A Citizen's 2% Solution

How to Repeal Investment Income Taxes, Avoid a Value-Added Tax, and Still Balance the Budget

Category : Uncategorized

A Message for Occupy Wall Street

Your “fairness” arguments are falling on deaf ears.  I suggest a more effective argument would be the inefficiency of our current investment tax policies.   

A fundamental precept of capitalist theory is that productive deployment of capital is the driver of economic growth, and building upon that precept the consensus of economic teaching today assumes that tax policies must affirmatively encourage savings and investment. That is the perspective economists (and politicians) use to justify offering preferential tax rates to investment income. By nature, most economists are pragmatists. So, operating in the belief that a “rising tide lifts all boats”, most economists today are ready and willing to accept inequality (even deep and increasing income and wealth concentration) as the Darwinian cost of a “greater good”. They are largely unmoved by fairness arguments.

If preferential tax policies subsidizing capital actually were stimulating productive investment, economic growth and job creation, then we could perhaps afford to be pragmatic about some level of resulting inequity.

But our tax and monetary policies are encouraging over-leverage and stimulating valuation bubbles.   Our policies have made tax avoidance and valuation manipulation far more profitable than productive enterprise, thereby destabilizing our economy. I do not challenge the core theory that productive investment is a driver of economic growth and prosperity. But I dispute the idea that speculation on valuation inflation constitutes productive deployment of capital. It is on that basis that I believe we need to fundamentally reexamine the structure and incentives embedded in our treatment of investment income.

Look carefully at how our tax policies treat alternative capital allocations. We a) penalize productive investments with our highest tax rates, (equaling and occasionally exceeding earned income tax rates via the “double taxation” of dividends and capital gains distributions), b) offer speculative trading activities substantially reduced tax rates, and c) subsidize illiquid and wholly unproductive capital allocations with perpetual tax deferrals. Perpetual deferral of unrealized gains is a strong and compelling obstacle to the rapid and fluid reallocation of capital to more productive uses – thus opposing a key tenet of capitalist theory. The actual incentives of existing policy are diverting capital away from the productive investments we intend to be encouraging. 

Too much of what we call investing, and incent and subsidize with preferential tax treatment, is simply gambling. I’m largely libertarian in my views, so I don’t want to preclude people from gambling. But I certainly think we ought to stop subsidizing it with preferential tax treatment.

Betting on whether a stock price or index fund is going to go up or down is not the same as investing in the development and operations of a productive business.  Nailing $2 million dollars of potentially productive capital on my wall in the form of a Picasso may well be a choice I choose to make, but I can’t justify it as an efficient deployment of capital generating much societal benefit – and I therefore don’t believe that tax policies should be providing me a financial incentive to do so.

Unfortunately, the bulk of our current debate on tax reform either ignores these structural challenges entirely, or threatens to exacerbate these problems by shifting our tax base to greater reliance on consumption taxes which are deeply regressive and would actually make our existing problems worse. 

There is an alternative which I believe deserves to become part of the public debate.  I believe if we would withdraw the subsidies that now obstruct the free and fluid flow of capital to higher and better uses, the natural influence of personal self interest would incent holders of capital to pro-actively seek out more productive investments; and thereby stimulate economic growth and job creation.  The structure I propose would simultaneously defuse increasing anger against the so-called “1%” by equalizing tax rates assessed upon labor and capital income. 

Specifically, I propose that corporate income taxes, personal investment income taxes, estate and inheritance taxes and gift taxes should all be repealed and replaced with an annual 2% tax on net assets (subject to a reasonable minimum threshold). Simultaneously, we should flatten and reduce taxes on earned income to a maximum of 25%, inclusive of all employment taxes (employee and employer). At these levels, the effective tax rate upon labor and investment income potential would be approximately equal:  assuming a long term target return on capital of 8%, a 2% annual tax is the equivalent of a 25% income tax rate.  This substantial reduction of earned income tax rates would stimulate middle class earnings, savings and consumer spending. 

This is not an anti-capitalist proposal.  It is a call to return to core principles of equal treatment and fair competition which are the foundation of capitalist theory. 

“Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man or order of men.”

~ Adam Smith (1723-1790), The Wealth of Nations

Mr. Smith was not advocating an unequal competition in which the wealthiest and most privileged among our society are subsidized with preferential tax rates. 

America is approaching a tipping point, as more and more of its capital is being diverted away from productive enterprise by ill-considered and counter-productive incentives embedded in our tax treatment of investment income.  It is time to evaluate and implement structural changes in those policies. 

Self-interest is a much more efficient motivator than guilt.  Our political leadership and most of the influential media are members of the 1%.  Advocating change by trying to make them feel guilty about their positions of privilege is unlikely to be an effective argument.  But preferential treatment of the already privileged has put our economic stability at risk.  Our top-heavy house of cards is threatening to collapse.  Convince leadership of that real and compelling risk – and perhaps then they will begin to evaluate meaningful alternative tax and budgetary reforms.  A good place to start would be purging our system of the counter-productive, undemocratic and anti-capitalist influences of cronyism that distort investment incentives. 

Replies, observations or rebuttals are welcomed, either publicly as a comment to this post, or privately through the nearby contact form.

Douglas Hopkins

Author – A Citizen’s 2% Solution: How to Repeal Investment Income Taxes, Avoid a Value-Added Tax, and Still Balance the Budget. ISBN 978-0-9828328-0-6

Re-thinking Investment Income Taxes

It is accepted dogma of economic theory that higher taxes on business profits and investment income discourage investment and stifle growth.  That is the justification for allowing the richest and most privileged Americans to pay lower taxes on investment returns than the working stiff pays on wages and salaries. 

I don’t challenge that dogma.  It is indisputably true. 

But, taken to its logical conclusion, that suggests that the best way to stimulate investment, hiring, and economic growth, would be to repeal all corporate profit and investment income taxes.  So why don’t we do that?  Why don’t we repeal all corporate profit and investment income taxes? 

Presumably because we (society) think that it would be unreasonable to allow the already privileged to accumulate still greater wealth without contributing a fair share to the costs of government and society.  Here again, I share the collective opinion.  I think the rich derive great benefits from society and I think they should fairly share the burden of supporting that society.  In fact, I think it is unfair and unreasonable that the wealthy pay lower tax rates than the working class – even though I understand the dogmatic and pragmatic rationale. 

Which raises a conundrum:  How do we repeal investment income taxes to stimulate economic activity without giving the wealthy a free ride?  And since we’re addressing a modification of existing tax policy, can we restructure policies in a manner that removes distorting incentives and encourages the “invisible hand” of Adam Smith’s capitalist theory to operate more efficiently? 

FlatTax advocates argue that we should replace corporate profit and investment income taxes with some variation of a consumption tax:  a Value-Added Tax, or a National Sales Tax, or some alternative variation or combination of regressive transactional taxes which would penalize that portion of the population who consumes all their income annually and favor the privileged and lucky few who are already accumulating an increasingly large percentage of the national wealth.  (To give credit to their benevolent natures, most FlatTax proponents do argue they would provide credits or adjustments for the poor to offset the inherent regressive nature of consumption taxes.   However, as I see it, taxes which favor the rich and favor the poor are still regressive toward the working middle class.) 

So I have a different alternative.  How about if we tax wealth instead of investment income?  Just like real estate.  (Actually, not like real estate.  Because we tax real estate on gross value, but I think we should only tax wealth on a net basis.)

Think about it.  Why don’t we repeal corporate and investment income taxes, and estate and gift taxes, and instead tax accumulated net wealth at a flat 2% annually? 

Our efforts to tax investment profits generate a multitude of undesirable unintended consequences.  In the first place, as per the old accountant’s axiom, “profit is just an opinion”.  Our tax laws have stimulated an entire industry revolving around manipulating “profit” for the purposes of tax avoidance.  The higher the rates, the harder and more aggressively businesses work to shelter their income from the tax man.  Worse yet, Congress conspires with them to do it.  The existing rat’s nest of complex laws and regulations all emanate from Congress’ efforts to manipulate the system.   Special treatment under the tax code is the tool they use to buy and sell power and influence.  Why don’t we take that tool away from them and return equal treatment to the tax code? 

Capitalist theory suggests that economic efficiency is achieved when the market blindly rewards individual self-interest.  Note, that invisible hand of the market is supposed to be blind of managed objectives, just like Lady Justice, devoid of favoritism, operating with its thumb clear of the scale and allowing the market freedom to accumulate the benefits of unfettered commerce.  But our existing tax code imposes penalties that obstruct that efficiency and discourage productive investments. 

You don’t believe it?  Let’s look at three simplified examples.  Alan, Bob and Charlie each have two million dollars in accumulated net wealth. 

Alan invested his entire $2 million in a sole proprietorship.  He works exceptionally hard and runs a profitable business.  He draws a small salary but takes most of his income as return on his invested capital.  Let’s assume a 12% return on assets, or $240,000 per year.  If he doesn’t shelter his operations through some tax advantaged ownership structure it’s taxed as ordinary income – with a top marginal rate of 35%.  If he structures the business as a corporation and leaves the money in the corporation he will have more flexibility to shelter some of it from taxes by manipulating “profit”, but corporate taxes will still take a nominal marginal bite of 39%. 

Bob invests his entire $2 million in publicly traded equities.  Unless it’s a loss position (so he can use it to shelter other gains) Bob never sells anything in less than 365 days.  For arguments sake let’s say Bob earns the same 12% annual return on his investments, an equal $240,000.  So the portion of his portfolio which turns over each year is subject to a long term capital gains tax, currently set at 15%, less than half Alan’s marginal tax rate.  To the extent Bob doesn’t need his investment income to support his current expenditures, and doesn’t churn his portfolio, he can defer his capital gains and pay zero tax on a current basis.  Thus, Bob, the passive investor, pays far less toward the support of society than his equally wealthy entrepreneurial neighbor, Alan.  In rough, round figures let’s say at least 50% less.  Depending upon just how infrequently he churns his investments, his annual tax bill could be much less than that. 

Charlie took his entire $2 million and bought a painting by Picasso.  He keeps it on the wall in his paneled office for his personal viewing pleasure.  Although he doesn’t intend to ever sell it, for symmetry ’s sake let’s assume it is appreciating in value by 12% per year, providing Charlie with the same annual investment return as Alan and Bob.  Yet Charlie pays zero annual tax.  Yes, he may eventually pay something in estate taxes.  It’s hard to tell how much because Congress has been manipulating estate taxes like a yo-yo.  (If he dies this year, he pays nothing because the estate tax has expired.  If he died last year he would have paid nothing because his assets were under the $3.5 million exemption.  If he dies next year he could pay 55% of any value in excess of $1 million – unless Congress changes the law again – which it almost certainly will.)  But as long as he lives, and maintains ownership of his Picasso, he will pay no annual tax on its appreciating value. 

So there you have it.  Three men of equal wealth pay three entirely dissimilar tax bills.  Certainly, if there is justice or rationality in our system the man who pays the lowest tax bill is being rewarded for activity which represents the highest benefit to our society.  Yes? 

Look again.  Charlie took $2 million out of economic circulation.  The primary benefit of his investment is the private smile that comes over his face when he sits quietly in his office.  Our tax code favors his choice.  Alan, the entrepreneurial businessman, actively building the economy, pays the highest tax bill. 

In my scenario, they would all three receive an equal tax bill, 2% of $2 million, or $40,000.  The Invisible Hand of capitalism would operate freely.  The distorting influence of investment profit taxes would be removed.  Each man would benefit from the wisdom of his own decisions.   At my posited 12% annual return, their 2% of assets would convert to the equivalent of 16.7% of income.  If, alternatively, they invested more conservatively in bonds paying a 5% return, their tax bill would be equivalent to 40% of income.  As a percent of their accumulated wealth and ability to pay, each investor’s tax bill would be entirely equal.  In contrast to existing policies, where the tax man reduces one’s bill in response to cautious decisions or poor returns, under my proposed system each investor would retain the full benefit (or risk) of their respective choices

Isn’t that how a free market is supposed to work? 

Comments, replies and rebuttals are invited and will be welcomed. 

Douglas Hopkins

Author – A Citizen’s 2% Solution:  How to Repeal Investment Income Taxes, Avoid a Value-Added Tax, and Still Balance the Budget

PS – for the FlatTaxers out there – Abolishment of employment taxes and establishment of a modified flat tax applied to all earned income is an accompanying feature of my proposed 2% Solution.  (For the record, I believe characterizing social security “contributions” as anything other than general tax revenues is simply a polite fiction, conveniently hiding the fact that the working middle class pays higher marginal tax rates on earned income than their more affluent and successful neighbors.  See Social Security: Trust? Or Ponzi Scheme?.)

The Big Lie of Government: the Myth of Progressive Taxes

“We have a system that increasingly taxes work and subsidizes non-work.”

–    Milton Friedman

If even Milton Friedman, one of the most ardent and influential free market economists, could see that, why hasn’t anyone in his profession or the political arena taken up the challenge of trying to redress that wrong? 

America’s tax revenue policies are grotesquely skewed in favor of the already rich.  Our vaunted Progressive Tax Policies are a Myth.  How do our leaders justify the intellectual dishonesty which allows public debate to be guided by the claim “nearly 50% of the public pays no taxes”?   The only way the myth is true, is if you close your eyes, hold your nose and pretend that employment taxes are not taxes. 

Today, inclusive of employment taxes, members of the “working middle class” bear the highest marginal tax burden on their wages and salaries, a rate which peaks at 40.3% for an individual with taxable earning of just $33,951, and drops sharply when earnings exceed $106,800. 

 

Yes, our government tries to distract us by pretending that employment taxes are somehow not “taxes” and by pretending that the employer portion of the assessment isn’t really a tax against the employee but upon the employer, but these are obvious semantic fictions.   If gross employer payroll represents the full value of services performed (and it obviously does), then whatever portion of that gross payroll is diverted to the federal coffers is a tax upon the employee’s wages. 

If one shifts attention away from earned income, i.e. wages and salaries, to investment income, tax rates drop still lower and policies are even more inequitable.  The privileged and lucky man or woman whose wealth is already so substantial that they do not need their income, can structure their investments to generate nothing but unrealized gains and avoid an annual tax bill altogether.  As shown in the example below, while an individual with $75,000 earned as wages or salary will pay tax of 33.4%, that same income earned on investments is taxed at rates from 40% to 100% lower. 

Did I hear you say you think the wealthy are over-taxed?  Until we stop lying to ourselves about the policies we currently have, we will never develop better options. 

Can anyone explain to me how/why the recent Simpson/Bowles’ and Rivlin/Domenici’ Tax Reform Commissions justify ignoring the issue of “inequity” inherent in federal revenue policies as they evaluate our fiscal options?  Once again, our leadership seeks to perpetuate preferences toward the wealthy while requiring sacrifice from the working middle class.  Are they willfully ignoring the facts of our current situation?  Or have they become victims of their own misrepresentations?  One recent insider assessment of the collapse of Merrill Lynch attributed its demise to having “fallen for our own scam”.  I posit that the financial gurus responsible for our tax policies have fallen into a similar trap; they have spent so much time semantically misrepresenting the nature of our tax policies that they have become unable to see the underlying truth and fallacy of what they have constructed. 

Let me re-frame the issue with a simple question: Do we really think the investment classes should be free from obligation to contribute to nearly one third of our government functions?  According to the CBO, 2010 budget outlays for social security and medicare were projected at $1.15 trillion, 32% of total projected outlays of $3.59 trillion.  But our tax policies assess the entire obligation for these important social programs upon low and middle income wages and salaries, exempting investment earnings and high wage earnings from assessment toward this obligation.  Worse yet, for roughly fifty years, while our historic social security “contributions” have exceeded social security outlays, instead of investing the surplus in tangible, productive assets our government has squandered those surpluses funding structural current deficits. 

The “Trust Fund” is empty.  It consists of a “soft promise” to provide future benefits which can only be funded from future tax revenues or borrowings.  This past year “employment tax” revenues exceeded income tax revenues and, being fungible as they are, they were intermingled as general receipts.  The “Trust” involved here is no more reliable than the promise Bernie Madoff gave his customers.

Now I’m sure Monique Morrissey of the Economic Policy Institute disagrees.  Supporting the legitimacy of the “Trust Fund” in a recent NPR discussion she described the situation between the Federal Government and its Citizens as similar to a parent and child and the “kid’s piggy bank” – suggesting it didn’t matter if the parents were living beyond their means so long as they had the ability to draw more on a credit card.  When the kid wants some of his money to buy a mountain bike they will simply draw on the credit card and buy the bike.  Her analogy is essentially correct.  Except spending social security contributions is not really like holding the average child’s paper route earnings while the youngster saves for a mountain bike.   It’s more like blowing a child star’s seven figure annual salary on cocaine, fast cars and trips to Vegas instead of investing in assets for his premature and extended retirement.  

The point she makes is not wrong.  The aggregate household (Treasury) situation doesn’t change regardless of whether there is or isn’t an IOU in the drawer saying Mom (Uncle Sam) owes Kid (John/Jane Q Public).  But exactly what that proves isn’t clear to me.  The Household (Treasury) either is or isn’t insolvent – and a bunch of pieces of paper in the Treasury that say effectively “I Owe Me” don’t make it any more solvent or provide any comfort or guarantee that the promises associated with those pieces of paper can or will be honored. 

If you ignore the semantic nonsense and simply evaluate the underlying facts it should be readily apparent that the only functional accomplishments of calling employment taxes “contributions” are a) it obscures the fact that the working middle class bears a higher marginal tax burden than their more affluent and successful neighbors and b) it shields those more affluent citizens from contributing to these important social programs.  The accumulation of “Trust” promissory notes in a drawer doesn’t change the fact that for fifty years social security contributions have been consumed by current government outlays and all future benefits will be funded with future taxes or increased borrowings.  We don’t have to wait until 2037 for the Trust to run dry; there are no real assets in it now.    

The current debate about the “Bush” tax cuts is a smokescreen which obscures a much deeper problem: a minor manipulation of marginal tax rates is not an adequate response to what Alan Greenspan recently described as a pending catastrophe.  We cannot tax cut our way to prosperity.  We cannot tinker this broken system to solvency.  Equitable and effective tax reform will require a structural rethinking of tax revenue policies. 

Neither the Simpson/Bowles’ nor the Rivlin/Domenici’ proposal address these critical problems.  Both Commissions address the challenge of social security by arguing we should start the process of breaking benefit promises without illuminating, or even acknowledging, the underlying inequity of how the contributions have been squandered to date.  Both plans will perpetuate and indeed exacerbate existing policy flaws. 

The critical first step in reforming our policies is to illuminate the deep, deep inequities that currently exist – and then evaluate how to correct them.  There are two questions we should be asking. 

  1. Is it right for us to continue taxing the middle class at higher rates than we tax the wealthy? 

  2. Is there a more effective tax structure we could use which would allow us to normalize tax rates between the working class and the investment class without stifling economic growth? 

For what it’s worth, I think the answers are respectively, and firmly, NO! and YES! 

Douglas Hopkins

Author – A Citizen’s 2% Solution:  How to Repeal Investment Income Taxes, Avoid a Value-Added Tax, and Still Balance the Budget. ISBN 978-0-9828328-0-6 www.2pctsolution.com

For a more specific and expanded response to the Simpson/Bowles proposal go here.

Simpson / Bowles Reform Proposal

Yesterday, Erskine Bowles and Alan Simpson, Co-Chairs of the President’s National Commission on Fiscal Responsibility and Reform, posted a 50 page powerpoint presentation on its website, their Draft Proposal to reform tax policy and put America’s budget back on a sustainable path.  In the area of cost reductions, I commend them for the effort.  They set forth a meaningful, yet understandable, discussion of the nature of changes which need to be considered and implemented in order to rein in rampant government growth and reduce our federal disbursements.  The bulk of their “illustrative cuts” in both Defense and Domestic spending should be implemented immediately.  One may quibble with the estimates and/or achievability of certain of the cost reductions, but they require no changes in law or extended debate – they simply require Executive and Congressional action.  The fact that they have not been addressed or implemented by Congress or the White House, and need to be articulated by a “nonpartisan commission” is a clear and simple indictment of our governmental dysfunction. 

Unfortunately, on the revenue side, I cannot provide Mr. Bowles and Mr. Simpson with a similar commendation.  Despite their oft-repeated insistence that “everything must be on the table” they have turned a blind eye to the fundamental inequity of our existing tax revenue policies.  They have neither acknowledged nor addressed the fundamental bias our tax policies have in favor of the already wealthy.  By ignoring this fundamental problem I believe they have set forth a proposal which would actually increase those inequities.  By my reading, their plan has two primary flaws.  First, it raises tax rates on investment income in precisely the manner which most economists have advised for years would stifle growth and investment.  Second, it makes our existing regressive policies still more regressive and does nothing to slow or reverse the steadily increasing concentration of wealth in our society.  I believe their proposals would increase the existing counter-productive incentives which stimulate tax avoidance strategies, thus slowing economic growth, and accelerating wealth concentration. 

Buried in a footnote on slide 24 they state that “all options … treat capital gains and dividends as ordinary income”.  If they have summarized their estimated impact of that assumption anywhere I did not find it.  Nor did I find any discussion of the pros or cons of such an action.  But the existing justification for granting capital gains and dividends preferential reduced tax rates is fifty plus years of economic advice and opinion citing higher taxes on investment income as an impediment to economic growth.  If the economic community has suddenly stepped forward and rescinded their previous opinions, I somehow failed to receive the memo. 

I am a staunch and vociferous critic of preferential tax treatment provided to the wealthy, and I have no doubt that the intention of the Co-Chairs’ proposed increase in tax rates upon investment income is to address this inequity, but I question the judgment behind this proposal.  History has repeatedly shown that higher tax rates imposed through our existing structure are counter-productive.  Having left the deferral for unrealized gains in place, the Co-Chairs’ Proposal will have the easily foreseeable, though presumably unintended, result of exacerbating existing preferences that obstruct the productive redeployment of capital.  Investors will react in precisely the manner economists have been cautioning against for years; those wealthy enough to do so will reassess their capital allocations with an eye sharply focused on tax preferences, hiding income, and trading capital gains and dividends for unrealized gains.  So long as they can obtain higher returns at less risk through tax avoidance strategies than via growth strategies, investors will favor tax avoidance strategies.  Why has the Commission not addressed these deeply ingrained preferences?  Where are the structural changes needed to eliminate these counter-productive misincentives?  Where are the pro-growth innovations and reforms we need in order to pull the economy out of the doldrums? 

Moreover, the Simpson/Bowles’ proposals do nothing to shatter the Myth of Progressive Taxes.  The combination of employment taxes and income taxes will continue to leave the working middle class paying a higher marginal tax burden than the wealthy.  For the past roughly fifty years we have collected more in employment taxes than we have paid out in benefits – and we have used it all to fund structural current deficits.  But we persist in calling employment taxes “contributions”, and claiming that nearly half the population pays no taxes – thereby derailing productive, rational and honest debate about the true distribution of the costs of government.  The Commission is perpetuating these intellectually dishonest misrepresentations.  Where is there recognition that the social security trust fund is already devoid of assets?  The Commission takes a short step forward by proposing to increase the cap on taxable wages.  But why slowly over time?  How do they keep a straight face when they state (on slide 46) they will “prevent rapid build-up of the trust fund” – as though that were desirable?  The retirement savings funded by the public over the last fifty years has been squandered, replaced with IOU’s backed by nothing more than the government’s promise to raise future taxes or borrow more money.  The Commission has devoted the bulk of its discussion of Social Security to suggestions about how to start breaking the promises made over the past fifty years.  But they persist in perpetuating the misrepresentations through which government shields the privileged asset-holding elite from bearing a fair share of the costs of the important social programs which now represent half of federal outlays. 

Effective tax reform will require a more honest assessment of our current situation, followed by a fundamental shift in the structure of tax revenue policies.  (Specific proposals of the type of structural modifications I think are required can be found elsewhere on this site.) The Commission has done a commendable job of illuminating the issues and opportunities which need to be confronted in order to start controlling Defense and Domestic program disbursements.  Now we need to send them back to the drawing table to confront and address the inequities of our revenue policies.

Comments, replies and rebuttals are invited and will be welcomed. 

Douglas Hopkins

Author – A Citizen’s 2% Solution:  How to Repeal Investment Income Taxes, Avoid a Value-Added Tax, and Still Balance the Budget.