 1 percent of earners (those with adjusted gross incomes of at least $369,691) paid about 37 percent of all income taxes but reported just less than 19 percent of all income. Based on these data, the U.S. income tax system looks truly progressive. This lends credence to the view that the wealthy are paying even more than their fair share.

But statistics can be only as good as the information on which they are based, and here the data are fundamentally misleading. People pay income tax only on amounts that Congress counts as income. This excludes the sources of revenue most commonly enjoyed by the richest Americans: gifts, inheritances, distributions from trusts and proceeds of life insurance.

How much tax-free income do the wealthy enjoy each year? While we can all guess — and common sense tells us that the numbers are significant — we cannot know for sure. This income is not only tax-free, but there also is not even an obligation to report it.

To illustrate the perversion of this system, imagine two taxpayers, each earning a salary of $50,000. Suppose, however, that during that same year one of the taxpayers is also the beneficiary of a trust that pays for his mortgage and all other living expenses. Suppose the same taxpayer, during the same year, also receives a $25,000 gift from his aunt and uncle, a $7 million inheritance from one set of grandparents and a $50 million distribution from a life insurance policy from his other grandparents. Even though we can all agree that this taxpayer became significantly more enriched than the other over the course of the year, our income tax system ignores all of this non-salary income and regards both taxpayers as if they were identical. Most surprising, the federal government has expressed no interest in even learning about any of these payments.

Estate and gift taxes will play no role, either. These examples fit well within current exemptions, and even Obama’s plan to increase estate and gift taxes would still exclude from taxation all of the transfers cited above.

It need not be that way.

The decision to track income is separate from the decision to tax it. There are many examples where our income tax system requires taxpayers to report income, even if it is not subject to tax. Income from tax-exempt bonds, distributions from Roth IRAs and capital gains on the sale of a house must all be reported on taxpayers’ annual tax returns even if these amounts are not subject to tax.

In addition, items that are deductible — such as charitable donations and mortgage interest — must still be reported to the federal government. This reporting plays a valuable function because it gives the government the ability to determine the cost of excluding these items from taxation. Much of the current focus on the cost of the charitable deduction and the mortgage interest deduction stems from the fact that the government can easily calculate the effect of these deductions on the federal budget.

It is time for Congress to shine a light on the types of income most enjoyed by the wealthy. Individuals should be required to report all sources of income, including gifts, inheritances, life insurance and distributions from trusts so that we can begin to assess the impact of these exclusions.

Everyone agrees that fairness matters when it comes to income taxes. But we cannot have an honest discussion about tax fairness when we are kept in the dark about how much income people actually receive. Only when full reporting is required can we have an accurate picture of people’s true income. Then we can begin to fashion a tax plan that is fair for all Americans.

For more on this topic: Robert J. Samuelson: The death of tax reform Greg Ip: 5 myths about tax reform

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