Friday, July 01, 2005

New York Times shocker revelation about the "non-taxpaying affluent"!

People who invest in tax-exempt bonds don't pay taxes on them! This we learn from the Times' latest effort in its relentless campaign to expose all who, in its opinion, don't pay enough tax...

The Nontaxpaying Affluent Grew by 15% in One Year

The number of affluent individuals and married couples who paid no federal income taxes jumped more than 15 percent in 2002, to 5,650, new government data showed yesterday.

The chances of having a large income but not paying taxes on any of it are growing, according to the data...

The I.R.S. report said that "the most important item in eliminating tax" was taking income in the form of tax-exempt interest on state and municipal bonds....
Alas for the point of the story, people who invest in tax-exempt bonds effectively do pay tax on them -- because they receive a lower yield than they would from comparable taxable bonds. And this cost to them is part-and-parcel of their providing financing to the government in the form of the bond principal. They are in fact paying an implicit tax to finance government.

As of this writing the yield on 10-year AAA-rated fully taxable bonds is 4.66%, and that on 10-year AAA-rated tax-exempt bonds 3.71% [Bloomberg].

Since 3.71% is 20% less than the 4.66% that investors could get on same-risk, same-maturity bonds elsewhere, they are paying an implicit 20% income tax to the state issuer of the 3.71% state bonds. (Which they do voluntarily, since the 20% is less than the combined federal and state tax rate that they'd pay on fully taxable bonds.)

The net cash position to the parties on a 3.71% state "tax exempt" bond is identical to what it would be if the state paid 4.66% to a bond owner but imposed 20% income tax through withholding, paying only the 3.71% after-tax net.

To understand the great value of "tax exempt" bond financing to states, note that this 20% implicit income tax rate on them is more than double the highest income tax rate imposed by any state (9.5% by Vermont). So the states collect much more implicit income tax from "tax exempt" bond financing than they do overt income tax on any kind of "taxable" income. (Of course, they can do this thanks to the federal government's waiving its claim for income tax on the interest paid by state bonds, which leaves the 20% implicit rate paid on state bonds still lower than the combined federal-and-state rate owed by higher-income individuals on taxable bonds).

And as a 20% implicit tax rate is a good deal more than 0% ... so much for the Times' latest alert about ever-growing numbers of the rich going "tax free".