Donald Trump's Taxes, And Yours (And Mine)

The progressive media establishment has now moved into the long-anticipated full attack mode against Trump in the final run-up to the election, and the official big story of the moment is the revelation in Sunday's New York Times of a few pages of Trump's state tax returns for 1995.  It seems that in that year he declared a loss of some $916 million.  That in turn might mean that he went for many years thereafter paying little or no income tax.  Cue the outrage!

My favorite part is the terminology with which Pravda chooses to discuss this tax situation.  In Monday's front page article, the lead headline is "Trump, the Tax Code and a Loophole for the Rich."  The headline in the online version of the same article is "How Donald Trump Turned The Tax Code Into a Giant Tax Shelter."  Quotes in the articles from the Times's chosen sources repeatedly use the terms "loophole" or "tax shelter" or some other comparable words of opprobrium.  For example, we have Steven Rosenthal of the Urban-Brookings Tax Policy Center:

“If it wasn’t clear before, it is now: The tax code is tilted toward the rich in its statutory framework, its exceptions, and in how it is enforced and administered,” said Steven M. Rosenthal, a real estate tax specialist and senior fellow at the Urban-Brookings Tax Policy Center.

Meanwhile, even at sources like Fox News -- where several talking heads have stepped up to defend what Trump apparently did -- the defense has been that his tax position was "legal" and essentially "if you don't like what he did, change the tax law."  It's hard to find anyone to articulate the obviously right view, which is that this is how the tax code should work, and indeed has to work, and there is little to nothing that can or should be done about it.  For a lonely example of a very brief and not fully articulated defense of the current tax code on this point, see Warren Meyer at CoyoteBlog here ("Yes, Let's Make Entrepreneurship and Business Formation Even Harder").

Here's the fundamental problem: The tax we are talking about is a tax on "income."  An "income" tax just doesn't fit very well with those people who live, not off "income," but rather off of assets.  The concept of "income" is very easy to define in the context of wages and salaries.  You worked during the year, and you were paid in cash during the year.  That's income to you for that year, and you must pay the stated proportion of it in tax.  Easy.  But there are many people who do not earn income in this way.  Millions of people, including many who are not at all "rich" or "wealthy," live primarily off assets.  As one example, very large numbers of retirees -- many tens of millions -- live wholly or largely off assets accumulated during a lifetime of savings.  Many, maybe even most, businesses are involved in some way in realizing revenue by dealing in assets.  Real estate businesspeople are a large category of those who live by extracting revenue from assets.

So if you own assets, and derive revenue from them, what part of that is "income" subject to the income tax, and what part is not?  It turns out that the answer to this question is almost entirely arbitrary.  The tax code defines some extractions of income from assets as "income," and some not.  It's whatever the tax code says.  Dividends?  Income!  Interest?  Income!  Withdrawal from savings?  Not income!  Except if the withdrawal is from a 401(k) -- then it's income!  Depreciation?  A subtraction from income!  Sell an asset?  Income -- but only to the extent of the excess of sale price over purchase price!  Borrow money against your assets?  Not income!  Why?  Because those are the rules we have established!  It's not that there is no logic to it, but the rules could easily be very different, and there are huge elements of arbitrariness.  If the rules were different, they would still be just as arbitrary. 

Every election cycle one or more candidates comes forward to propose revisions to the tax code supposedly to make it so simple that you can file your taxes on a post card.  In the recent primary season, Ted Cruz was one such candidate.  That proposition makes sense as to wage and salary income.  But, if you want to have a regime that deems some part of revenue derived from assets to be "income," there is nothing you can do to make it simple.  It will always be inherently arbitrary.  And because it is arbitrary, it will be subject to gaming. 

Here's an obvious illustration of the problem.  Say Warren Buffett owns $10 billion of Berkshire Hathaway stock and its value goes up in a year by $1 billion to $11 billion.  Does Buffett owe income tax on the billion dollar increment?  This is in fact how Buffett makes most of his money.  The answer under our tax system is that increase in value of assets, unless they are sold, is not a taxable event; so Buffett owes nothing on the incremental billion.  And when Buffett writes op-eds about how high a tax rate his secretary pays compared to his own, he completely leaves out that most of his "income" is defined by the tax code as "non-income" and not subject to tax.  Does that sound fair to you?  So, should we make it such that increase in the value of assets is taxable each year?

Good luck with that.   You've caught Buffett, and forced him to pay maybe $350 million on his incremental billion; but meanwhile, does every homeowner in the country (there are about 87 million of them) need to get an appraisal of the house every year and pay income tax if the value went up?  Unfortunately, the large majority of those 87 million people won't sell their house this year and are simply not going to have the money to pay the tax on an increase in value.  Should they all be sent to jail?  This is not going to work.  The reason we don't tax increase in value of assets except on sale is the simple practicality that if we try that it will mostly be impossible to collect the tax.

So we tax assets only on sale.  On all of the value?  No, on the difference between the purchase price of the asset and the sale price.  Why?  There is a logic, but at heart it's another arbitrary rule.  And what if the sale price of the asset is less than the purchase price?  For example, suppose a taxpayer has some assets that have increased in value and others that have decreased.  Should it really be that he must pay tax on the increases and get no offset for the decreases?  If you have that rule, then people who in fact have seen massive decreases in net worth will still face big tax bills.  Your business went broke and lost $500,000, but you made $100,000 in the stock market -- do you really need to pay tax on the $100,000 with no offset for the loss?  Many heartrending cases will come forward -- and among not-wealthy people.  So again, that won't work; and the rule is, you can offset.  

And once the rule is that you can offset losses against gains, you find that, since tax is only due on sale, people have discretion as to when to sell.  They sell the assets where they have had losses, and sit on the gains.  Why voluntarily incur tax when you don't have to?  As I said earlier, whatever rules you set up as to taxation of income from assets, those rules will be subject to gaming.  There is no way around it.

So is there any sense in which what Trump did was to use a "loophole" or a "tax shelter," or was it just an application of the established tax code definition of "income"?  I would say the latter.  And if you propose "closing the loophole," what exactly is the proposed fix?  End the carryforward of losses?  That would just mean that Trump would be forced to sell some assets with gains in 1995 to offset within the year, or alternatively hold on to some of the losses for whatever years necessary until he had offsetting gains to use within one year.  The result would be no more tax revenue for the government, but would it somehow be good for the economy?  Not that I can see.

Meanwhile, fast forward to today.  The likelihood is that the $916 million loss carryforward has been used up.  The real estate assets that Trump bought in the 80s cratered in the early 90s and led to the 1995 loss.  But the assets that he acquired more recently, particularly those in New York, have likely performed very well.  I strongly suspect that today Trump funds his lifestyle and even his presidential campaign in that time-tested game of the real estate entrepreneur, borrowing against the appreciated assets.  In the real estate game, they call it "taking some money out of the property."  Usually, if the rent coverage of the debt service is sufficient, you can borrow "non-recourse" -- you don't even owe the money back personally!  Oh, and the borrowing is not a taxable event.  You don't even need to mention it on your tax return.   Hey, it's just how the system works.  Did you report it as taxable "income" when you took out a mortgage to buy your house?  Neither did I!