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.
I fully agree with consumption taxes being preferable over income taxes. However, as so often, the devil is in the details. How should progressive consumption taxes be implemented? (Maybe with reclaim vouchers for the first 10k or so?) How can distortions between marginal personal spending and marginal business spending be avoided? (E.g. should the consumption of the same steak be taxed differently when a business does so?) Would the consumption of labor (e.g. hiring a nanny) also be taxes? It would be great to hear how you would actually implement such a tax. If all tax revenue comes from it, it must be as free of frictions and distortions as possible.
ReplyDeleteJohn,
ReplyDelete"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."
Taxing consumption does not get you there. Any level of complexity in an income tax code can be easily replicated with a consumption tax code.
"The right response to this affair is outrage at the astonishing crony complexity of the income tax code..."
Correct, and there is nothing astonishingly simple about a consumption tax.
"The attempt to tax income is at the root of all this mess."
Wrong. Dead wrong. The attempt to treat some forms of income differently than others is the root of all this mess. Your consumption tax system is a solution worse than the disease itself.
http://www.revenue.state.il.us/businesses/taxinformation/sales/rot.htm
"For purposes of this document, Illinois Sales Tax has three rate structures — one for qualifying food, drugs, and medical appliances; one for items required to be titled or registered; and another for all other general merchandise."
Yep, that sounds much simpler. We have gone from 3 types of income to 3 types of merchandise. And that is just one example.
And please don't give me the single consumption tax rate b. s. In your first paragraph you make this statement:
"A consumption tax can be more progressive."
This leads me to believe that you in fact don't support a single flat consumption tax rate, that to gain political support you would entertain any myriad of exceptions, exclusions, or carve outs identified by Representative Joe or Senator Sue in the name of "progressiveness".
Seems to me, Hong Kong has done well with a 15% flat tax. It gets around your concern for consumption tax rate b.s.
DeleteSounds good to me.
DeleteHas Hong Kong gone through any recessions of recent memory?
How was tax policy adjusted in response to the recession?
It doesn't matter what type of simplified tax code is implemented during good times. A tax code meets muster when the bad times happen. That is when the cronyism creeps in. Senator Sue and Representative Joe both realize the economy is underperforming so Sue introduces a tax break for corn growers (being from Nebraska) and Joe introduces a tax break for oil companies (being from Texas).
What I am getting at is that real time adjustments may need to be made to tax policy (monetary policy can't do it all), and so how are those policy changes made without re-introducing the cronyism that was eliminated?
Neither I, nor anyone else can say very much that is intelligent about Trump's 1995 tax returns, because we do not have the full Federal return, nor do we have any of the underlying deal documents. Further, the loss happened in 1995. We do not know the amount of pre-1986 transactions that affected it. The 1986 amendments to the IRC made it a lot harder to utilize deductions generated by non-recourse debt. If the debt was recourse, but was discharged by insolvency proceedings, the NOL, might have been wiped out.
ReplyDeleteOn the estate tax. Discussions of this make me cry. The most important tool in estate tax planning is time:
"On Junior's first birthday he gets ... 50 years later ... it's worth $50 million"
50 years is a very long time. a return rate of 7% would give you about 5 doublings of the initial investment, or 32x. Throw in a bit of inflation it could look like a lot more. Of course, the investment has to be good. Land in mid-town Manhattan has kept up. Detroit, not so much, of course no one notices what happens to the heirs of those investments.
It is the 50 years that is the key. not the final liquidation at the end of that time period.
" If the debt was recourse, but was discharged by insolvency proceedings, the NOL, might have been wiped out."
DeleteI relocated IRC §108, the debt can be discharged outside of formal court proceedings, but the effect is the same. The NOL is reduced by the discharge of indebtedness.
Professor Cochrane, thanks for this post - it eloquently gets to the heart of the problem. Despite my abhorrence for Mr Trump, I don't understand how people see an NOL carry-forward as a smoking gun.
ReplyDeleteWhat doesn't make any sense to me is why you see consumption tax in lieu of income tax as "adequately" progressive? Under the math you showed above, Mr Trump would owe ~$113k in his covenant years - less than what I pay in income taxes now - and a somewhat higher (3x? 4x?) lifestyle and inflation adjusted number in normal years. Over 20 years, it would surely be less than ~$20M and vastly out of line with the currently accepted societal understanding of progressive.
I would certainly be happy to raise the consumption taxes on goods that the rich consume in exchange for lowering the marginal income tax... but how would one do that in practice?
ReplyDeleteHere are some questions that immediately come to mind: How do we find and choose what goods and services that the richest in a country consume? How do we deal with the challenge of the inevitable substitution effect, and the creation of new goods and services for rich people that deliberately try to skirt the tax code? And what if these richest then proceed to move out of the country to a 'friendlier' one, where their consumption would not be taxed?
It seems to me, at a first glance, that there are serious, but not necessarily insurmountable challenges to substituting one for the other.
Frank R. is, of course, correct to worry that a consumption tax might be gamed. But I have two questions.
ReplyDeleteFirst, is it plausible to think that a consumption-based tax will be harder to manipulate than an income tax? VAT, for example, can be avoided at the margin (e.g., not running cash transactions through the register) but is it really that hard to collect. If governments are spending at least 40% of GDP, we might need a more complex consumption tax that requires individuals to file returns, but wouldn’t that be based mostly on cash flows? Aren’t cash flows easier to audit and harder to hide than income?
Also, doesn’t a consumption tax change the public choice story behind tax policy? It seems easier for a Donald Trump to claim that he needs generous tax write-offs to support casino building in Gomorrah. It’s harder for him to make the case that he needs a tax-free yacht.
Second question. Even if a consumption tax is riddled with cronyism, could this be less distortionary than an income tax riddled with cronyism? If the sausage makers in Congress gave us a system that favors certain types of consumption and certain consumers, I’d be disappointed. But I might be less disappointed than the current system that favors certain kinds of….Hmm…what is the deadweight loss of the current system? It’s big, but who knows how big?
One more thing. While reasonable people can disagree about a consumption tax, can we at least agree that a corporate income tax is just silly?
Mike,
Delete"While reasonable people can disagree about a consumption tax, can we at least agree that a corporate income tax is just silly?"
Can we agree that trying to define what is and what is not a corporation is just as silly?
It's one thing to say that corporations should pay no taxes, it's another to say that the tax code should define what and what is not a corporation.
It's easy enough to incorporate yourself and define all of your personal income as corporate income (no taxes).
So if you want to eliminate the distinction between personal and corporate income, that's fine (corporations would pay no tax because there would be no such thing as a corporation). If instead you want corporations to pay 0 tax and individuals to pay an income tax, how should a corporation be defined?
It's all intertwined. If you tax income, you must tax corporations. Otherwise, people incorporate to avoid personal income taxation. By taxing only consumption, you open the door to eliminating the corporate income tax.
DeleteFrank,
DeleteI may be missing something but I’m not sure I see this as a huge problem. If we’re going to have corporations, they’re going to be defined by law. And corporations are, on balance, a good thing no matter what the tax environment (limited liability, ease of contracting etc.)
Taxing the income of these corporations is not a good thing. It leads to tremendous inefficiencies because of distorted price signals, wastes enormous resources through rent seeking, avoidance and enforcement efforts and is politically corrosive since it hides the burden of a tax (to say that corporations don’t pay taxes, they collect taxes is a cliché but it’s true.)
You and John seem to worry that if there were no corporate income taxes, people would try to claim that they’re corporations earning only tax-free corporate income? Of course they will try. But the IRS is pretty good about dealing with this kind of stuff. Suppose some bright entrepreneur forms the HRC Corp, an entity in the business of charging customers for the right to have the founder give public talks, write research papers and so forth. That business would make a huge profit (despite the fact that HRC doesn’t charge for his blog, puts his papers on SSRN and makes many public talks available as podcasts!) HRC’s profits would be untaxed, but if they pay HRC dividends or a salary, he gets taxed. Of course, HRC might be try to hide some personal expenses as business expenses and he might be able to slip through the occasional first class ticket or nice bottle of wine. But claiming something big-- a kid’s college tuition or an expensive sailplane-- as a necessary business expense is not going to work.
Actually, your concerns about corporations are very similar to the problem of charitable/religious institutions. They don’t pay income taxes on the activities related to their mission and they’re hard to define. But if these places pay for services, including to clergy, income taxes are involved. There are, to be sure, sleazy preachers who have the church pick up personal expenses. But sleazy people are going to do sleazy things under any tax system.
I guess my real concern with a corporate income tax is that it creates a world in which different sources of income are taxed differently. That’s also why I dislike estate taxes. I suppose you can make a case for this sort of thing on equity grounds but since we don’t understand the burden of corporate taxes, an equity argument is pretty lame. In any case, the inefficiencies created when people try to game the system are a terrible loss to an economy that needs to grow.
None of this is to argue against a consumption based tax system. But if we can’t have that, we can still make things better.
Mike,
Delete"I guess my real concern with a corporate income tax is that it creates a world in which different sources of income are taxed differently."
I agree whole heartedly and John voices the same concern, but I fail to see how a consumption based tax system addresses the underlying problem.
Mike,
Delete"If we’re going to have corporations, they’re going to be defined by law."
A corporation is simply a group of people who earn a shared income and then divy it up based upon an agreed upon arrangement - wages, capital improvements, profits, etc.
If we are going to treat corporations as simply pass through enterprises -taxes paid by the company are ultimately pulled from it's employees then
the question becomes how should the tax burden of the corporation be split among it's individual members under a progressive system?
https://en.wikipedia.org/wiki/Corporate_tax_in_the_United_States
A corporation could have $10 million in earnings (34% corporate tax rate), but this $10 million may divied among 5,000 employees ($2,000 per employee).
Should the 34% tax rate apply for the $10 million earned by the corporation or should the 15% tax rate apply for the $2,000 per employee?
This is one of many problems inherent in a progressive tax system with differential treatment of various levels and types of income. And a progressive consumption tax would be no better.
A simple flat tax solves all of this.
OK, I know VERY LITTLE about tax law (no, less than that), so someone please correct me if I am wrong but this doesn't make sense to me
ReplyDelete"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"
Trump can be insolvent, and not have to report his debt forgiveness as income, but then he can't carry over the losses against future income, correct? Not correct? Should be correct but this loophole he could exploit would allow him to do so?
"Trump can be insolvent, and not have to report his debt forgiveness as income, but then he can't carry over the losses against future income, correct? "
DeleteCorect see IRC §108
I am not a tax expert either, see above comment from FatMan:
Delete"The 1986 amendments to the IRC made it a lot harder to utilize deductions generated by non-recourse debt. If the debt was recourse, but was discharged by insolvency proceedings, the NOL, might have been wiped out."
And so your question - Can Trump carry over losses against future income if he is declared insolvent and has his debt forgiven?
Answer: It depends on whether the debt was non-recourse or recourse debt. If it was non-recourse debt - lender has no means to recover lost principle / interest in the event of bankruptcy - then it is unlikely that Trump could carry that loss forward.
If the forgiven / restructured debt was recourse, then the lender can go to court and ask that Trump's assets be liquidated and / or his future earnings be garnished and used to service the debt. In that case, it is possible that Trump could continue to carry that loss forward until the debt obligation is fulfilled.
The closest answer is probably: "Should be correct but this loophole he could exploit would allow him to do so[.]" The term "exploit" is almost certainly inappropriate (as explained below), but the rest sorta works.
DeleteWhile Fat Man's analysis is 100% accurate, it fails to account for two things: (1) the loss was likely attributed to Trump via an S-Corp, and (2) prior to a 2002 technical correction, the cancellation of indebtedness tax rules did not work especially well when applied to insolvent S-Corps.
The way to think of all this conceptually is that the $900M of NOLs made their way up from the S-Corp to Trump, but the rules that should have reduced those NOLs following insolvency got hung up at the S-Corp level, thus never reaching Trump at the shareholder level. Tax nerds out there can read the 2001 SCOTUS decision in the Gitlitz case for a more nuanced discussion.
Of course, none of this really changes anything beyond exactly how much money Trump lost after tax. Even if I'm correct, it means Trump "only" lost $300M after tax instead of losing $600M after tax (assuming a 1/3rd tax rate and ignoring TVM for the sake of simplicity).
Further, this was one of those tax "loopholes" that you would just fall into by accident, rather than being something you could/would actively pursue to reduce your tax bill. It also wasn't some crazy, hyper technical, super aggressive position developed by a genius tax attorney only Trump could afford... it was instead just a function of how you calculated taxes if you owned an S-Corp prior to 2002. In short, Congress just plain old goofed up in drafting a tax law, Congress learned that it goofed up in 2001, then Congress fixed the laws in 2002. Since laws aren't retroactive, a bunch of owners of unsuccessful S-Corps enjoyed a windfall.
Personally I have no problem with paying as little tax as possible under the law (which is good, since I earn my living by helping large companies do precisely that). However even those poor, misguided, helplessly indoctrinated souls out there who disagree with me would not blame Trump for this particular tax loss if they actually understood it. While I'm sure Trump generally does everything he can to reduce his tax bill, including some dubious maneuvers, in this particular case he just got "lucky" (to the extent losing $300M can ever be called lucky). Unless people think he should have voluntarily overpaid out of some misguided sense of civic duty,* they should leave him alone on this one.
*Of course when Mitt Romney did precisely this in a misguided attempt to avoid his tax returns becoming an issue during his presidential campaign, people still called him a tax cheat. One left wing professor even went so far as to say Romney committed perjury in overpaying hiss taxes (by purposefully entering an incorrect amount on his return, even though it was too high instead of too low). So maybe it wouldn't matter either way...
The nihilist approach: "it is tough to define income so lets not try" has no appeal to me.
ReplyDeleteThe statement "Sell worthless debt to offshore entity. Get creditors to forgive debt. " somewhat misapprehend how it would work.
Debt parking works by having a "friendly" buy the debt for pennies on the dollar and take an assignments. Suppose Trump did this through a vehicle in a tax haven. Then Trump would owe the money to the entity located in a tax haven. Trump could use the loss carry forward to eliminate tax on future American domiciled income and pay the money to the tax haven entity.
For me the question is not whether Trump paid taxes before 1995 - the question is what became of the billion dollar debt.
I regret to disclose I prepare income taxes each Jan.-April, as a "penitence" for my years working with the Senate Finance Committee to "crony" the tax (and trade) laws.
ReplyDeleteThe taxation of "income" is irrational, since even the Haig-Simons rules are unmeasurable without rules; complexities. Only what one "takes out" of life's fruits should possibly carry a surcharge for the "public services" we hope might be proportional to that consumption metric.
Mazsurement, and enforcement, is the key detail. The Unit of Accounting for the tax ledgers also matters. One should not assume the government's own U of A are best for the government's solvency (Hayek suggested opposite). We now live in a world of multiple fungible assets, not just the world's major currencies. A world financial system and a world payments system is based on a competition for "strength" in currencies. So much for today's price of oil, and the rush of private capital out of China and into US Treasuries and real estate.
Judge Learned Hand - "Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes."
ReplyDeleteTrump didn't write the rules. He just followed them. Get over it and try to change the rules.
Trump says hes a genius and he knows how to fix this. Someone shoul d ask him how he would fix this.
ReplyDeleteEgads. Great post. I vote for cutting federal agency soending in half and going to a national sales tax, import and pollution taxes.
ReplyDeleteCanada introduced a national sales tax - the GST / HST - with exemptions for things like food and a rebate for low income earners. Business oriented conservatives supported it as a rational policy. Populist conservatives hated it with a deep and abiding passion and tore the conservative party apart over it. (For "pollution" taxes - sure go ahead, suggest a national US carbon tax.)
DeleteIt would be really interesting to hear Prof. Cochrane's thoughts on the Trump econonomic plan, in particular before The Donald is elected as president / imperator. Hopefully he will have the time and the impetus to do that before November; it is unlikely that the WSJ would ask him to do that.
ReplyDeleteMy views on economic policy start with completely free trade and quite open immigration. And if you don't like immigration, free trade is one of the best ways to reduce it -- buy what they have to sell, and they don't need to come here to make a living. Oh, and massive simplification of the tax code. There's not much point in going deeper into Trump "plans" (i.e. Trump staff plans) given that starting point.
Delete