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04/16/2006

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Mike Sasin

I have gone back and forth as to whether I should go back to school and get an LL.M. in tax (that's an advanced law degree for those who may not know). Crazy as it may sound, the complexity of tax law is challenging and somewhat "fun." It's a technical area of law so clients don't try to second-guess you with "Well I was watching Boston Legal the other night and this guy got a $1 million when someone sneezed on him."

The other half of my brain realizes that the money spent on compliance could be better used for other purposes.

And therein lies the problem. I think the current tax system is entrenched - too many people depend on the complexity of the tax code on their livelihoods to create an incentive to change. I'm on the edge of being one of those people. I once heard from a CPA who favored tax simplification that he would gladly wash dishes for a living if the tax simplification meant eliminating his job. Yeah, right.

Richard Mason

Wes,

I can only see four things wrong with your IRA-is-bad scenario.

1. You are confusing the early withdrawal penalty with the payment of tax. You might owe tax when withdrawing early from an IRA, but then you would owe tax on the same earnings (and perhaps earlier) if you had never had an IRA at all. The only thing that an IRA could possibly cost you is the 10% early withdrawal penalty.

2. Suppose that indeed you could have a net savings of $10,000 in interest by spending the $20,000 from the IRA. Then you should certainly do so. Again, the most you can have lost compared to never having the IRA is the $2,000 withdrawal fee: not $6,000 or $10,000 or any such miscalculated number. You are confusing the act of opening the IRA with the act of irrationally keeping money in the IRA even when circumstances make it unprofitable to do so.

3. Your scenario supposes that you are withdrawing IRA earnings, and therefore presumably all IRA principal and all your other savings, in order to make an unspecified non-emergency purchase, perhaps of a house. Spending every penny of your savings is itself risky and not necessarily advisable. Realistically, it would probably be a better idea to keep the IRA earnings in reserve against the possibility of a genuine emergency, such as serious illness or disability.

4. You are ignoring the time value of money. Even if you have to pay tax on IRA earnings, because of early withdrawal, you may have postponed that tax for several years. A tax postponed is a penny earned. Depending on the nature of your investments, this could well outweigh the 10% penalty and let the IRA be profitable overall despite early withdrawal.

In principle, you could imagine that you had a high tax rate in the year that you withdrew from the IRA, so it would have been better to pay the tax earlier when you had a lower rate. This is theoretically possible, but rather contrived: why would you need to draw on the last penny of your savings, in a year when you had no emergencies and significantly more income than normal?

So, scenarios where an IRA is bad are theoretically possible, but in practice more contrived and unlikely than you appreciate.

All that said, you should certainly pay more taxes if you find retirement accounts too complicated or unacceptably bourgeois.

Richard Mason

Tom Klein,

A similar justification for income tax might be that the government provides law enforcement that promotes faith in business transactions and institutions. So those who profit from economic transactions in that environment (often making use of currency issued by the government) owe a fraction of their profit to the government for its good offices.

W

I understand Tom Klein to be making a PoMo, "We are all radically autonomous individuals and income taxes are controversial so they can never satisfy the doctrine of public reasons" argument; I understand Richard Mason's counter to be a "there is common-ground upon which we can all agree that income taxes are good; public safety and responsible business practices benefit us all".

At the risk of (again) being accused of saying nothing, I am going to disagree and agree with you both.

I take issue with the notion that our government "provides a free and democratic political system with an independent judiciary and national defence." First, in reply to all of your quote except the last two words, our government does not provide itself: that is nonsense. As to the last two words, I agree that national security is a public good; you, Richard Mason, and I all agree that taxes to support national security are public reasons that justify income taxation. But that doesn't mean we all agree as to how large our defense budget should be, whether we should borrow or pay in cash, whether foreign or domestic defense contractors should have the contracts, which tanks or planes or guns we should have more or less of, or what the role of the military should be, etc. Our beliefs about each of these smaller issues shapes what our ideal tax code would look like. So we can have common ground in the generalities, but disagreement over the specifics. Likewise, we might all think there's nothing wrong with the Sixteenth Amendment being in the Constitution, but then gripe about this or that provision of the tax code on becker-posner. What's more, consumption taxes are even more controversial than the income tax. People hate them. Your notion that we should have proportionate insurance for everything of value is also controversial, see Ronald Dworkin's Sovereign's Virtue. There is no way to decide what proportional is, or what value is, without taking into consideration more than ability to pay (otherwise we would assume poor people who drive without car insurance really don't want medical care); once you do that, the same can of worms is opened with determining the details of the Insurance Code. So, you get rid of the Internal Revenue Service and replace it with the Insurance Rebate Service.

To the notion that "the government provides law enforcement that promotes faith in business transactions and institutions" I say that law enforcement, like sanitation and national security, can surely be a public good, but one wonders. The police rarely investigate homicides before they occur, so they rarely actually protect you. Most murderers only commit one murder, so the police are pretty much ineffective. There is the argument that police presence may have some deterrent effect on lawlessness, but that same argument would suggest we can reduce the police force to one guy and increase sentences to 9 gazillion years to achieve the same effect. Of course, you could say, there is the limit of one's lifetime or the death penalty to be throw into play, but that is beside the point. The point is that the police only provide protection in functional relationship to the resources allocated to them, which means they work, more or less, like insurance. You allocate the resources where you think the major risks will be incurred and make sure to cover the minor risks that have major impact. (You know, you never play the lottery, except when the jackpot is ginormous.) Anyway, the point is that economic crime is "policed," say, by the SEC and the FTC, etc. But most of the economic crime could either be flushed out of the market by letting the market shake out the bad competitors, without regulation, i.e., let the cheaters and liars feel the boomerang effect of word-of-mouth, "Coke cans exploded in two of my girlfriend's faces! Pepsi never has. The next time I take a girl out I am drinking Pepsi," or is committed by corporations, which are entirely creatures of state law, which I think you were fairly suggesting. What you did not suggest is that we pass a tough federal securities law or a tough federal economic fraud law that only state attorneys general can prosecute under (more regulation could work), or suggest simply that states change their corporate law (meaning change the mandatory elements of bylaws, certificates of incorporation, reporting requirements, increase shareholder democracy, etc.) so that corporations cannot engage in certain crimes.

It seems one of you is suggesting we abolish the tax code and switch to a consumption tax, as if that is costless and the other is suggesting that there are no costs to the present regime so long as we can conceptualize justifications for it. By contrast, I agree with the posters who say that lobbying is rampant and lobbying weighs down the tax code. Good thing. Let the First Amendment reign. The tax code is the price of free speech.

Richard Mason

W: I understand Richard Mason's counter to be a "there is common-ground upon which we can all agree that income taxes are good; public safety and responsible business practices benefit us all".

The line of Tom Klein's argument (as I understand it) is that government practices which benefit us all equally would justify a head tax.

In order to similarly justify an income tax, one would have to claim that a person with income has benefited from some government services more than a person (even a wealthy person) with less income. I don't know if that's true, though it seems plausible. It was just a suggestion.

Wes

The only thing that an IRA could possibly cost you is the 10% early withdrawal penalty.There are also substantial costs to having one's money tied up in an IRA. The most obvious is having to take out a loan while one's money is tied up in an IRA. Other more insidious costs are the lack of flexibility that can results in devastating investment decisions (for example, not dumping a bad investment soon enough)....the most you can have lost compared to never having the IRA is the $2,000 withdrawal fee: not $6,000 or $10,000 or any such miscalculated number.I'm not sure if we agree or disagree here. The way I see it there are three possibilities. 1. Don't open the IRA: this is the baseline - the net financial impact is $0. 2. Open the IRA but take the early withdrawal penalty to avoid the loan: $2,000 net loss. 3. Open the IRA and take the loan: $6,000 net loss. The only way to avoid a loss is to not open the IRA.This makes an interesting point. Supposedly the purpose of this complication to the tax code is to modify people's behavior rather than to just give rich people a tax break (they will be saving for retirement regardless). As this example shows, however, for those people who are actually trying to decide whether to save for retirement, the IRA tax policy may push then toward bad investment decisions such as taking out a loan while simultaneously having money in a savings account.Spending every penny of your savings is itself risky and not necessarily advisable.I agree that spending every penny is not advisable but keeping $20,000 in a savings account when that $20,000 could be used to pay off a loan sounds a bit excessive. Furthermore, given that houses cost hundreds of thousands, we could be talking about quite bit more than $20,000.Realistically, it would probably be a better idea to keep the IRA earnings in reserve...That depends on inflation rate. In an ecomony with high inflation, the "earnings" can rapidly dwarf the initial investment.Imagine an economy where the inflation rate is 15% and the interest rate is just keeping pace with inflation so it is also at 15%. A $20,000 initial investment would have $327,330 of "earnings" after 20 years. That is, even if there were no real earnings, most of the IRA would be counted as earnings for tax (penalty) purposes.You are ignoring the time value of money. Even if you have to pay tax on IRA earnings, because of early withdrawal, you may have postponed that tax for several years.In my experience, once the real inflation rate is taken into account (not just the inflation rate that politicians fudge together to make people feel good), then it is very hard for an investment to even just keep pace with inflation. That is to say, the real time value of money is very low or even negative.Let's assume, for the sake of argument, that the real interest rate that takes inflation into account is 1%. Someone who delays paying a 20% tax on $20,000 will have $4,000 to invest. That will yield $40/year in real interest so after 10 years someone would have $400 - not insignificant but not the lottery either.

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