Underlying all conversations about annuities is the issue of tax deferral and the marginal tax bracket for most investors. This calculation of the value of tax deferral, plus the acknowledgement of the exclusionary ratio (the percentage of annuitized withdrawals credited as principal or interest) represent the two key tax advantages annuities provide American savers.
This is true for fixed annuities. In the case of variable annuities, and to a lesser extent fixed annuities, a potential annuity consumer needs to analyze the current preferences for either dividends or capital gains. Low marginal tax brackets and high tax preferences for capital gains results in variable annuities becoming more competitive from purely tax perspective. Elimination of these preferences for dividends and raising of the marginal tax brackets makes fixed annuities and variable annuities more competitive.
There is a nationwide debate emerging over the extension of the tax cuts initiated under President George W. Bush early last decade. Marginal income tax rates as well as the preferences for capital gains and dividends were lowered. Today there is a public policy debate over spending, taxation and the long-term deficit.
A side portion of this debate focuses on the core structural design of our tax system. A recent proposal for tax reform that has gained an incredible amount of support is the fair tax. The fair tax is a major consumption tax that seeks to replace the major existing tax structures—namely, income, property, estate, and capital gains. Historically, policies like the “Fair Tax” and the “Flat Tax” have emanated from the political right. I don’t know whether there is a real groundswell for this change, but the last decade of public policy decisions; our two wars, the Medicare prescription drug benefit, the Bush era tax cuts, and now the twin problems of the recession—lower receipts and stimulus spending—are creating greater discussion.
Robert Longley of About.Com elaborates,
“In place of all current federal taxes, the Fair Tax would place a 23 percent tax on the final sale of all goods and services. Exports and business inputs (i.e. intermediate sales) would not be taxed. Individuals would file no tax return at all. Businesses would only need to deal with sales tax returns. The IRS and all 20,000 pages of IRS regulations would be abolished. Under the Fair Tax, no federal taxes would be withheld from employees' paychecks. Social Security and Medicare would be funded by sales tax revenue.”
There are three advertised major benefits of such a tax. First, a fair tax would make the system infinitely less complicated and nuanced. Second, it is hoped that a fair tax generates more revenue than the existing federal taxes because it eliminates the underground economy. Finally, proponents predict that a fair tax would make the United States an attractive place to do business.
However, the existing political capital in this country is probably not enough to pass such a bill, never mind overturn the 16th Amendment.
The federal tax system has not been refined with age. Throughout the years additional rules and regulations have been implemented.
The graph above shows how much the total number of pages of the federal tax rules has expanded. As of 2003 the IRS had 54,846 pages of tax laws and regulations. In order to make the system run, we have had to create a massive coalition of lawyers and accountants. Chris Edwards of the CATO Institute writes,
“Income taxes are so complex that there are up to 1.2 million paid tax preparers in the country -- six times more than the number of troops in Iraq. The tax army includes legions of accountants, lawyers, and computer experts -- some of the best minds in the country. Unfortunately, their brainpower is adding little to the nation's standard of living.”
Regardless of your political affinity and biases; individuals, companies and nations must ruthlessly fight against inefficiency and waste. My personal enlightenment during the health care debate was the level of waste in the system. The underwriting process—each insurer attempting to improve their pool of the insured—represents a significant waste of our nation’s resources. The same is true of the tax preparation, however, it is not only the tax preparers, it is also the millions of hours we all dedicate to the tax preparation process.
I haven’t prepared my own taxes for years. Long ago I lost the ability to translate 1040 in any reasonable manner. I do remember my midnight drives to the post office on April 15th of previous years. So, like most Americans I sympathize with the frustration of tax filing and the complication. A recent report purports that Americans’ spend $140 billion on filing costs and $7.6 billion hours per year to file their taxes. This undoubtedly does not count the hours or dollars invested to avoid taxes.
This large, inefficient bureaucracy has not helped to enforce compliance with tax codes. Arduin, Laffer, and Moore of Econometrics predict the following results of a fair tax:
“Government revenues, after accounting for Social Security expenditures, also benefit from the growing economy. In the first year following implementation of the FairTax, total government revenues are estimated to be 0.5 percent above baseline revenues. Revenue growth under the FairTax exceeds the baseline scenario during the first six years following implementation. However, beginning in year seven revenue growth under the baseline scenario begins to grow faster due to the more progressive nature of our current tax system, which increases tax revenues at a faster rate than economic growth. This leads to total revenues under the FairTax to be only 6.2 percent above the baseline scenario by year ten, compared to 6.9 percent above the baseline scenario in year six.”
Art Laffer
Stephen Moore are both friends of mine—and they have been passionate about these issues for their entire careers. Stephen Moore was a very influential friend of mine during my work on Social Security reform.
The principal reason for this is that the United States has a massive underground economy. What is an underground economy? The Wall Street Journal Class Room Edition differentiates between a legitimate economy and an underground economy:
“First, there's the legitimate economy, in which craftsmen are licensed and employers and employees pay taxes. Then there's the fast-growing underground economy, where millions of nannies, construction workers, landscapers and others are paid off the books, their incomes largely untaxed. The best guess as to the size of the output of this shadow economy is about $970 billion, or nearly 9% that of the real economy. It could soon pass $1 trillion.”
Consumption taxes take away individual tax filings and make the IRS a null and void institution, except for the management and supervision of the collection of consumption taxes. Illegal immigrants and people involved in traditional underground professions could no longer undermine the income tax system. They would need to invent means to short the consumption tax system, however, the predominance of electronic funds transfer, credit cards, debit cards, PayPal and electronic banking make circumvention of consumption taxes far more difficult.
The last major benefit of the fair tax is that America’s image as a great place to do business is once again restored. Embedded taxes, like capital gains and corporate taxes, steer businesses away to tax free havens. In the case of the United States several businesses have opened up shop in places like Bermuda to offset these costs. This is particularly true of my industry, insurance. Although corporate taxes are often the plaything of demagogues, they are ultimately merely a “pass-thru” tax. Much evidence exists of their growth-reducing effect. Most importantly, they can be an inducement for corporations to locate factories and jobs elsewhere, and this creates a negative drag on productivity, and income growth.
Leo Linnbeck of the Wall Street Journal writes,
“Eliminating embedded taxes will also do something else -- it will remove significant price disadvantages suffered by American producers competing with tax-free imports. Eliminating corporate income taxes and capital gains taxes, which the Fair Tax would do, would likely make the American economy the most desirable place in the world to do business.”
Unfortunately these perceived benefits are meaningless because the United States may never have the political capital to enact a full fair tax and perhaps we should not. There are tremendous issues of equity and the veracity of the tax that are yet to become clear. We also have the small issue of the constitutional amendment authorizing the federal income tax. The reason is that the 16th Amendment would first have to be repealed, entirely eradicate the federal income tax. Some suggestions have been made: namely, to get rid of the income tax for people making less than $100,000 and replace it with a national sales tax of somewhere between 10 and 14%. This is essentially the same thing as enacting the fair tax and it’s more politically viable. Fareed Zakaria, a major Newsweek and CNN contributor as well as a bestselling author, is one of the largest proponents of enacting such a tax. In his strategy to alleviate the national debt Zakaria states,
“First, adopt a value-added tax. More than 100 countries have some kind of a national sales tax. If America were to enact one tomorrow, at something like the average for industrial countries (18 percent), and drop income-tax rates to compensate somewhat, we could bring in hundreds of billions of dollars every year. To get a sense of the revenue potential, imagine if the United States were to adopt a VAT at the high end of the range—25 percent, similar to that of many Scandinavian countries whose economies have still grown as fast as America's over the last three decades. Such a tax, Leonard Burman calculates in the University of Virginia Tax Review, would bring in enough money to balance the federal budget, pay for health-care expansion, eliminate the income tax for all those earning less than $100,000 (90 percent of households), and cut the top tax rate to 25 percent. The tax would also restrain Americans from over--consuming and reward them for saving, the single most important long-term shift we need to encourage.”
The opponents make two strong cases against the fair tax. One is basically math—the tax does not raise what proponents’ claim. Competing math, some of it from non-partisan agencies, suggest that the appropriate fair tax level (the new sales tax) would actually need to be around 34%, rather than the much more palatable 23% suggested by fair tax supporters. The second issue relates to the regressive nature of a Fair Tax.
“With the prebate program in effect, those earning less than $15,000 per year would see their share of the federal tax burden drop from -0.7 percent to -6.3 percent. Of course, if the poorest Americans are paying less under the FairTax plan, then someone else pays more. As it turns out, according to the Treasury Department, “someone else” is everybody earning between $15,000 and $200,000 per year. The chart below compares the share of the federal tax burden for different income groups under the current system and under the FairTax. Those in the highest and the lowest brackets will see their share decrease, while everyone else will see their share of taxes increase.”
Annenberg Political Fact Check
“Americans for Fair Taxation rejects the Treasury Department analysis, objecting that Treasury considers only the income tax. By leaving out payroll taxes (which are actually regressive) Treasury’s chart makes the FairTax look worse by comparison. We found that including all the taxes that the FairTax would replace (income, payroll, corporate and estate taxes), those earning less than $24,156 per year would benefit. AFT’s Burton agreed that those earning more than $200,000 would see their share of the overall tax burden decrease, admitting that “probably those earning between $40[thousand] and $100,000” would see their percentage of the tax burden rise.”
Annenberg Political Fact Check
Most Americans are frustrated with the level of complexity that has evolved into our current 1040 tax filing. The complexity results in wasted human energy—both in the attempted avoidance planning and the actually submitting.
We have differing opinions on equity and justice—the level of progressivity embedded in the tax code and the inherent level of the social safety net provided by our tax receipts. In many cases the debate around the Fair Tax has these ancillary debates waiting in the wings, however, it doesn’t need to be this way.
A debate around a new, simpler tax system, can focus upon tax preferences, impacts to our consumer economy, overall societal acceptance (thus reducing the illegal economy), and elimination of wasted effort on avoidance and processing. As the debate relates to annuities, and other savings vehicles, my assumption is that as the cost of benefit programs—Medicare and Social Security—continue to rise as a percent of America’s GDP, then we will move to more incentives for saving and cost-sharing. However, as they say—that’s another story.
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