Tax Rates and Tax Loopholes

In 1975, when I started writing about tax loopholes, the top federal income tax rate was 70%.

And the tax law was full of diverse ways for different taxpayers to reduce their taxes.

Most people who didn't take the time or effort to look for ways to save income taxes referred to these diverse tax saving opportunities as "loopholes". The government called them tax incentives. Economists often referred to them as "tax expenditures" because they had the same effect as giving money to a select group of taxpayers. Quite often the select group consisted of members of an occupational group such as real estate developers and brokers or homeowners.

Taxpayers who had enough income to be faced with a 70% marginal tax rate were highly motivated to take advantage of as many of these "loopholes" as possible. In many cases, the loopholes required the taxpayer to invest in something (like a real estate venture) that would generate a deductible loss. By using borrowed money that didn't have to be paid back for many years, the taxpayer could secure the equivalent of a low interest loan in the form of a tax reduction.

In some cases, taxpayers could rearrange their business so as to qualify for some tax break they were not currently eligible to use. For example, a self-employed person was (back then) not able to get a tax break for his medical expenses comparable to an employee. But an owner and employee of a corporation could establish a corporate benefit plan that would pay the medical expenses of the employees and the owners. Businesses could qualify for substantial tax credits for an investment in business equipment. So some investors would put up the money to buy the equipment and would share in the use of the investment tax credits. Parents would loan money to their children (or to a trust for the benefit of their children) at a zero interest rate. The children (or the trust) would invest the money to earn interest, dividends or capital gains. The children were in a low tax bracket and the parents were in a high tax bracket.

At one point I had accumulated and documented more than 200 of these pre-meditated tax breaks. By "pre-meditated" I mean that the taxpayer generally needed to engage in some planning to identify which of the tax breaks were suitable for that taxpayer and then had to write a check or take some action to qualify for the tax break.

But in 1981, President Reagan pushed through a tax law that reduced the top tax rate to 50%. And that tax law eliminated or curtailed many of the loopholes that were being used to shelter income from high tax rates. Then in the Tax Reform Act of 1986, Reagan pushed through a reduction in the top rate to 28% -- along with a huge reduction in the many different tax shelters, loopholes and tax breaks that were still being used.

As tax rates have crept back up to a top rate of 35%, each new tax law includes new tax incentives -- often for various energy conservation or production investments. For many years the government has been trying to motivate small business owners to provide retirement benefits for their lower income employees. But the Congress also tries to restrict the ability of the business owner to benefit from the plan. The result is that the owners don't jump on the tax breaks and the Congress keeps raising the incentive. After the investment tax credit proved to be popular and was used by a lot of people, the Congress imposed severe limits on who could use it and it fell out of favor. But now, the Congress has increased the one year deduction of business equipment to $250,000.

But there is a pattern to the ups and downs of tax rates and tax loopholes. The higher the tax rates, the more loopholes the politicians will create to encourage investment in selected parts of the economy. And when tax rates are reduced, there is usually a compensating reduction in the variety and the appeal of various legislated tax incentives, aka "loopholes".

Vern Jacobs