Commentary

How to Slash Your Tax Bills

This article was published in the Washington Times, April 25, 2004.

I have discovered a foolproof strategy for beating the income tax, the Social Security tax and the Medicare tax: Lower your income.

Lowering your income is much easier than increasing your income. And it helps you avoid the nasty traps Congress sets to catch those foolish enough to earn too much money — phasing-out deductions and exemptions, selectively repealing deductions with an alternative minimum tax, limiting the share of income you can put away in a 401(k) plan, and denying eligibility for tax-financed benefits such as student loans and scholarships. Lower your income and these problems disappear.

To do this comfortably, it helps to have some savings. This game is best played by previously industrious but frugal people now approaching the ripe side of mature.

Like others in that group, much of my income comes from past savings and some from work. Income from work is the easiest to tax and measure. Since 1991, when Congress turned Medicare into another income redistribution scheme, every dollar we earn from working is now taxed to shore up Medicare for a few more years. “Taxed Medicare Earnings” in your Social Security statement provide an excellent measure of earnings from work.

When I looked back at my own earnings, I saw I had already started cutting my labor income by 26 percent in 1998-99 by greatly reducing extra writing and speaking. The resulting savings in taxes was much greater than 26 percent, of course, because marginal tax rates rise with income. Uncle Sam took the biggest hit, as planned.

My wife got this message even earlier, responding to the 1991 tax increase by retiring a dozen years earlier than is usual. All her income would otherwise have been taxed at my steep rate. By not working, she also stopped paying the increased Social Security tax, and later began collecting Social Security benefits at 62. Because I continue working, however, 85 percent of her modest benefits are taxed at my marginal tax rate. Another incentive to work less.

After the market began to tumble in March 2000, I rapidly liquidated stocks and thus ended up reporting a one-time surge in capital gains. Although most gains were taxed at a reasonable rate, they were nonetheless included in total income for figuring out how all other income is taxed.

As a result, every dollar of my middling labor income was taxed at the highest possible tax rate. With the U.S. government practically ordering me to work less, I promptly cut my labor income another 27 percent that year alone. I did that by shutting down a consulting business I had run for 10 years.

The Internal Revenue Service, which had been collecting about 30 percent of my consulting income, then was collecting 40 percent of nothing.

By 2003, I had managed to reduce my labor income another 36 percent by asking my employer to pay me less in return for less time in the office. Altogether, I have cleverly reduced my taxable labor income by 67 percent from 1997 to 2003. My Medicare tax likewise fell by the same amount, and the Social Security tax fell nearly as much.

Past efforts to tax my wife and me more ruthlessly in 1991-93 had the opposite effect. Yet Sen. John Kerry now imagines he can make us fork over a much larger share of investment income by reverting to taxing dividends at ordinary income tax rates. Ironically, that would cut my taxes, not raise them.

I have only lately begun for the first time to accumulate dividend-paying stocks and funds. If I ever believed dividends would again be taxed at rates of up to 39.6 percent, as Mr. Kerry proposes, I would rush out of dividend-paying stocks and back into tax-exempt bond funds.

Instead of collecting 15 percent of something, the IRS would then be collecting at least 30 percent of nothing.

For brave souls who keep working past 65, federal work penalties grow even more severe. Such heroic Americans must keep paying into Social Security and Medicare even though those payments add nothing to their benefits. This is the government’s “nothing for something” plan for working seniors. Even a middling salary will also result in 85 percent of their Social Security benefit being taxed, while those who avoid work commonly get tax-free benefits.

To make matters worse, money taken out of individual retirement account (IRA) or 401(k) plans normally will be taxed at a higher rate if seniors keep working, because income from work puts them in a higher tax bracket.

The sensible solution is to stop working at 62-65, or work as little as possible — like running a 12-cylinder engine on four cylinders. Yet this is a dangerous message to send our rapidly aging population. Future growth of tax revenues, and of the economy, will depend heavily on whether older Americans choose leisure over work.

Between 2000 and 2020, the population between ages 25 and 54 is seen increasing only 3 percent while the population older than 55 rises 63 percent. If older people shun work, there will be virtually no labor-force growth aside from immigration. America’s medium-term challenge is not a job shortage but a prospective shortage of willing and able workers.

If only a fraction of future seniors respond as I have to tax penalties on work, money flowing into the Treasury, Social Security and Medicare from an aging work force will slow even more than expected.

A few years ago, the Russell Sage Foundation (which routinely bankrolls egalitarians) sponsored a collection of papers turning Ayn Rand’s opus into a question, “Does Atlas Shrug?”

The authors could not get the right answers because they did not ask the right questions. Work effort cannot be measured by hours on the job. Work effort is more like a dimmer switch than a light switch; we adjust it by degrees.

And mature, educated taxpayers are not docile sheep but wily foxes. When tax collectors set out to punish extra effort and investment, we get the message.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.