1986
1986
In 1986 we had evolved to a point where we had relatively high tax rates, marginal rates, but we had certain kinds of investment that were particularly favored so that if you made investments in those kinds of activities, you ended up paying at a much lower effective rate. So if you think about the base this way, say our gross national product (total income) is $50 trillion and if you said we need to raise a certain amount of money - say $2 trillion ? and you said our total gross product is $50 trillion and you need $2 trillion, 4% will do it, right? Say we?ll tax all income at 4% and get our $2 trillion and be done and we?re in good shape. But of course that would be a "true" flat tax...even on the kid who mows your yard and you pay him $50 and he?s got to pay 4% and you say that?s not fair...little johnny shouldn't have to pay. So we?re going to exempt low income folks who are below the poverty line and we?re not going to tax them.... So immediately we go from $50 trillion to $40 trillion and now in order to raise the same amount of money, we have to charge 5% across the board...but it doesn?t stop there. We?re going to allow deductions for things like charitable contributions, tax-exempt interest, home mortgage interest...you name it. What I started with was my tax base, which was the total income. Now I?m taking stuff off of it.... I?m going to take off home mortgage interest. I?m going to give a special break for capital gains and tax that at a lower rate. Accelerated depreciation for equipment because that?s what keeps the economy running. I?m not going to tax pension contributions or employer-paid medical insurance ? that?s part of the income that we all have but the employer says instead of you paying for your own healthcare, I?ll pay for the healthcare. If you had to pay for it, I would have to pay you money, you?d have to pay tax on it. This way, you don?t have to pay tax on it so the question is, would you rather get $1,000 raise or would you rather have me pay your healthcare which is costing you $1,000. I?d say pay my healthcare because I?ve got to pay tax on the raise, but I don?t have to pay tax on healthcare because it is exempt. I?m going to get a deduction for state and local taxes, property taxes and income tax. See where we?re headed? Eventually, we?re down to about $8 trillion because of all of the exemptions, deductions and special rates and investment incentives and we still have to raise $2 trillion. So now our rate has to be 25% of what is left in order to be able to raise the funds that we need...a big, huge chunk of what was coming out of the base back prior to 1986 was depreciation, which is a non-cash deduction. Remember the S&L's?
Here's the way it went...with some nice round numbers. I take $100,000 and go out and put it as a down payment on an apartment building. The building cost $1 million. The rent generated by the apartment building is $100,000 annually. The $900,000 that I borrowed at 10% interest cost me $90,000. So the other expenses of operating the apartment building cost $10,000 so I?m breaking even and no making any income.... So, $100,000 cash out of pocket, but no return on my money. Why would anyone do that, you ask? Now if the government says we?re going to give you a deduction for the depreciation on the apartment building and that?s going to be 10% on what you paid for the building, then the first year I take a deduction of $100,000. So I took $100,000 and invested it in the building and I get $100,000 deduction on my tax return and if my marginal tax rate is 50%, then that $100,000 deduction, assuming I?m making $1 million a year practicing medicine and I?m paying 50% of that in tax, but I?m now going to get a deduction for $100,000, which means I make $50,000 after tax on my $100,000 investment. For the first year, that?s a 50% return even though I?m breaking even in cash. The second year I get another 10% deduction for depreciation. So I make $50,000 the second year. What has happened is I?ve only owned this thing two years, invested $100,000 cash, second year, I?ve got all of my money back. It only gets better, right? And I?m still not making any money on the apartments because the rent is going to pay the interest and expenses and all of that is a wash.... So, what happens is, after 10 years of that at 10% a year, I?ve run out of depreciation, but out of my $100,000 investment, I?ve got $500,000 back in taxes. Now the problem is with my investment, I?m no longer going to get a deduction and because the depreciation reduced my cost basis in the building, if I sell the building, I?ve got $100,000 of income. The good news is it is pre-1986. The good news is even though I?ve got $100,000 in income, it is capital gains. So I get taxed at a much lower rate. I?m not too broken up about the fact that I have this building that let?s say is still only worth $1 million, but my cost basis is zero because I depreciated it. So when I sell it for $1 million, I have $1 million of capital gain. I?m going to pay tax on that at 25% rate because I get a 50% capital gains deduction. So I?m going to owe $250,000 in taxes, which isn?t too shabby considering that I?ve already saved $500,000 in taxes up front. But there is one real kind of serious problem and that is when I sell it for $1 million, I have to have $900,000 to pay the mortgage back so I?m only going to get $100,000. But not to worry.... What I need is a tax deduction to offset the $1 million in capital gains.... What I need now is a $10 million apartment building because if I can buy a $10 million building, pay 10% depreciation, I get a $1 million deduction, and then I don?t have to pay the $250,000. So what happens is this is like a pyramid. I just keep buying bigger, more expensive, unproductive real property. In 1986, that was causing a tremendous shrinkage in the tax base which meant that even though the nominal rate was 50% or more, the actual effective rate of tax was much lower for higher income folks for whom it made sense to engage in this kind of tax plan.
So in 1986, the compromise that was struck was the Liberals and the Conservatives got together and said.... We need to expand the tax base and we need to cut these rates...they?ve gotten way too high...and in the course of less than a 48-hour period, like on the back of an envelope, they struck a deal that said we will virtually shut down this depreciation deduction business entirely, which will substantially expand the tax base and will knock the rates down to a maximum of 28% and everybody was happy except, of course, the folks that were in the middle of one of these deals and their lenders!!! Probably the most unhappy people were the lenders who had loaned the money!!! A lot were savings and loans associations and you all know that story. The people that owned property said I don?t want to pay $10 million for anything.... As long as I could take the depreciation, things were fine and I didn't care that the property didn't generate any income because of the tax deduction, but when I lost the ability to take depreciation deduction, I started to care about how much income it generates. Then, when looking at the prices of property with a new point of view, what I would really be paying for the property plummeted and the $10 million mortgage went back to the lender...and so went the S&L's. So that was what happened in 1986.... Broaden the base, lower the rate.
1986
In 1986 we had evolved to a point where we had relatively high tax rates, marginal rates, but we had certain kinds of investment that were particularly favored so that if you made investments in those kinds of activities, you ended up paying at a much lower effective rate. So if you think about the base this way, say our gross national product (total income) is $50 trillion and if you said we need to raise a certain amount of money - say $2 trillion ? and you said our total gross product is $50 trillion and you need $2 trillion, 4% will do it, right? Say we?ll tax all income at 4% and get our $2 trillion and be done and we?re in good shape. But of course that would be a "true" flat tax...even on the kid who mows your yard and you pay him $50 and he?s got to pay 4% and you say that?s not fair...little johnny shouldn't have to pay. So we?re going to exempt low income folks who are below the poverty line and we?re not going to tax them.... So immediately we go from $50 trillion to $40 trillion and now in order to raise the same amount of money, we have to charge 5% across the board...but it doesn?t stop there. We?re going to allow deductions for things like charitable contributions, tax-exempt interest, home mortgage interest...you name it. What I started with was my tax base, which was the total income. Now I?m taking stuff off of it.... I?m going to take off home mortgage interest. I?m going to give a special break for capital gains and tax that at a lower rate. Accelerated depreciation for equipment because that?s what keeps the economy running. I?m not going to tax pension contributions or employer-paid medical insurance ? that?s part of the income that we all have but the employer says instead of you paying for your own healthcare, I?ll pay for the healthcare. If you had to pay for it, I would have to pay you money, you?d have to pay tax on it. This way, you don?t have to pay tax on it so the question is, would you rather get $1,000 raise or would you rather have me pay your healthcare which is costing you $1,000. I?d say pay my healthcare because I?ve got to pay tax on the raise, but I don?t have to pay tax on healthcare because it is exempt. I?m going to get a deduction for state and local taxes, property taxes and income tax. See where we?re headed? Eventually, we?re down to about $8 trillion because of all of the exemptions, deductions and special rates and investment incentives and we still have to raise $2 trillion. So now our rate has to be 25% of what is left in order to be able to raise the funds that we need...a big, huge chunk of what was coming out of the base back prior to 1986 was depreciation, which is a non-cash deduction. Remember the S&L's?
Here's the way it went...with some nice round numbers. I take $100,000 and go out and put it as a down payment on an apartment building. The building cost $1 million. The rent generated by the apartment building is $100,000 annually. The $900,000 that I borrowed at 10% interest cost me $90,000. So the other expenses of operating the apartment building cost $10,000 so I?m breaking even and no making any income.... So, $100,000 cash out of pocket, but no return on my money. Why would anyone do that, you ask? Now if the government says we?re going to give you a deduction for the depreciation on the apartment building and that?s going to be 10% on what you paid for the building, then the first year I take a deduction of $100,000. So I took $100,000 and invested it in the building and I get $100,000 deduction on my tax return and if my marginal tax rate is 50%, then that $100,000 deduction, assuming I?m making $1 million a year practicing medicine and I?m paying 50% of that in tax, but I?m now going to get a deduction for $100,000, which means I make $50,000 after tax on my $100,000 investment. For the first year, that?s a 50% return even though I?m breaking even in cash. The second year I get another 10% deduction for depreciation. So I make $50,000 the second year. What has happened is I?ve only owned this thing two years, invested $100,000 cash, second year, I?ve got all of my money back. It only gets better, right? And I?m still not making any money on the apartments because the rent is going to pay the interest and expenses and all of that is a wash.... So, what happens is, after 10 years of that at 10% a year, I?ve run out of depreciation, but out of my $100,000 investment, I?ve got $500,000 back in taxes. Now the problem is with my investment, I?m no longer going to get a deduction and because the depreciation reduced my cost basis in the building, if I sell the building, I?ve got $100,000 of income. The good news is it is pre-1986. The good news is even though I?ve got $100,000 in income, it is capital gains. So I get taxed at a much lower rate. I?m not too broken up about the fact that I have this building that let?s say is still only worth $1 million, but my cost basis is zero because I depreciated it. So when I sell it for $1 million, I have $1 million of capital gain. I?m going to pay tax on that at 25% rate because I get a 50% capital gains deduction. So I?m going to owe $250,000 in taxes, which isn?t too shabby considering that I?ve already saved $500,000 in taxes up front. But there is one real kind of serious problem and that is when I sell it for $1 million, I have to have $900,000 to pay the mortgage back so I?m only going to get $100,000. But not to worry.... What I need is a tax deduction to offset the $1 million in capital gains.... What I need now is a $10 million apartment building because if I can buy a $10 million building, pay 10% depreciation, I get a $1 million deduction, and then I don?t have to pay the $250,000. So what happens is this is like a pyramid. I just keep buying bigger, more expensive, unproductive real property. In 1986, that was causing a tremendous shrinkage in the tax base which meant that even though the nominal rate was 50% or more, the actual effective rate of tax was much lower for higher income folks for whom it made sense to engage in this kind of tax plan.
So in 1986, the compromise that was struck was the Liberals and the Conservatives got together and said.... We need to expand the tax base and we need to cut these rates...they?ve gotten way too high...and in the course of less than a 48-hour period, like on the back of an envelope, they struck a deal that said we will virtually shut down this depreciation deduction business entirely, which will substantially expand the tax base and will knock the rates down to a maximum of 28% and everybody was happy except, of course, the folks that were in the middle of one of these deals and their lenders!!! Probably the most unhappy people were the lenders who had loaned the money!!! A lot were savings and loans associations and you all know that story. The people that owned property said I don?t want to pay $10 million for anything.... As long as I could take the depreciation, things were fine and I didn't care that the property didn't generate any income because of the tax deduction, but when I lost the ability to take depreciation deduction, I started to care about how much income it generates. Then, when looking at the prices of property with a new point of view, what I would really be paying for the property plummeted and the $10 million mortgage went back to the lender...and so went the S&L's. So that was what happened in 1986.... Broaden the base, lower the rate.
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