Those tax hikes were tempting, but this kind of story showcases one of the big problems with raising taxes during a recession: that unstable tax code gives everyone an incentive to earn less and lie more, since they don’t know what they’ll actually get to keep. Instead of spending big during good times and squeezing taxpayers during bad times, states should plan ahead for this kind of crisis.

A better plan is to set aside savings for bad times — New York could have kept spending low during the boom years, paid down debt, and had a large expense cushion when times got more difficult. That might have slowed the boom down a bit (with less hiring going on at city hall, wages citywide would be a tad lower), but that’s not such a big problem: a crash from a Dow at 13,000 or 12,000 is less painful than a crash from 14,000, and if the states didn’t have such high ‘leverage’ in the form of ratcheted-up expenditures, the market might not have dropped so far, either.

This hypothetical story of responsible state spending reads a little like a fairy tale, which just shows how far we’ve fallen. It should be possible for legislators to be responsible — to have spending grow 2% when revenues grow 3%, so taxes won’t have to soar after the inevitable shortfall. Instead, we have a system where swings in the market are exacerbated by optimistic politicians, who convince everyone (including themselves) that the trendline can point straight up forever.

Now, we’re facing the consequences. A taxpayer doing a business tax filing would need to be especially careful here. Since these taxes apply to high incomes with high deductions, sole proprietors and small LLCs are going to be walloped by the tax hikes.

We’re now several years into a credit crisis caused by people buying homes they couldn’t really afford. And the response? Creating a new incentive to buy more homes — and to borrow money to do it. There is no way this will end up moving prices to an appropriate level, and no way it’s going to make the finance and housing industries change their behavior.

In fact, the main result is to make things even worse: in the past, the government just made borrowing cheaper (through the income tax deduction, which made interest cheaper than other kinds of interest, and through Fannie and Freddie, which made mortgage loans easier loans to make). With this new law, they’ve gone from making promises to just plain writing checks.

You can’t really take this much farther without making it even more absurd. In the future, we’re going to have to raise taxes (on everything except real estate, apparently). Or huge deficits will lead to rampant inflation (making dollar bills worth less than wallpaper — also a boon to the housing industry, incidentally).

Dear IRS,

I am sorry to inform you that I will not be able to pay taxes owed April 15, but all is not lost.

I have paid these taxes: accounts receivable tax, building permit tax, CDL tax, cigarette tax, corporate income tax, dog licence tax, federal income tax, unemployment tax, gasoline tax, hunting licence tax, fishing licence tax, waterfowl stamp tax, inheritance tax, inventory tax, liquor tax, luxury tax, medicare tax, city, school and county property tax (up 33 percent last 4 years), real estate tax, social security tax, road usage tax, toll road tax, state and city sales tax, recreational vehicle tax, state franchise tax, state unemployment tax, telephone federal excise tax, telephone federal state and local surcharge tax, telephone minimum usage surcharge tax, telephone state and local tax, utility tax, vehicle licence registration tax, capitol gains tax, lease severance tax, oil and gas assessment tax, Colorado property tax, Texas, Colorado, Wyoming, Oklahoma and New Mexico sales tax, and many more that I can’t recall but I have run out of space and money.

When you do not receive my check April 15, just know that it is an honest mistake. Please treat me the same way you treated Congressmen Charles Rangle, Chris Dodd, Barney Frank and ex-Congressman Tom Dashelle and, of course, your boss Timothy Geithner. No penalties and no interest.

P.S. I will make at least a partial payment as soon as I get my stimulus check.

Ed Barnett

Wichita Falls

He’s touched a nerve: Google an excerpt from the letter, and you’ll find dozens of quotes on blogs and message boards. The question is: how many Ed Barnetts are out there? How many of them were waiting for him to say what the rest of them were thinking? And what will that mean for us on April 15th?

• TaxProf, if you’d like to know why to blame the Democrats, and
• A Taxing matter in case you’d prefer to blame the Republicans.

Essentially, the function of this new rule is that banks that acquire other banks can shelter their own profits by applying the past losses of their acquisition target to their own profits. So if Citigroup buys out a company that just lost $1 billion, Citi can avoid paying taxes on another $1 billion in profits (assuming Citi ever makes a profit again).

There are basically two views on this: one view is that it’s a terrible move, because the treasury is basically giving away money to the banks; the other is that this is true, and that they’re doing so while stealing Congress’ ability to make the rules. It’s bad enough that the treasury department can invest $700 billion with basically no oversight — but it’s much worse that they can arbitrarily rewrite tax laws without Congress’ permission.

That said, it’s important not to forget the rationale for this move. This law basically makes the tax code more symmetrical: $1 of profit is taxed at a certain rate, so why should -$1 be taxed differently? If there’s some kind of social value to saying that expenses reduce the tax burden when there is a profit, why should this stop being true when expenses exceed revenues? There aren’t many ways to go broke losing money only two thirds as fast (just as there are many ways to get rich paying income taxes of 35% or more).

How should Congress respond? The simplest way would be to just tell the treasury department to stop, but the result of this depends on just what they’re up to. If this is an honest mistake, it should be easy to correct. If it was a deliberate attempt to pay banks to buy one another out, there’s no reason it won’t happen even if the specific rule being used is phased out: the treasury can just spend extra money buying (or bailing out) assets owned by the banks involved in the merger; so instead of giving Citi a billion-dollar tax break, they buy $10 billion of Citi’s assets for 10% more than they should.

A low-oversight plan like the current bailout is destined to have conflicts like this all the time. As long as they have absolute freedom to invest hundreds of billions of dollars, they can create whatever subsidy scheme they think would make the most sense. Fortunately, I suspect that Paulson and the rest are honestly doing what they think is best for the country, and that they happen to think that the best bailout is for healthy banks and sick banks to merge so our financial system is merely anemic instead of mostly healthy and occasionally near-dead. Whether they have the perspective and skill to make this happen remains to be seen, but there’s no good reason to confident.

Not so with the case of Igor Olenicoff and Brad Birkenfeld. Everyone in this deal tells a different story (one thing every version has in common is that the narrator is innocent), but it looks like it went something like this:

Birkenfeld was a middling banker at a very well-reputed bank, with exactly one great client. Igor Olenicoff was a billionaire with office space and apartments in Vegas, Arizona and Florida — he wasn’t exactly thrilled with the performance of his bankers. At some point, Birkenfeld started shifting assets offshore, presumably to keep Olenicoff happy. Unlike a normal tax cheat who might do this by wiring money around cleverly, or arranging dummy sales, Birkenfeld stuffed diamonds into a toothpaste tube and personally carried them overseas.

A bad idea for several reasons, not the least of which is that X-rays see right through toothpaste tubes. Somehow, Birkenfeld wasn’t caught for years — but once he was, he helped nail Olenicoff for his role in the fraud.

Olenicoff, who didn’t become a billionaire by taking this kind of thing lightly, sued UBS for tricking him into thinking that a transaction involving diamonds in toiletries was somehow not completely aboveboard. It took a while for him to get this together, given the time he spent doing community service and paying fines for lying on his taxes (the fines, by the way, are about seven times as high as the amount he allegedly hid).

At this point, Olenicoff is doing fine (Forbes only reports his net worth to the nearest $100 million, so he’s even despite paying a fine of over one thousand times the annual median salary). Birkenfeld is trying to figure out if he should stick around in America, where he may go to jail for aiding tax evasion — or go back to Switzerland, where he’ll definitely go to jail for violating bank secrecy laws. And UBS has started to suspect that when super-rich Americans are desperate to deal with Swiss bankers, it’s not because they think they might get a collectible cuckoo clock as a bonus for opening a new account.

Oh, and the IRS? Olenicoff allegedly got away with about $7 million in evaded taxes, but they got $52 million in fines. Add that to the money they’re doubtless collecting from his legitimate businesses, and it looks like they’re the only ones coming out ahead, here.

It’s all decent, well-meaning stuff, but the problem with these tax incentives is that they’re just not as dramatic as the ‘tax’ Americans pay when oil prices rise. This tax creates a huge incentive to find alternative energy sources, with or without a subsidy — and as long as no viable alternative is in sight, the prospect of using up oil reserves pushes prices that much higher.

It’s tricky to analyze a balanced situation like this, particularly when turmoil in the financial markets has had an effect on prices. But to anyone who dreams of building an electric car, an ultra-efficient solar panel, or a cost-effective geothermal system, every 1% increase in oil prices is a 1% larger market to sell to (and a market that’s that much more angry at oil companies, and that much more willing to consider alternatives). The very goods Congress is taxing function as a ‘tax’ on consumers and a ’subsidy’ for anyone with a better plan.

With oil down to $92 per barrel (from $140 just a few weeks ago), one might argue that we need incentives to push prices back up. After all, we didn’t solve the energy crisis at $140 per barrel, so how will we do it with prices one third lower?

The answer is lead time: as oil’s rise in price began to feel less like an aberration and more like a dreadful certainty, the idea of investing in alternative energy startups seemed like a better and better idea. Unlike an oil investment, for which reserves are at least sometimes measurable, an alternative energy company with an unproven technique might spend years on research before investors know whether they backed a winner or a dud. For them, a change in the tax code now can’t affect their business unless it makes new investments as attractive as they were when oil reached $140 per barrel. Even if that’s a reasonable policy, it’s not politically viable.

So even if there aren’t new alternative energy companies being formed now, the last few years give us a healthy backlog of unknown firms striving to balance America’s energy consumption with a new and better source. For them, the best thing we can offer isn’t tax breaks or subsidies — it’s consistency. If they know that the biggest energy companies will be hit with special taxes whenever profits go up, they won’t pursue massive, paradigm-changing solutions. Instead, they’ll go for safe, incremental changes; moving towards self sufficiency half a cent per kilowatt-hour at a time.

It’s possible to argue that an energy tax bill is necessary for alternatives to flourish, or essential to save the American consumer. But tax incentives simply don’t wield the same power as a high price at the pump.

Elasticity refers to how use responds to price changes. For a product that’s competing directly with lots of other, similar products, elasticity is very high: if a gas station raises their prices 5%, but the one across the street keeps prices constant, nearly all of first station’s customers will desert it.

But for a low-elasticity product, the opposite is the case. If you consider an addictive product (like cigarettes or alcohol), or a cheap product that you have to buy repeatedly to make an expensive product work (movies for your big screen TV and surround-sound system; replacement razor cartridges), changes in price don’t make a big difference. Smokers might complain, but they wont kick the habit over a 10% increase in cost; similarly, you won’t let your $4000 entertainment system go to waste because your Friday night movie rental costs $1 more.

What economists have found is that when there’s a sales tax, normal spending behavior is distorted. If there’s a 10% tax on gas that costs $3.50 per gallon, producers produce (and profit) as if it cost $3.50 per gallon — but consumers buy it as if it cost $3.85 (10% more). So, producers produce a little less than they otherwise would, and consumers buy a little less than they otherwise would. Some of that lower total production is made up for by the tax revenues, but the total value of the gas sold plus taxes received is always less than the total value of the gas sold with no taxes.

Now, we can apply that to your question: who *really* pays a sales tax? The answer: for elastic goods, the seller pays. For inelastic goods, the buyer pays. How does that work? Think of cigarettes. Imagine that they cost $4 per pack without taxes. Then consider what happens when a $1 tax is added. Producers still produce like cigarettes cost $4, but buyers now buy as if cigarettes cost $5. Of course, this price increase would lead to only a tiny decrease in the number of smokers or the amount that they smoked. If almost everyone is smoking just as much, they’re paying 20% more to do it, and the seller is basically unaffected — it’s clear that the consumer pays most of the burden.

Now let’s consider another scenario. Let’s imagine that lawmakers decide that a big oil company has been price gouging, and, for whatever reason, declare that its penalty will be to pay an extra 5% gas tax. If the company just raises prices — even by a mere 5% — most of their customers will simply buy gas from other gas stations. There may be a few places where customers don’t have that option, but for the most part being the only commodity seller to sell for 5% more than anyone else is a bad deal. So the company will have to cut prices, to keep their prices in line with that of the competition. But if the company cuts prices and still pays the sales tax, where does the tax revenue come from? Clearly, it comes out of the company’s profits — they have to act as if gas was worth about 5% less than consumers are paying, so they produce less, at a lower profit.

These are all fairly contrived examples, but I think they illustrate a pretty complex topic in a simple way: the real ‘payer’ of a sales tax isn’t the buyer, and it isn’t the seller — it’s whoever has the least freedom to respond to price changes.