Recent revelations that presidential candidate Donald Trump may have been able to avoid paying income taxes for two decades has piqued the public’s interest in taxes. Critics have accused Trump, who is no stranger to controversy and doesn’t hide his aversion to paying taxes, of engaging in strategic tax avoidance. While there is still much more we need to know in order to judge these accusations (the leaked tax returns were only partial and covered one year but Trump seemed to admit extensively using tax write-offs during the second debate), fiscal sociology offers at least a partial defense of Trump’s tax return based on what we know at this point. Criticisms of shady practices hinge on two concepts unknown to most of the public before the story broke: income averaging and net operating losses. In order to understand why the real story isn’t about taxes, we need to understand how these two practices work.
Incoming averaging is a rule where some taxpayers can use income gains/losses over several years to average out their tax burden over time. It can be useful in industries where folks see a lot of income volatility from year to year. It is currently available to fisherman and farmers but was eliminated for the typical (nonbusiness) taxpayer as part of the 1986 tax reforms. There were several good reasons for eliminating it.
First, it made tax administration unnecessarily complicated for the average taxpayer. While most of us can and must cough up onerous fees to have H&R Block prepare our taxes, hiring a tax lawyer to take advantage of complex income averaging rules would cost more than its worth for the average taxpayer. Second, the shift to a smoother progressive income tax has made the issue moot for most taxpayers. Back in the 1970s, the U.S. income tax had twenty-six narrow brackets with different rates depending on your income. A small bump up or down in income could drastically change your tax burden. There are now only seven relatively broad brackets. Small or moderate changes in income are unlikely to result in change your effective tax rate.
Canada eliminated income average for ordinary taxpayers as part of their 1988 tax reforms for the same reasons. If you’re worried about fairness middle and working class who see their income plummet in any given year then you’re better off strengthen unemployment insurance or introducing wage insurance. Income averaging simply doesn’t make sense for most taxpayers.
Net Operating Losses for Real Estate
Net operating losses (NOL) are related to income averaging in that businesses (or individuals in their capacity as entrepreneurs) can deduct losses in one year from their taxable income in previous or future years. As NPR points out, it is a rather common and uncontroversial accounting practice because business income often fluctuates over time. This is especially the case for real estate developers like Trump. This led Matt Yglesias of Vox to wonder why ordinary homeowners, many of who are still recovering from losses they took during the recent housing boom and bust, have not been able to claim the same deductions.
The reason is simple: Homeowners aren’t subject to the same taxes associated with renting or selling their homes. In fact, private homeownership is actually already highly subsidized by the U.S. tax system. Unlike real estate developers, homeowners are exempt from paying taxes on their imputed rental income or any capital gains they derive from the sale of the home. It doesn’t seem fair to allow homeowners to deduct losses if they’re not going to be taxed on gains. At the same time, homeowners are still able to claim tax benefits like deductions for mortgage interest and state/local property taxes. The average homeowner would likely see their taxes go up if they were subject to the same tax regime as real estate developers. This isn’t to say that the rules for developers couldn’t be tweaked to make them fairer but NOL rules are far from the unfair loophole for the rich as some critics have characterized it.
Donald Trump has said and done many things that should make him the subject of intense criticism – including losing a billion dollars while claiming to be an astute businessman – but taking advantage of ordinary tax provisions should not be one of them. Voters should resist falling prey to tax populism based on misunderstandings of how the tax code works.