I wish I lived in Theory… everything works in theory

by WCE

I read this article not long after LfB’s Nov 10 post “The Welfare Myth” and others where many Totebaggers expressed support for “adequate” levels of social support, with “adequate” not thoroughly defined. :)

This Washington Post article discusses the problems with both Democrat and Republican approaches to tax policy. You can’t cut taxes and maintain our current government, Republican candidates, and other than new defense spending (vs. VA benefits, what I consider “back end defense spending”), there is little government spending that the public supports eliminating. Democratic candidates don’t want to admit that raising taxes on the 1% is not going to generate much revenue.

What do you think?

The coming middle-class tax increase

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147 thoughts on “I wish I lived in Theory… everything works in theory

  1. I’m not following this:

    The simulated gains [in economic growth as a result of tax cuts –Milo] are large. After a decade, the economy’s output (gross domestic product) is 15 percent bigger under Rubio’s plan, 12 percent under Trump’s and 10 percent under Bush’s.

    But the model is artificial; it isolates the effects of tax incentives and holds constant other factors that might dampen growth (the business cycle, interest rates, the effects of budget deficits).

    Isn’t isolating the effects of one variable while holding constant other factors precisely what you’re supposed to do with this kind of thing? How is that “artificial”? What’s the preferred alternative?

  2. Milo, it is called ceterus paribus analysis. Holding all else constant, what is the effect of this one thing? It is how you look at the effect of a specific variable.

  3. In it, economists William Gale, Melissa Kearney and Peter Orszag asked this question: What would happen if the top income tax rate were increased from 39.6 percent to 50 percent? The answer — less than you think.

    That’s a little misleading. The top tax rate kicks in above an AGI of $464,850.

    $151,201 to $230,450 $29,387.50 plus 28% of the amount over $151,200
    $230,451 to $411,500 $51,577.50 plus 33% of the amount over $230,450
    $411,501 to $464,850 $111,324.00 plus 35% of the amount over $411,500
    $464,851 or more $129,996.50 plus 39.6% of the amount over $464,850

    I’d like to know the number if we took the above $230k bracket and cranked it up to 50%.

  4. “I’d like to know the number if we took the above $230k bracket and cranked it up to 50%.”

    Otherwise known as the middle-class tax increase that the author is predicting.

    Murphy – But is there a better method?

  5. Otherwise known as the middle-class tax increase that the author is predicting.

    I’d hardly call an AGI above $230k “middle-class.”

  6. “I’d hardly call an AGI above $230k “middle-class.””

    When Obama was campaigning in ’08, his threshold was then defined at $250k. 8 years ago. In later negotiations, $400k became the benchmark, and that also approximates the entry point of the infamous “One Percent.” So in terms of tax policy and who’s been promised a future free of increases, the $230k households consider themselves middle class and are not expecting to pay any more.

    Furthermore, the bulk of the $230k households are either 1) already Republicans, or, more importantly 2) Democrats already living in high-cost-of-living, high-tax areas (many paying AMT). This is the group that’s going to revolt if someone tries to take more of their money. The furious backlash against Obama’s ill-fated 529 elimination proposal was just a tiny preview of that.

  7. MIlo,

    As far as I know, economic analysis is conditioned on the ceterus paribus assumption, otherwise, you can’t tell which variable is causing the effect.

    Generally, an analysis would be done over a plausible set a scenarios, eg what happens under each candidate’s plan given a recession, given a tax increase, given a tax cut, given a major earthquake/natural disaster, to develop a range of outcomes. Then the policy makers argue/debate over what outcomes are more important to avoid or encourage. E.g. is it better to have the potential for a 15 annual growth rate that would result in a major recession if X event happens? Would a maximum growth rate of 5 percent be a better result if the downside risk is limited?

  8. “Democrats already living in high-cost-of-living, high-tax areas (many paying AMT)”

    I don’t I’d “revolt” if by revolt you mean vote Republican, but I sure wouldn’t be happy! Darn AMT gets me every year.

  9. I’d hardly call an AGI above $230k “middle-class.”

    Then you’re one of the few people here with that opinion.

  10. I went to an interesting presentation last month that talked about tax expenditures and how much $$ the Repubs’ plans would bring in in revenue (flat taxes = WAY lower revenue, so no chance of getting passed) and what would need to be cut to make up the difference.

    The biggest tax expenditure is employer-provided health insurance (207B) followed closely by housing (164B). Most of the Republican proposals would decrease the top income tax rate and the corporate tax rate, reduce by half (or eliminate) the mortgage interest deduction and the state/local taxes deduction, and change the charitable contribution deduction.

    Congress is so dysfunctional, though, that I think nothing has a chance of passing unless there is one party control of both houses (that is how past legislation got through in the 103rd, 107-108th, and 111th Congress).

  11. This is the group that’s going to revolt if someone tries to take more of their money

    Too bad they are such a small % of the population.

  12. “I’d like to know the number if we took the above $230k bracket and cranked it up to 50%.”

    Tax planning accountancy becomes even more lucrative.

  13. When looking at tax policy, you are really trying to estimate the revenue that will be coming in againast the expenses that are going out, not just the effect of this one change in isolation. The goal is for the revenue to at least meet if not slightly exceed the expenses. Changing one thing almost always changes something else. For example, you increase the sales tax on a category of items. What happens?

    1. Some people just pay more and do not decrease their spending on these items, but they do decrease their savings. So you receive the bump up in sales tax, but then you have to reduce it by the effects on the taxes collected on capital gains and interest that would otherwise have been collected if they had continued the same level of savings.
    2. Other people, just pay more and do not decrease their spending in this category, but spend less on something else that sales tax is collected on. Again, you get your bump up in the category, but then you have to reduce it by the lesser amount paid in sales taxes elsewhere.
    3. Still other people, just consume less of this category of item so that their expenses did not change. In this case, you get a bump on a lesser volumne, which may or may not result in more revenue.

    In reality, all three of those happen at the same time, so you model of the effect of the change is already complicated. Now, throw in other things that are expected to occur….more veterans with higher cost health care needs will increase the expenses, so your tax increase may not cover the expenditure increases.

    Creating a “full” model that takes all of this into account is very, very difficult to do at any level of sophistication.

  14. They’re a crucial voting group.

    You know what’s an even more crucial voting group? The 98% of voters who live in households with AGI’s below $230k.

  15. Tru dat, Milo.

    (Having fun with the slang my boys come home with versus my western NY/Midwest inlaws manner of speaking. The holidays should be interesting. The boys will be with family from Wisconsin. Not sure who will be more taken aback.)

  16. Austin,

    The idea is that only one variable can be changed in the analysis or it impossible to determine what is causing the change. And, of course, there is always the issue about the direction of causality.

    All of those effects are part of the analysis, although the expectation is that tertiary effects and beyond are assumed to be dampened. Yes, it is very difficult to incorporate all the factors, hence the “simplifying assumptions” that are a crucial part of any analysis. We won’t even discuss how bad data is in general.

    in broad strokes, micro economists tend to model the effects of a policy change on a consumer or firm. Macro economists model the effects of a policy change on the economy. I’m not a macro economist. To be perfectly honest, it always seemed way to much hand waving and voodoo to me.

  17. “You know what’s an even more crucial voting group? The 98% of voters who live in households with AGI’s below $230k.”

    Rhett – if it worked like that, we’d have much higher taxes already. As just one example, a relatively small proportion of voters both itemize their deductions and deduct mortgage interest, but that’s not going anywhere. Obama had the same thought you’re arguing–that only a small percent of households use 529’s and a higher percentage would benefit from the credits he wanted to hand out. But that didn’t work.

  18. “I’d hardly call an AGI above $230k “middle-class.” “Then you’re one of the few people here with that opinion.”

    I don’t know about that. I think there are plenty of “people like us” who understand that an AGI > $200k puts us in a pretty special place economically in almost all parts of the USA. (assumes no other financial issues, like overhanging debt obligations from earlier in life that are really constraining choices) I sure do.

  19. Rhett – if it worked like that, we’d have much higher taxes already.

    No we wouldn’t, as the average voter is pretty happy with the level of public services they receive. The question then is what happens as the number of aging boomers on Medicare increases along with the number of boomers requiring medicaid funded nursing home care.

    Do you think the average 55 year old voter with a HHI of 62k and 120k in retirement savings is really going to be that opposed to higher taxes on those making 4x as much when the alternative is even more Dickensian nursing homes or telling folks on medicare, “Were just not going to pay for that new hip, Grandma?”

  20. Agree with Milo — taxes and politics, like everything else, do not make for efficient markets, where people objectively evaluate the alternatives and then vote for the one in their own financial best interests. All you have to do is look at the estate tax: lots and lots of $$$ available if we had maintained the $1MM exemption level indefinitely + only a very small portion of the overall voting populace at risk of ever hitting those levels. And yet that was hugely unpopular — and remains so, even at the current much higher levels.

    The best theory I’ve heard to explain this disconnect is that people are perpetual optimists: they may not be in [insert category] now, but they still hope to get there in 10 or 20 or 50 years. Which makes me wonder if that may change over the next 10-20 years, as the overall population ages and realizes that they really won’t make $1.2MM a year/leave $25MM estates, etc.

  21. LfB, There’s also a contingent that is opposed to the estate tax on the grounds that it is double taxation, regardless of how high the exemption is set. And there’s an even larger group that opposes any tax increase on the grounds of it being too much government.

  22. “Do you think the average 55 year old voter with a HHI of 62k and 120k in retirement savings is really going to be that opposed to higher taxes on those making 4x as much when the alternative is even more Dickensian nursing homes or telling folks on medicare, “Were just not going to pay for that new hip, Grandma?””

    You’re assuming that they accept that as the only alternative. They could also believe that a better alternative is less foreign aid, less defense spending, eliminate National Endowment for the Arts, cut back on “waste” and “pork” and grants to universities, higher taxes on corporate CEOs, and on and on.

  23. They could also believe that a better alternative is less foreign aid…

    That can work for a while. But, at some point, it will come to a head with the only two options being cuts to medicare/medicaid or higher taxes.

  24. “I’d hardly call an AGI above $230k “middle-class.” “Then you’re one of the few people here with that opinion.”

    I would agree with anon on this. It seems in previous discussions most of consider ourselves UMC, which IS middle class. Very few of us here admit to being upper-class or rich.

  25. Rhett – agreed. Social Security = 24% of govt spending, Medicare/Medicaid/CHIP = 24%, defense = 18%. Then 11% on the safety net, 8% on benefits for fed retirees, 7% on interest on debt, etc. Only 2% on infrastructure and 1% on foreign aid.

    If I were in charge I would reduce defense spending and means-test Social Security and see where that got us first, but Medicaid/Medicare has to be up there for cuts too.

  26. “(Having fun with the slang my boys come home with versus my western NY/Midwest inlaws manner of speaking. The holidays should be interesting. The boys will be with family from Wisconsin. Not sure who will be more taken aback.)”

    I remember when my NY kids and I attended a wedding with some of my Southern/Western family members. My kids thought my family talked “funny” and all but called them “hillbillies”.

  27. CoC – I was taking a narrower view, perhaps saying that MIDDLE class equates to the middle 3 quintiles, roughly right $20-$100k HHI (not AGI, which would be even lower). Above that is, well, where UPPER middle class begins and true MIDDLE class ends, my definition. If you expand the upper bound of true MIDDLE class to those at the 90th %tile, that would make the HHI range $20k-$140k (using data from this chart: http://theglitteringeye.com/u-s-income-distributiona-chart-to-contemplate/ ).

    Qualitatively, I agree with you. Even among the 1%, though, many people have/live by MIDDLE CLASS values, which is part of why this whole taxation thing is so difficult. It’s not defined by bright-line income (whether HHI, AGI, or some other definition) strata.

  28. Murphy,

    I understand the process of holding all other things equal to determine the effect one change would have. My point was to Milo’s comment about that process being artificial and why that is a problem.

    It is artificial and it is a problem for those whose job it is to figure out the overall government revenue (or corporation’s revenue) to determine if it will meet the expenditures (and/or profit target). To do that, you have to take all the effects into account to the best of your ability. You cannot ever remove all of the artifical nature, but you do your best, because, if you are off significantly, then you are the one who was too “stupid” not to realize if you did X, Y would happen. This is especially true when, without some unforseeable act of God, the result is a revenue gap that is larger than expected.

  29. CoC – the phrase used for my boys by my DC suburbanite friends was “urban”. Really they pick up much of it from Minecraft related you tube videos by hosted by English men. (Seems odd to call them men but they are of age.) Maybe the Wisconsin kids won’t find my boys so “urban” after all.

  30. Medicaid coverage for nursing homes will be cut back hugely when the proverbial stuff hits the fan. Medicaid is a more than people realize a state by state system, with federal funding often through block grants, a favorite tool of smaller govt types to shrink or kill programs. However, in many states it is common to have group homes, often run or at least staffed by immigrants of the sort that many claim to want to deport, with minimal regulation. My friend’s mom who spent her last 20 years in a double wide (zero value by the time she died) in Tucson buying her pills in Mexico managed with her meager but too much for medicaid assets to cover the cost of the last few months in such a home, her burial expenses and a bit left over for her sons.

    Old people vote, and they vote their pocketbooks. In general, they don’t take a mortgage deduction or have a lot of dependents. Many live in jurisdictions without state income tax. They often have special reductions in property tax. Only if they give a lot to organized churches or charities, might they have enough to itemize. AMT is not even on the radar. There may be a little fiddling with Medicare and SS payouts to the elderly (not the same as disability, which is what is really hurting the SS system) around the edges, but when push comes to shove, they feel that these are earned benefits from their years of working and paying taxes and they will protect them.

    Rather than worrying about those small items such as foreign aid or NEA (the conservatives’ bandaid mantra equivalent to increase the highest marginal rate on the 1% for liberals), how about negotiating Medicare drug prices?

  31. Realize that my citing foreign aid and NEA was not to indicate that they are significant, but rather quick scapegoats.

  32. “Tax planning accountancy becomes even more lucrative.”

    Yes. The apparent assumption that high-income taxpayers will not change their behavior in response to what some of them might regard as confiscatory tax rates is nonsense. Maybe the policy wonks who are floating these proposals don’t remember the good old days before the 1986 Tax Reform Act, when lots of smart people spent their time dreaming up tax shelters, like alpaca farms. But that was a fairly substantial industry, and it will spring up again in the face of significantly higher tax rates.

  33. Milo and Scarlet,

    If we continue as we are we’re going to have to pay a lot more for medicare and for medicaid funded long term care as the baby boomers age. In your ideal world where should that money come from?

  34. Does tax planning really have much use for the upper-upper middle but not super-rich? For example, if you had an IT professional making 200k, and a physician making 200k, what can they do to minimize their taxes that they are not already doing, beyond the stuff that money magazine tells everyone to do? For people who make their money in salary (as opposed to stock, etc), there are few ways to shelter that income, as far as I can tell. If marginal tax rates go up, perhaps one works less, but that is not really a tax avoidance situation, just an income avoidance situation.

  35. I mentioned the other day that I’m still a liberal democrat, but I dislike my tax bill. I understand why it is necessary, and I do live in one of those states with a lot of services that have to be funded.

    There is a good article this week by Ron Lieber in the NYT about why some people that can afford expensive gifts for their kids don’t buy these items. The article was something I shared with DD because she still doesn’t understand why we are always looking for sales and coupons. We finally had a chat with her after she defined our family as lower class when she learned about lower, middle and upper class in a social studies unit about ancient civilizations.

    It’s what anon was being snarky about above. I know we’re not middle class, but she sees us living a middle class lifestyle as compared to our surrounding neighborhoods.

    I usually won’t vote for any republican presidential candidates that don’t have the same social values as me. I don’t think I would change my vote even if the tax rates go much higher. They have an impact on this country for many years beyond their presidency via the Supreme Court. I think Scalia is smart, but I was angry about some of the stuff I read this week associated with Scalia. The legacies and policies of some President’s live for a VERY long time via their nominees.

  36. “doesn’t understand why we are always looking for sales and coupons.”

    It’s simple economics, really. That (loaf of bread) doesn’t provide enough utility to me at $3.99. But with a $0.50 coupon that the grocery store will double, I am perfectly the utility I derive is worth $2.99 out of pocket. Said another way…I can well afford $4/loaf, but I choose to spend my money on other things.

    Is it really worth it to use all those shoppers cards we all have? Sure. And if you choose to actually transfer real $$ equal to the “savings” you derived from swiping the card and maybe even using coupons from your checking account to a “Christmas Club” (savings) account at your bank, you’ll actually see how much that activity is worth to you. At some point, probably fairly quickly for many of us, the amount thus saved can be spent for a nice bottle of scotch/wine and we can toast the Great American market economy as we enjoy the “free” beverage.

  37. Rhett,
    I’m not necessarily arguing that UMC tax rates shouldn’t be higher, just pointing out that an increase in those rates, even if politically feasible, would not necessarily generate the expected revenue, and would almost certainly waste societal resources in workarounds. And I agree with Ada that high-income folks getting W-2s don’t currently have many ways of reducing their taxable income, but higher rates would create a bigger incentive to find some.

  38. “We finally had a chat with her after she defined our family as lower class ”

    Really? Based on what?

    Ada – What about buying a lot of real estate and depreciating it over your next 27.5 (iirc) working years? If you buy $2M worth of properties, and let’s say your rental income matches your mortgage payments and expenses, so you’re basically just breaking even, the depreciation on that gives you an annual loss of $72,000.

    In actuality, you’re converting income to capital gains. That’s pretty good by itself. But you can go one step further and defer those for decades, or even until you croak, and let your kids take the stepped up cost basis.

    Not that I’m considering any of this.

  39. L – thanks for your answer to Ada. That’s what I figured, but I’m not professionally close enough to offer an opinion.

  40. “I’m not necessarily arguing that UMC tax rates shouldn’t be higher”

    Me neither. We don’t have huge incomes, but compared to most people with our household income, our expenses are much lower, so we’ll be better positioned for the kind of maneuvering Scarlett referenced and I just described.

  41. Milo – rental real estate does not sound appealing to me at all. It seems like so much extra work! My clients who own a lot of real estate are 7-days-a-week-of-work people. No thanks.

  42. ” It seems like so much extra work!”

    Well, as Fred says, it depends, right? If you’re being hit with a 50% tax rate in federal alone, you might suddenly be more motivated if you can get a $72,000 write-off.

    As we’ve discussed, it works out well at the typically lower end of the spectrum because skilled tradespeople can add a lot of value to their own properties at only the cost of their time (not paying the taxes and costs and profit margin of hired work). But for the reasons I’ve illustrated, and correct me if I’m wrong, this could likewise be very good for those who can most benefit from getting that earned income out of the top brackets.

  43. “If you buy $2M worth of properties, and let’s say your rental income matches your mortgage payments and expenses, so you’re basically just breaking even, the depreciation on that gives you an annual loss of $72,000.”

    Above a certain income level you can’t deduct real estate depreciation/losses, unless you actively manage those properties. And I doubt Ada’s $400K IT professional/physician couple has a lot of free time to devote to that.

    I think that’s where I go to the WCE point, where the marginal dollar is no longer worth the added cost. I’m liberal and support higher taxes on people like me, but when I look at the taxes every year, even I start to think about whether my income is really more valuable than the time/energy/balance I give up to earn it.

    I do think there’s something psychological about the 50% point — there’s something about seeing more of the marginal dollar going to someone else instead of to you that feels like, you know, screw it.

  44. We try to live below what we can afford. In fact, DH has gotten very MMM like as he has gotten older. This attitude sometimes puzzles me because over incomes have increased. Overall though it has been very good for the household balance sheet.

  45. L- that is what I was thinking. I know a lot of people who make >150k per year, and I can only think of one that might have some ability to control how he is compensated. So, the idea that increasing taxes would lead to more complicated tax avoidance doesn’t make sense to me. I can see how it might not increase tax revenue.

    I guess I would not want to have so much net worth in real estate. The historical appreciation of homes is smaller than the djia, iirc. So, there is opportunity cost that may negate any gains over putting the money in the market.

  46. If you put $2 million into real estate, you don’t put it into homes. You put it into either a farm/ranch or into apartments, either market-rate (by a university or in a big city with lots of demand) or into section 8-type housing.

  47. “I do think there’s something psychological about the 50% point — there’s something about seeing more of the marginal dollar going to someone else instead of to you that feels like, you know, screw it.”

    I agree.

    Owning a bunch of property sounds like a huge nightmare to me. I’d rather pay the taxes. $72K a year in tax avoidance is not worth the pain & suffering.

  48. Re: Middle class: ditto the above comments — I think we are all smart enough to recognize where we are in the income distribution spectrum; the discussion about “feeling” MC has more to do with values and morals and world view. But maybe a less loaded term is “middle income.”

    (Not that that would actually help in the public debate, as politicians of every stripe have a clear incentive to invoke the emotional pull of the fully-loaded terms).

  49. Rhett, yes. I was on the subway and I couldn’t figure out how to paste.

    Milo, they are learning about how how civilizations formed. This was a unit about how government and laws started in the earliest civilizations. They learned about the three classes in one of the units. When I asked why she thought we were lower class, she said it is because I always respond with we can wait for a sale, or I’ll think about it. I did learn from some article years ago that I shouldn’t say that we can’t afford it because that isn’t true. She was comparing herself to some of classmates that DID get the overboard as soon as they came out at the end of the summer. They have grandparents that seem to shower their grandchildren with expensive sneakers, uggs, timberlands, and any new clothing item that the kid wants to buy. We don’t have grandparents like that, AND i won’t do it at back to school shopping. I do buy her a lot of stuff to fit in ( as per our discussion with Sky last week), but I won’t buy it unless I think it is a fair price AND she will actually wear it. I am down with clothes or shoes that just sit in closets.

    I explained what Fred said above about how income and expense. I tried to explain it in terms that she would understand such as if we save money on “x”, then we can use it for camp or a great hotel. I tried to explain why we like to have savings for emergencies, and to make choices about when to spend money.

    I also told her how much everything in her room cost when we did the renovation. She was away, and she had no idea about the cost to make some of the changes that seem like basics to her. Once I showed her the cost of her new bed, closet materials, towels, everything – I think she understood more about how we are choosing to spend our money.

  50. “unless you actively manage those properties”

    I don’t know that that’s all that well-defined.

    Also, there’s a big disconnect between what I read on here about the horrific time demands of active real estate management, and the extremely minimal amount of time and effort I see FIL devoting to his multiple properties.

  51. I should also note, however, that the depreciation is only good for the structure and improvements, not the land. So $2M doesn’t quite get you the $72k.

  52. Lauren – Got it. I think my kids would answer that we’re in the middle. If prodded, they would maybe point out that we don’t have a pool, so we can’t be at the upper end. But I might have to ask them.

    They’re young, of course, but it’s interesting to me that they generally assume they’re going to be quite rich as adults (in terms of all the things they’re going to have–yachts, mansions with equestrian stables, etc.). I wonder how common that assumption is, or along what lines it breaks down.

  53. “I assume he’s outsourcing all the plumbing, HVAC, painting, yard work, etc?”

    Yes. And up until a few years ago, one of them was a late-1970s time capsule (DW’s elementary school house), and they gave it a pretty extensive renovation.

  54. Our clients who do real estate arbitrage are mostly gifting the vacation home to the kids in small chunks. We have some people who gave 2 2-families in metro west to the kids (one to each); one with a ME coast vacation home who has transferred all of the interests (through tiny percentage gifts each year for the past 20 years) to her kids; and a family with a $5M Nantucket house currently making fractional interest gifts.

    The clients running the rental real estate (the really hard working ones) tend to be super disorganized and not want to do any planning, AND they are control freaks so don’t want to make any transfers. They do this FT, not like the doctor and tech couple who would have to outsource all the mgmt.

  55. I have to admit that I really love learning how kids think when they share their thoughts with you about what is going on in their brains. They learn so much in school each day, and when you hear how they apply it to their own lives…i think it is so interesting.

    They learned about ancient Egypt this week, and tone unit was about King Tut. It was fun to see DD’s face when she realized that some of the words from a song that she knew had actual historical information in it vs. a funny song/dance from camp.

  56. “$72K a year in tax avoidance is not worth the pain & suffering.”

    If you’re willing to flush that much a year down the tax toilet because it’s a hassle, then you’re probably not middle class.

  57. “If you put $2 million into real estate, you don’t put it into homes.”

    Probably not single family homes.

    I’ve heard that another option with good returns is storage.

  58. “Not that I’m considering any of this.”

    You brought it up earlier. So have you decided against pursuing it?

    “rental real estate does not sound appealing to me at all. It seems like so much extra work! My clients who own a lot of real estate are 7-days-a-week-of-work people. ”

    Outsource.

  59. This just came out from Pew Research —

    Are you in the American middle class? Find out with our income calculator

    Our new calculator below lets you find out which group you are in – first compared with all American adults and then compared with other adults similar to you in education, age, race or ethnicity, and marital status:

    http://www.pewresearch.org/fact-tank/2015/12/09/are-you-in-the-american-middle-class/?utm_source=Pew+Research+Center&utm_campaign=a3d4223616-Weekly_Dec_10_201512_10_2015&utm_medium=email&utm_term=0_3e953b9b70-a3d4223616-399644129

  60. “I have to admit that I really love learning how kids think when they share their thoughts with you about what is going on in their brains. They learn so much in school each day, and when you hear how they apply it to their own lives…i think it is so interesting.”

    I totally agree. It is one of the joys of having a school-aged child I think. I’m not surprised that your DD would have thought that she was “lower class” compared to her surrounding environment even though you know that your family is quite privileged. I think sometimes it’s jarring to be reminded what a bubble your kids live in when things like that come up.

  61. “it works out well at the typically lower end of the spectrum because skilled tradespeople can add a lot of value to their own properties at only the cost of their time ”

    To Ada’s question, the tradespeople in this example are essentially converting their compensation from wages into capital gains.

  62. My uncle-the-slumlord actively manages his dozens (hundreds?) of properties by having a preferred carpet installer guy, a preferred roof-leak fixing guy, a preferred appliance repair/replace guy, a preferred handyman outfit, etc. and calling them for problems/renovations. He is “active” in the sense that the tax bill is minimized over time by replacing the carpets in years other expenses are low, etc. I won’t ask how much of the labor is done by legal US residents.

    Kind of like the rancher uncle actively managed the decision to grow niche-grass-seed on his ranch, and actively managed the decision to rent out part of it for cattle.

  63. “they gave it a pretty extensive renovation.”

    That would be too much work for me, even with outsourcing. Others would not consider it a big deal, be that because of their experience, temperament, interest in remodeling, and maybe interest in the pay off. :)

  64. “The historical appreciation of homes is smaller than the djia, iirc.”

    My guess is that real estate investments are more often leveraged than stock investments, especially long-term investments.

  65. “Above a certain income level you can’t deduct real estate depreciation/losses, unless you actively manage those properties.”

    Aren’t you just limited to the amount of income you have from income from similar investments? And can’t you carry forward losses that are disallowed?

    This suggests diversifying to put some money into investments that produce income that can be offset by those losses.

  66. Until recently, my kids always thought we were poor compared with many of their peers. We were and are “cheapskates” in some ways. However, as they’ve gotten older they’ve realized more that we spend on some luxuries that are not apparent until you realize what things really cost.

  67. Re: managing rentals, yeah, it doesn’t have to be a huge deal — my understanding is that you have to be the “manager,” but that doesn’t mean you have to do it all yourself — i.e., you rent out the property/do the background checks/advertising, you make the arrangements with the repair people/etc. You don’t have to personally fix the toilet at 3 AM — you’re just the guy who gets the call and then arranges the plumber. I was not willing to do that and so hired a property management service. OTOH, if you do it for a living, I think you could easily have your own handyman-type guy whom you appoint to receive and respond to those calls, and that would probably still qualify.

  68. “So have you decided against pursuing it?”

    Well, it’s still on the back burner. One of the most difficult parts is just knowing what to buy and where, and I’m paralyzed by the fear of making a significantly less-than-optimal decision.

  69. CoC – interesting calculator. Most especially the fact that when I entered my demographics I learned that 57% of people like me are high income.

  70. “That would be too much work for me, even with outsourcing. Others would not consider it a big deal, be that because of their experience, temperament, interest in remodeling, and maybe interest in the pay off. :)”

    Someone who was working for him at the time was kind of a hobbyist renovator/project manager, so he handled the whole thing, for a fee of course. The house is about an hour’s drive from where they live, and I doubt they visited the project more than three or four times. As for interest in remodeling, they care very little about specific details of their own house; they certainly weren’t worried about them in a rental. I’m sure it was more like “whatever granite and cabinets you can get cheaply that look decent…”

    The only complaint I’ve heard in the past few years is with another house, FIL left work early to meet prospective tenants, showed them the property, they were very friendly, and at the last minute said “I know that the listing said ‘no pets,’ but we just have a tiny little dog who won’t be a problem at all…” to which his immediate and annoyed response was an absolute no and disbelief that they would waste all that time of his.

  71. Milo, is your FIL willing to advise? My Dad bought a condo with my uncle when my uncle was short of cash when prices were down in ~2009 and my uncle manages it. I suspect many people entering the business do so with the advice of friends/relatives. And not every decision you make will be optimal- my uncle has been doing this for 35 years. My uncle and Dad were both providing support to my grandmother and have each other’s financial best interests at heart.

  72. ““The historical appreciation of homes is smaller than the djia, iirc.”

    My guess is that real estate investments are more often leveraged than stock investments, especially long-term investments.”

    This, and also if they’re only talking about appreciation, well, of course. You have to include annual rents.

  73. One of the most difficult parts is just knowing what to buy and where, and I’m paralyzed by the fear of making a significantly less-than-optimal decision.

    Ha. Try bringing yourself to make a decision about Bay Area/Silicon Valley property. “But what about the next tech crash? What about The Big One (the earthquake that will wipe out the West Coast)?” Etc.

  74. Yeah, he’s happy to advise me. I’ve asked flat out if we should do this and he said ‘yes.’ We just haven’t done it.

    They’ve previously lived in their rental houses, so there’s less of that fear of making the wrong decision. They’re also in good, Totebaggy school districts. They simply never sell any houses when they move. I could always just buy something in one of those neighborhoods (the first one, more likely, since it’s cheaper). I still think the earnings yield is better at the lower end, especially in multi-family housing, although maybe that’s because the headaches, rent interruptions, and maintenance costs are typically higher or more frequent.

  75. Milo,

    The guy who wrote into MMM made a pretty convincing case that when you properly account for everything, it’s only a good investment when you really know what you’re doing.

  76. “it’s only a good investment when you really know what you’re doing.”

    True. I’ll try to re-read that, but I don’t think he was accounting for the tax depreciation/conversion effect, which is what got us on this tangent in the first place, and that’s going to be dependent on your marginal rate and long-term outlook.

    Also, in this case, it’s not really a choice between rental house(s) and S&P index fund. Since it’d be leveraged, it’s between rental house and nothing. So it doesn’t have to be a great investment to be worthwhile.

    Finally, good investment compared to what? I’m generally optimistic about stocks, but at a CAPE of 26? Some real estate diversification might be wise.

  77. “CoC – interesting calculator. Most especially the fact that when I entered my demographics I learned that 57% of people like me are high income.”

    For me, 41%. Probably because I’m younger than you?

  78. I keep thinking about flipping houses, because I like renovating and my GC. But it looks like local real estate is going to take a beating in the next five years, so it would be really risky.

    I wouldn’t want to hold for the long term here, because I think it’s going to get really ugly when government employee pensions for the boomers come due.

  79. Milo, other than active manager status, what do you gain by holding individual properties compared with an REIT? One benefit of an REIT is that it spreads geographic risk.

  80. From what I can tell from the income calculator, if you are white, married and have a college degree, you have a greater than 50% chance of being what they consider upper income. That does not sound surprising to me. That almost applies to senior citizens, and they are not considering wealth, but income.

  81. WCE – I have a few REIT shares under an IRA right now. Not much, though, just a little over 1% of total investments, which now seems totally inconsequential.

    This would get us the tax write-off and an additional investment.

  82. WCE,

    With a REIT you can only lever up 2:1 @ 6% interest. With an individual property you can lever up 4:1 at 3% interest.

  83. Milo, you’re right about the advantages (and disadvantages) of leverage for an individual property. I’ll be surprised (and scared) if you can get a mortgage on a rental property at 3%.

    CoC, the boundary between middle and upper income on your calculator is just under $30k/person.

  84. It would be higher than 3%.

    As for Pew, of the white, married 18-29 year olds who have a bachelor’s degree, only 12% are lower income.

  85. There is enough poverty on our schools that our kids don’t think they are poor. I do point out things they get to do that are special, but they get it.

  86. I’ll be surprised (and scared) if you can get a mortgage on a rental property at 3%.

    Google is saying investment property interest rates are 0.5 to 1.5% higher than for a primary home depending on how much you can put down. If you can put down 25% the rate is closer to 0.5%. With a 15 year fixed at 3.05 you’re looking at a 3.55% mortgage on an investment property with 25% down. Or so it seems.

  87. OT: Atlanta & HM – Remember that Amazon Pantry order I talked about the other day? Well, part of it was delayed, so they refunded the shipping cost for my entire order. So the $5.99 no-rush credit covered the prime pantry delivery fee, but they ended up sending it in 2 packages so I got a refund of $6.17. Woohoo, I made $0.18!

  88. Milo, don’t wait for the optimal purchase, go for the good enough investment.

    Regarding tax avoidance strategies in the days of high income tax rates: Most orchards can be depreciated as soon as the capital improvements (irrigation system and trees are purchased) not citrus or almond orchards. Apparently in the old days of higher tax rates, doctors would purchase ground and plant an almond or citrus orchard and take an immediate tax deduction, so the IRS rules now state that an almond orchard cannot be depreciated until it starts producing income. A walnut orchard can be depreciated immediately.

  89. “A walnut orchard can be depreciated immediately.”

    Do you have any you want to sell?

    It’s funny how we finally get tuned into something like this depreciation thing. One of my grad school courses (sorry, Rhett) had us calculate ROIs that included depreciation effects or variables, plus I knew all about it from talking to FIL. But it was only a couple weeks ago when I was listening to a book on real estate investing that it kind of hit me all of a sudden that it’s effectively transferring income from earned rates to cap gains rates.

  90. WCE, Must you share this info :)

    If you put $2 million into real estate, you don’t put it into homes. You put it into either a farm/ranch or into apartments, either market-rate (by a university or in a big city with lots of demand) or into section 8-type housing.

    One of our landlords is a retired commodities trader, another is a dot com type. They pay the property taxes and I imagine they carry the proper insurances. We send them checks and Christmas gifts and take care of upkeep for them.

  91. Milo,

    It is speculated, on some the trade press I read, that the massive runup in land prices is in large part due to low interest rates and the ability to write off all manner of stuff necessary to manage the property. Legitimate farm/ranch equipment includes pickups, ATV, utility vehicles, horses, etc.

    No, I don’t have a walnut orchard to sell. We will be planting our first one next year.

    I have been having many conversations with our accountant about what equipment to buy this year, whether Section 179 will be passed, what income to take this year versus next year. Generally, it is worth our while to spend 90 cents to avoid a dollar in taxes.

  92. “They simply never sell any houses when they move.”
    “I’ll be surprised (and scared) if you can get a mortgage on a rental property at 3%.”

    The latter is one reason to do the former. Buy a house, live in it, perhaps fix it up, but with a residential mortgage. After a couple years, turn it to a rental, and now you have more favorable mortgage terms than you could get for a property purchased as a rental.

    An “uncle” of mine accumulated a bunch of property this way.

  93. “I don’t have a walnut orchard to sell. We will be planting our first one next year.”

    Are those less thirsty than almond orchards? Is it part of the business plan to eventually harvest hardwood?

    I’ve heard that you need to be very careful about keeping walnut wood from horses.

  94. “An “uncle” of mine”

    We call him uncle, but he’s actually the husband of my mom’s BFF. Their family is, and was, quite close, to ours.

  95. “Our clients who do real estate arbitrage are mostly gifting the vacation home to the kids in small chunks.”

    Which does not have the advantage of cost basis step-up.

    From a tax avoidance standpoint, it makes more sense to gift things other than appreciated assets (or depreciated assets, for that matter).

  96. Finn, Walnuts require better soil than almonds, but the water requirements are roughly the same. Most crops use between 2 and 4 acre feet of water. Walnuts are somewhat less risky in that they bloom later in the year, so they are less susceptible to frost and they don’t require bees for pollination. Unless climate change picks up a little, we still have to worry about damaging frosts during almond bloom, and finding bees during bloom. However, it take about five years for walnuts to start to economic production versus three years for almonds.

    China has apparently figured out how to grow walnuts, but haven’t gotten into almonds
    A walnut orchard lasts a 35- 40 years, so I’m not planning on taking out this orchard. The kids can worry about that.

    I know nothing about horses eating walnut wood. However, given that horses are the Barbies of the animal kingdom (pretty, but not terribly bright), I could easily see them eating something toxic.

  97. Our clients who do real estate arbitrage are mostly gifting the vacation home to the kids in small chunks.”

    Which does not have the advantage of cost basis step-up.

    I think it does, as I understand it, one can gift assets at their market value.

  98. Update on the Spanish situation: the teacher is going to be out longer than expected (at least through January now) and the school hired a long-term sub who actually does speak Spanish. She started this week.

  99. There may not be tax shelters any more, but since I minimize the fed tax rate on my umc retiree income more or less as a hobby there is stuff you can do even if not wealthy. However, it is probably not worth the professional fees to pay someone else to figure it out.

  100. “I know nothing about horses eating walnut wood.”

    I don’t know if eating the wood causes problems, but horse stalls are often covered with wood shavings or something like that, and using walnut for that can apparently cause some serious health issues for horses.

  101. “I think it does, as I understand it, one can gift assets at their market value.”

    My understanding is that for the purposes of estate taxes and gift limitations, market value at the time of inheritance of gift is what matters.

    But for capital gains calculation, you only get the step-up with inheritance. If you receive an appreciated asset as a gift, you also receive the original cost basis.

    BTW, another tax dodge for rich people is charitable giving of appreciated property. Your deduction amount is based on the market value at the time of the gift, and no tax is due on any appreciation up until then.

    Or Milo could convert his appreciated real estate (or other appreciated asset) to a charitable gift annuity.

  102. “I think she understood more about how we are choosing to spend our money.”

    I think the key word here is, “choosing.” Spending, and not spending, is a series of choices.

    I’ve tried to explain this to my kids in basic econ terms: unlimited wants and limited resources requires choices to be made in the allocation of those limited resources.

  103. “how about negotiating Medicare drug prices…”

    ..with one goal being getting other countries to pick up a larger share of the cost of developing new drugs.

    Or would that result in a migration of some of our drug industries to other countries?

  104. “If marginal tax rates go up, perhaps one works less, but that is not really a tax avoidance situation, just an income avoidance situation.”

    I am old enough to remember when marginal tax rates reached 70%, and my dad explaining to me how that contributed to many doctors not working on Wednesdays, and many medical practices shutting down, or not taking appointments, at year end.

  105. “Too bad they are such a small % of the population.”

    But they provide a large %age of campaign contributions.

  106. This, and also if they’re only talking about appreciation, well, of course. You have to include annual rents.

    I thnk you posited in the beginning that you were just going to break even. “Rental income matching rotate income and expenses” – so the only money you are among is on depreciation and appreciation. Which doesn’t entirely make sense when you put it that way.

    You may recall we have rental properties – 3 now, have had 5. DH keeps meticulous records (which eats up time) though we don’t actively manage. We get more than 1% of the value per month in rent, but our returns aren’t great. I will see if we can pull up the numbers.

  107. Break even, but they are paying your mortgage.

    Have you priced out places where that is possible net of management fees, outsourced maintenance, etc?

  108. Rust belt college towns have the biggest mismatch between property value and rental rates, in my limited experience.

  109. The people I know who have an investment strategy based on real estate own it in preference to stocks and bonds. They definitely use leverage, and offset operating costs by income, but the idea is generally to break even for tax purposes because of depreciation and realize some cash flow. That cash flow might be to fund future real estate purchases, but often in the kind of extended family network of properties I see from comfortable working class on up, the initial mortgages were paid off long ago, and there is steady cash flow to support retired family members, college kids and the livelihood for a family member who actively manages the portfolio of properties, as well as the ability to provide housing to extended family to some extent. Keeping the townhouse and paying the mortgage taxes and other costs is a way to establish a college or retirement fund, or at least an asset for a line of credit.

  110. The idea with the family properties and fractional giving is that the kids will want to keep them and not want to sell. They usually set up some sort of house trust/fund to fund the carrying costs, as well as giving away the interests in the property (and you can take at least a 20% discount on those gifts for lack of control and lack of marketability). Plus, the estate tax rate is 40% while the cap gains rate is only 20%, so you save by getting assets out of the taxable estate. These families are all above the fed exemption, you’re looking at more like 20-50M.

  111. Rhett – I would look more closely, but I think I can make it work. And I would not be hiring a property manager.

    As for generational houses on Nantucket, I wonder how that works going from one couple, to three children/siblings, to seven grandchildren/cousins, and all their spouses and exes, in-laws and outlaws…

    What happens when one wants to renovate everything with Water Works, and another is perfectly happy with the 30-year-old bathrooms?

  112. The reason I feel middle class is that I grew up middle class and had so little contact with upper class people that I really felt, and still feel, uncomfortable in that world. That leads to paradoxes. Right now I am sitting in the waiting area while my oldest kid sees in ADHD coach. The office is up in northern Westchester in a pretty wealthy area. There are several teen girls all waiting for their therapists. Two of them just struck up a conversation – they seemed to sort of know each other. The conversation revolved around the fact that one girl is in private school but will be going to Horace Greeley next year (for non Westchesterites, one of the top public high schools in the US). The other one says she is at Greeley, and they they got into a conversation about clubs (ski team, officer of charity clubs, which clubs to focus on, etc), and then they started comparing notes on resorts in Hawaii, which both of them had been to numerous times. And I felt like I did when I went off to college and met rich people for the first time – so uncomfortable and out of my element. But then I realized – my kids may sound just as bad. I am mentally not of the same economic class as my kids.

  113. That’s a good point, Moosh. I certainly am not in the same economic class as my kid.

  114. Regarding taxes–I’m with LFB. I’d happily cut back in my work and income v. pay taxes in a higher bracket.

    Regarding sheltering income–I like the walnut tree suggestion. I’ve already queried on whether walnut trees grow well in Texas. : )

  115. L: Interesting idea WRT gifting property. You can do the same thing when investing in a start up company–gift the shares when the company is worth next to nothing. If the company does well, you’ve transferred wealth to your kids without tax consequences.

  116. My parents once they had reached a comfortable point started looking for land to buy. At one points our weekends were spent driving around looking for suitable land. I had always wanted them to buy by the beach but they were more interested in orchard type land so that’s what they bought. They put a lot of time and money into it. It was/is their hobby/investment. Now about some thirty years of owning it, they are looking for a seller. I’d probably be more of a rental property owner or buy pieces of vacant land to sell in the future. I’ve had enough of orchard trees (tropical type in the home country).

  117. Regarding the calculator…when we both worked full time, pre-retirement, we fell just above the upper class cut-off. Now, both retired, but I work a part-time job, we are pretty solidly middle class, with income down about 40%. However, achieving middle class on pension, social security, investment income and part-time work seems to bring into question what class we fall into.

  118. ” If the company does well, you’ve transferred wealth to your kids without tax consequences.”

    As I’ve pointed out earlier, unless the transfer is via inheritance, the cost basis is also transferred, and thus there will be tax consequences, i.e., the kids would need to pay CG taxes if they sell their any part of their interest in the company.

  119. Finn – but the advantage there is that they’ve transferred something that’s ultimately very valuable past the estate tax fence before it was worth anything, so it counted very little against the exemption amount.

  120. Or against the maximum lifetime gifting amount I mean, I think.

    Similar to how Meme’s mentioned people like Romney putting shares of a start-up in a Roth.

  121. Milo – correct, the idea is to transfer it while the value is low and then you won’t have to pay any gift tax or count it toward your lifetime exemption. The only problem with gifting stock in startups as a founder is if you lose control of the stock (like with an irrevocable trust or a grantor retained annuity trust) – usually that’s not OK with the company. What I am hoping happens with DH’s shares is that his startup shares are worth a little bit – not a ton – and he transfers some of them into a zero-out GRAT with an appraisal of X and then they appreciate 100x during the term of the GRAT – then he will have transferred 99x out of his estate with zero gift tax . Also note, principal distributions from trusts have no tax consequences to the beneficiary.

    Rhett – the best solution is a co-owners’ agreement with some sort of lottery or rotation for the summer weeks, BUT we have very few clients who have actually gotten around to signing one. Usually we send them one and they argue about it for a year or so and don’t sign it.

    The other solution is when only one of the kids wants a property, or if there are 2 roughly equivalent properties – we have dealt with both. The first of those only works if there is enough liquid in the estate to make up the difference from the real estate.

  122. L, it was my impression from my estate tax colleagues that there were plenty of ways for the extremely affluent to minimize their estate and gift tax liability, so that few of them were paying the taxes that “should” have been collected on their transfers. Is that what you see in your practice?

    (My impression was based both on casual conversations and by observing that these attorneys seemed to be enjoying a pretty high standard of living, so evidently they were providing valuable service to those clients.)

  123. Another application of Benford’s Law to the detection of illegal activity is a history of cash purchases beginning with 9, since 10K is the threshhold at which businesses are required to report cash transactions.

  124. I’m exceptionally bad at cross-referencing actors from one movie or show to another. I was pumping gas this morning at one of the new pumps that have TVs, and they said something about Bryan Cranston. I remembered that I had just come across that name, but then I also thought “wasn’t he the one in Breaking Bad?” I saw his name the other day when I posted the Seinfeld dialogue about “going upstairs.”

    I never realized that Walter White and Tim Whatley were the same person.

  125. For UMC retirement (not inheritance) tax planning there are also CRATs and CRUTs – donations to charity that give you a small annuity until death or a fixed term of years, with the bulk going to the charity after the annuity term (or death). The transfer (usually appreciated securities) can be made while taxable income is high in the last working years (and the charitable deduction worth more), with a deferred payout starting at any age – 75 say. An alternative to longevity insurance.

  126. Milo,
    That’s what IMDB is for. Perhaps not that useful when you’re pumping gas, but when I see an actor on a show that I sort of recognize but can’t quite place, IMDB comes to the rescue and I don’t have to ask DH “is that the suspicious woman from season 2 of 24 whose sister was getting married?”

  127. Scarlet – I do that, or just check Wikipedia, which is what I did at the gas pump (now that people have finally abandoned the myth that cell phones trigger fuel pump explosions, I won’t have people yelling at me).

  128. Scarlett – yes, very true. We even have clients that have used up all their gift exemptions to stash *everything* in spousal limited access trusts – that was the rage in 2012 when we thought the exemption was going to go back down.

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