The tax rate that may drop below zero

If Republicans in Congress have their way, tax rates will be negative for a large portion of investment income. What does that even mean?

Let’s start with current law. If you are fortunate enough to have purchased a stock for $1,000 and sell it for $10,000, under current law you would pay tax on the $9,000 capital gain — in other words, on the $9,000 your investment earned. Assuming you are an individual with income between $48,351 and $533,400, the federal tax rate on your $9,000 of investment income would be 15 percent, for a total tax bill of $1,350. The bottom line is that you would have sold the stock you bought for $1,000 at a price of $10,000, paid $1,350 in taxes, and pocketed the remaining $7,650. 

If, however, Congress passes the Educational Choice for Children Act, instead of selling your stock and pocketing $7,650, you could simply donate your stock in accordance with the legislation and pocket the full $10,000.

To be eligible, all you would have to do is give your stock to a “Scholarship Granting Organization” that funds vouchers for private and religious schools. That would qualify you for a $10,000 credit on your federal taxes. 

A credit is totally different from the conventional and very familiar charitable deduction. The charitable deduction reduces your taxable income, which reduces your taxes in an amount that is a mere fraction of the amount you donated.

Donating stock under this new act is different: It would give you an actual credit on your tax bill — a reduction in the total taxes you owe on all of your other income — for the full $10,000. In other words, if you give your appreciated stock to such an organization, you get $10,000 from Uncle Sam in the form of a tax credit — the same amount of money you could have gotten from selling your stock. The only difference is that, this way, you pay no federal tax.

But it gets even better: You will also be able to claim the $10,000 donation as a charitable deduction on your state and local tax return. For high income earners where I live in New York City, this could reduce one’s state and local taxes by as much as 11 percent, or $1,100. This would make the tax rate minus-12.2 percent on your $9,000 gain, since the income would not be taxed and it would be enhanced by a $1,100 reduction in the state and local tax bill.

In essence, if you sell your stock worth $10,000 and live in a high tax state like New York or California, you could pocket something like $6,550 (the $9,000 profit less $1,350 in federal taxes and $1,100 in state and local taxes). But if you give it away pursuant to the legislation, you could pocket the full $10,000 federal tax credit against your other taxes, plus the state and local tax reduction.

The bottom line for those who prefer words to numbers is that for a large portion of investment income, the federal tax rate would go to zero and there would be a state and local tax cash benefit. 

It would be like having zero federal tax on a teacher’s income of $70,000 and then have the local government give the teacher a check for a portion of his or her income. This is something that inconceivable for most workers, but it seems likely to become a reality for most investors.

The act does have some limitations. But the wealthier the investor, the more millions they could save in taxes. And every dollar saved by an investor under this act is a dollar some other taxpayer will have to pay.

The measure is expected to be enacted by mid-July and has already passed the House. Almost all the discussion concerns the debate over government funding for private and religious schools. Although this debate has merit, it has unfortunately eclipsed the extraordinary tax benefit that this provision would confer upon wealthy investors.

Congress would have a hard time directly shifting a substantial part of our nation’s tax burden from wealthy investors to working people. Doing it indirectly under the guise of funding school vouchers, has enabled them to evade public scrutiny. Evading public scrutiny will, however, become much more difficult when the act ultimately takes its toll on tax fairness and budget deficits.

Howard Yaruss is a lawyer and a professor at NYU. He is the author of “Understandable Economics.”