The main issue, really, is not what taxes Mr. Trump did or did not pay after the big loss. The big issue is what taxes he did or did not pay beforehand.
If we're going to tax income, the principle of net operating loss carry-forward (this sort of taxese by itself tells you a lot about what's wrong with the system) makes a lot of sense. Suppose you run a business that makes $1,000,000 in even years, and loses $900,000 in odd years. On average, you make $50,000 per year. But if you pay a 40% Federal income tax rate (plus state, local, etc.) in the good years, then you pay $200,000 per year on average in taxes, a 400% tax rate.
So, if Mr. Trump really had earned $1,000,000,000 of income, paid taxes on that income, then lost $900,000,000 as reported, allowing him to deduct future income against that $900,000,000 until he pays taxes only on the net $100,000,000 makes abundant sense. (I'm struggling to keep track of the zeros here.)
Now you see the big issue. The real question is, did Mr. Trump actually make income, pay taxes, and then suffer that $900,000,000 loss? Or, did other people suffer the loss, and Mr. Trump got to use the losses to protect his future income? Or, are the losses basically fictitious? The reporting (New York Times ) suggests the latter
...net operating loss, or N.O.L., allows a dizzying array of deductions, business expenses, real estate depreciation, losses from the sale of business assets and even operating losses to flow from the balance sheets of those partnerships, limited liability companies and S corporations onto the personal tax returns of men like Mr. Trump.The follow up offered more detail on where fictitious or other people's losses come from:
... he might have been able to record write-downs of assets under a doctrine known as “abandonment,” an aggressive accounting tactic used when an investor walks away from a worthless or nearly worthless asset and writes off the entire capital investment in the property. ["The" does not mean "his?"]
... Mr. Trump personally guaranteed $832 million of debt related to his casinos and other assets. Under tax code provisions available to real estate developers, he could take the full amount as a deduction even if he didn’t invest a dime of his own money. [my emphasis]
Ordinarily, that deduction would be recaptured when the debt was forgiven or the underlying assets sold. If the debt were forgiven, Mr. Trump would have to report that as income. But there are various exceptions. If Mr. Trump was insolvent at the time — if his debts exceeded his assets — he might have avoided having to report the forgiveness of debt as income...
There are other provisions, too, that might have allowed Mr. Trump to deduct the loans but never have to report them as income.
Real estate developers are also uniquely able to realize losses as soon as they occur, but defer gains, often indefinitely, through such tactics as like-kind exchanges. “It’s heads Trump wins, and tails the government loses,” Mr. Knoll said.As a simple version, lunch conversation had the following anecdote: If you rent out property here, you can depreciate the cost of the house. But the cost of the house in the bay area is 99% value of land which doesn't depreciate. So you can cut your taxable income by this fictitious depreciation. I don't know if it's true, but it is a similar story.
Now, for lessons.
Income and corporate taxes. Compare this outcome to a consumption tax. Suppose that no matter what his income, Mr. Trump had to pay, say, 25% VAT on
...Mr. Trump’s opulent lifestyle over the years. At the nadir of his personal financial crisis in the early 1990s, his lenders put him on an annual “budget” of $450,000 in personal expenses — more than enough to sustain his lifestyle of lavish homes, private jets, country clubs and golf coursesAssuming that he did not, in fact, pay 40% taxes on the $900,000,000 before he "lost" it, he would have ended up paying a lot more in consumption taxes. A consumption tax can be more progressive than an income tax. The attempt to tax income is at the root of all this mess.
It's not just Trump. The great news of this story is that it shines a light on the affairs of America's "dynastic families" (aristocracy), and the puzzle of why they all seem to be so heavily invested in real estate. From the Times again,
...America’s dynastic families, which, like the Trumps, hold their wealth inside byzantine networks of partnerships, limited liability companies and S corporations.
...According to Mr. Mitnick, Mr. Trump’s use of net operating losses was no different from that of his other wealthy clients.
“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.It goes on. A real estate lawyer once explained to me how she set up trusts for one of these "dynastic families." On Junior's first birthday he gets complex shares in a limited partnership worth just under the gift tax limit. 50 years later, what do you know by capital gains it's worth $50 million, so the property passes outside of estate taxes.
What fixes it? Neither candidate's tax plan does anything that I see to eliminate these shenanigans among the super-rich who can afford to hire armies of lawyers. (Correct me if I am wrong, please. I have not read them in great detail as I know they will be shredded on Nov. 7). Mrs. Clinton's plans to raise personal income tax rates doesn't raise more taxes from people who have sheltered all their income. Raising capital gains and estate tax rates just raises the incentive to pursue shelters. (See for example Zuckerberg's GRAT)
The right response to this affair is outrage at the astonishing crony complexity of the tax code, not really Mr. Trump's apparently perfectly legal behavior. I can't see a way to get around this than to abandon the attempt to tax income, and just tax consumption instead.
As for Mr. Trump, I actually have a kind thing to say: This affair makes it clear that politics is indeed a recent avocation. You can tell which economists want government jobs and which don't by how they pay their nannies. Nobody planning to run for office would have done this!
Update: Debt Parking by John Hempton (HT Marginal Revolution). Short version: Borrow lots of money. Lose it, take tax loss. Sell worthless debt to offshore entity. Get creditors to forgive debt. Normally, debt forgiveness counts as income and eats back your tax losses. But since that "income" is not cash, it's easy to hide it. The big question will be whether Mr. Trump did this, or whether he later paid taxes on the forgiven debt or not.
Hampton speculates he did not pay that tax:
There is a vehicle out there (say an offshore trust or other undisclosed related party effectively controlled by Donald Trump) - which owns over $900 million in debt and is not bothering to collect it.
I do not have the time or energy to find that vehicle. But it is there. Now that this blog has gone public journalists are going to look for it.
There is a Pulitzer prize for whoever finds it. Just give me a nod at the acceptance ceremonyUpdate 2: Josh Barro writes about a more plausible explanation from Lee Sheppard -- the "Gitlitz loophole." Until 2002, someone in Mr. Trump's position could, in fact, set up a company, borrow a ton of money, lose it, have the debt forgiven in the company's bankruptcy, but use the lost borrowed money against future personal taxes. Apparently, it was an error in writing the tax code, which Congress fixed when it came to light.
I stick to my interpretation that the episode reveals more about insane complexity of the tax code, a necessary result of trying to tax income, than much of anything else.