A Citizen's 2% Solution

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

Category : Investment Tax Policy

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?.)

Stimulating Job Creation

The business and political press is anxiously awaiting Fed Chairman Ben Bernanke’s pending speech from Jackson Hole later this week,  looking for him to once again prop up the financial markets with words of wisdom and promises of support.  The market has already exhibited signs of lift in anticipation and pundits are offering subtle and not so subtle threats of coming catastrophe should he dare to disappoint – because while we give lip service to job creation, what we really seek from our financial leaders are perpetually rising stock prices. 

The rationale for the Fed’s persistent zero interest rate policies, and any other feats of legerdemain and levitation that Mr. Bernanke may  produce from his hat, is that they are supposed to stimulate productive investment.  But they don’t.  They stimulate leverage and financial speculation.  They stimulate inflated asset valuations:  bubbles, destined to pop. 

The rationale for preferential tax rates on investments is the same; it is presumed that savings and investment must be subsidized by preferential tax policies in order to stimulate growth.  But here again, reality has diverged from intention.  Our tax code has evolved to incorporate byzantine complications and exceptions which have the unintended impact of subsidizing unproductive capital and obstructing its free and fluid reallocation to more productive uses.  By sheltering investors from losses and subsidizing low return investments with tax preferences, our current investment tax structure impedes productive private investment and is a brake upon the economy.  The impact is directionally the same as with artificially low interest rates;  tax preferences which subsidize low return capital distort valuation metrics, inflate the value of unproductive assets, and help make financial speculation more profitable than productive enterprise. 

The popular consensus claims that slow private sector job growth is a result of high taxes.  But reality suggests that slow job growth is more accurately attributable to misplaced subsidies and incentives in government tax and monetary policies that are diverting private investment away from productive job-creating opportunities.  

Private job growth will not significantly recover until we change those policies. 

How big is the opportunity?  The Fed reports aggregate Household and Nonprofit asset holdings total approximately $72 Trillion.  Reallocate 3% of that toward more productive activities and you will unleash $2.1 Trillion of private stimulus.  Now measure that opportunity in relationship to the obstacles, both political and financial, of a comparable public stimulus program.  A $2 Trillion government stimulus program, initiated over a twelve month period, would require increasing federal disbursements by well over 50%, placing vastly increased pressure upon the federal balance sheet and its continuing solvency.     Not only does the private balance sheet have more capital to draw upon, more productive reallocation of private capital has its own underlying benefits, while all government expenditures eventually must be funded from tax revenues, either current or future. 

Late last week the Obama administration floated a trial balloon proposing to bribe business to increase hiring with new tax credits and increased subsidies.  Business leaders, true to form, responded with cautious optimism, quietly salivating over the prospects of another opportunity to feed from the public trough.  But increasing credits and subsidies is simply doubling down on the cause of our problem.  We need to return to principles of more equal treatment that lie at the core of both democracy and capitalism.  We need to unwind the rat’s nest of special preferences and subsidies that raid the treasury and distort investment incentives.   

The key to private job growth is comprehensive structural reform of investment tax policies.   I believe if we level the playing field and stop subsidizing unproductive capital with preferential tax and monetary policies the natural response will be an aggressive reallocation of private capital that would provide far greater economic stimulus than anything government can afford to offer

If we desire to stimulate job growth we must first examine and acknowledge the myriad ways in which current policies are obstructing it. 

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

Guest OpEd published by Commercial Finance Association

The following editorial opinion was published by the Commercial Finance Association in the July/August edition of The Secured Lender. To read it at the TSL site click here. To view a pdf version of the TSL publication click here.

Want to Stimulate Economic Growth and Job Creation? Try Reinvigorating Capitalism

Over the past year the budget debate in Washington has heated up – driven by an angry populist energy that screams out at our political class demanding government reform its profligate spending. For the first time in my recollection Congress is seriously considering substantive cuts in the scope and cost of government programs. It is understandable and appropriate. It is commendable. But it attacks only one side of the problem – and perhaps the less important side.

Effective fiscal reform cannot be achieved by focusing on just the expense side of the equation. We must demand Congress address the revenue side of our tax policies, not just because we need to generate more revenue, but more importantly because our current policies are deeply inequitable and riddled with misguided incentives.

Incentives matter. And the incentives currently imbedded in our tax code are stimulating speculative, non-productive trading activities, driving jobs and investment overseas, and obstructing the fluid reallocation of capital to more productive uses. The unintended consequences of existing investment tax policies have been instrumental in destabilizing our economy. High nominal corporate tax rates discourage domestic hiring and investment and encourage tax avoidance activities, including off-shore transfer of profitable operations. Reduced tax rates on investment returns and deferral of taxes on “unrealized gains” subsidize low profit and loss operations, discourage capital reallocation and actively stimulate asset valuation bubbles. We are crippling our economic engine.

As to equity: We lie to ourselves and pretend we have a progressive tax system, but inclusive of employment taxes, the working middle class bears a marginal federal tax burden twice as high as that imposed upon their more affluent neighbors. Where is the public rage against this inequitable assessment of our tax burden? Today a large part of our population argues against their own principles of equal treatment and personal self-interest because our leadership pretends employment taxes are ‘contributions”, not taxes. But Washington, beware – someday the public will wake up to this deception and the resulting demands for change will be far louder and insistent than anything seen from the Tea Party so far.

Why do Warren Buffett and his fellow billionaires pay tax rates only half as high as the working middle class? Why does our society, founded on the principles of democracy and capitalism, perpetuate policies which provide preferential treatment to the wealthy, distort investment decisions, and are resulting in an ever-increasing concentration of wealth?

Justification certainly can’t be found in the theories of Adam Smith, who advocated, “Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest in his own way, and to bring both his industry and capital into competition with those of any other man or order of men.” I’m confident Mr. Smith wasn’t contemplating an unequal competition in which the wealthiest and most privileged among our society are subsidized with preferential tax rates.

True believers in capitalism, who understand how entrepreneurial vitality in pursuit of competitive self-interest drives economic growth, should recognize that preferential tax policies offered to an elite class of citizens are incompatible with the core premise of capitalism. It constitutes cronyism; and cronyism is not just ethically wrong – it destroys the vitality and benefits of capitalism.

Effective tax revenue reform will require structural change, not just a change in rates. But if we reform investment tax policies and eliminate the subsidies and mis-incentives that currently distort investment decisions, we can normalize tax rates between labor and investments while simultaneously stimulating more productive investment in America.  We can once again unleash the full entrepreneurial energy of capitalism.

Douglas Hopkins

President – Kestrel Consulting, LLC

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 an expanded discussion of a potential alternative tax structure designed to stimulate more productive allocations of our national wealth, see –

Premise – A Citizen’s 2% Solution

Could Higher Taxes Stimulate More Productive Investments and Growth?

It is a popular truism that “we get less of whatever we tax.”  It is similarly true that we get more of whatever we subsidize.  So eliminating subsidies for undesirable activity is just as important as reducing taxes on those activities we value. 

Following the core truism, when we tax income, profits and labor – we get less of them.  By taxing corporate profits and investment returns we get less productive enterprise and investment.  Since we value savings and investment we attempt to stimulate them by applying lower tax rates to investment income and capital returns than to labor.  There are many voices offering sound arguments that further reducing taxes on investment income – including total repeal of the corporate income tax – would further stimulate economic activity and growth.   For the record, I share this belief. 

But there is an ongoing debate that rages over whether further reducing taxes on investment income is appropriate as a matter of equity.  I also share this view; if the result of preferential tax treatment of investment income is that we absolve our investment class from paying a fair share of the burden of government, I must oppose it.  It is a dilemma.  This impasse is where the popular argument typically stops. 

But let’s look at the subsidy aspects of our current policies.  Our attempts to stimulate investment and savings by providing our investment class with preferential tax treatment are not only an insult to democratic principles of equal treatment, placing an unequal burden upon middle class wage earners,  they result in a variety of consequences which run counter to our desired economic goals.  Perhaps the most obvious and egregious example: by not taxing unrealized gains, we get more unrealized gains – locking investments statically in place, often unproductively, both depressing tax revenues and dis-incenting more productive investments

Our leadership justifies this undemocratic preference as a necessary evil in order to stimulate investment and growth – but the actual impact of these preferences runs directly counter to their stated objective.   Tax preferences offered to holders of accumulated wealth aren’t simply undemocratic, they are anti-Capitalist.  The Invisible Hand extolled by Adam Smith was supposed to operate blind of managed objectives, like Lady Justice, establishing a level playing field and relying upon the aggregate decisions of many individuals seeking advancement and self-interest to drive collective progress and prosperity. 

“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

I’m confident Mr. Smith was not advocating an unequal competition in which the wealthiest and most privileged among our society are subsidized with preferential tax rates.  Preferential treatment for the already privileged is Cronyism, not Capitalism. 

My point here is twofold.  First, preferential treatment of our investment class is an undemocratic and anti-Capitalist practice.  It not only runs counter to core American principles, it imposes negative consequences on our economy.   Second, and more importantly, the solution to this problem is not simply a matter of adjusting existing tax rates; it will require us to re-think the structure which we use to tax investment returns.   So long as we maintain our current tax structure, then the “common knowledge” opinion that raising rates will stifle growth, remains true.  Higher rates imposed upon investment returns will exacerbate the existing disincentives. 

Warren Buffett, arguably our most prominent capitalist font of investment knowledge and insight, has quite commendably, and publicly, decried the fact that he and the rest of his fortunate fellow billionaires are under-taxed, paying lower tax rates than their office staff.  He has come out publicly in favor of repealing the so-called “Bush tax cuts”.  But simply repealing the Bush tax cuts won’t make a significant dent in the preferences Mr. Buffett and his peers now enjoy; because very little of their income is derived from wages or salaries. 

I should perhaps be expressly clear here: this is not a narrow partisan critique.  Yes, a certain faction of the Republican Party has been most adamant and vocal about its pledge for “No New Taxes”.   But I’ve not heard many liberal voices challenging the preferences toward wealth which permeate our tax code and benefit their well-heeled campaign contributors.  The liberals who publicly argue for higher progressive tax rates on income while they quietly support the structural preferences toward accumulated wealth that effectively strip our tax system of any real progressive impact, are just as complicit as the conservatives in undermining the position of the middle class.  If enacted, higher progressive tax rates would be counter-productive – because our tax structure is the cause of our greatest tax inefficiencies and inequities.  

So unequal tax rates are undemocratic and anti-capitalist, higher taxes on investment income stifle growth, and increasing marginal rates on earned income is ineffective.  That leads us to the question  “Is there an alternative structure we could use which would allow us to equalize tax rates between investments and earned income without stifling investment and growth?”  I think there is.  I think we need to take the blinders off and broadly reassess our approach to taxing investment returns in America. 

Today, we not only apply preferential rates to most forms of investment returns, we have constructed complex and self-contradictory definitions of what and whom is “taxable” – and have reached a point where “taxable investment returns” have become a very poor proxy for real returns.   We provide subsidies and preferences for unproductive capital allocations – and thus, back to my premise, we stimulate and obtain more unproductive capital allocationsBy punishing productive capital with taxes, and subsidizing non-productive capital we also distort valuation metrics – and stimulate asset valuation bubbles

It may at first sound heretical, but I believe we should shift our perspective toward wealth itself as an appropriate and far more even-handed basis for taxation.  If we want to unleash the full power and vitality of capitalism, we need to stop distorting decisions about capital allocations.  Certainly one way to do that would be to repeal all taxes on capital and investment returns.  That is essentially the position taken by advocates of consumption taxes.  But, as noted at the outset, that has the effect of absolving our investment class from paying a fair share of the burden of government.  The wealthy neither need nor deserve such absolution.  Utilizing consumption taxes as the primary source of government revenues  would shower unneeded benefits upon those among us who do not need to, indeed could not possibly, consume all their income. 

But there is an alternative.  We can remove the distorting influences we now impose upon capital allocations by simply applying equal treatment.  I believe we should apply a nominal tax directly upon accumulated net wealth, with the objective of taxing its earnings potential at a rate equivalent to that imposed upon earned income.   Such a policy would remove the fickle and discriminatory hands of Congress and the IRS from influencing investment decisions and unleash that Invisible Hand of Capitalism. 

Specifically, I propose We should combine and simplify our existing employment and income taxes into a single two-tiered income tax and supplement it with an annual 2% Tax on Net Assets.  Corporate income taxes, personal investment income taxes, estate and inheritance taxes and gift taxes should all be repealed.

Assuming a long term WACC (weighted average cost of capital, the earnings potential of capital) of 8%, a 2% tax on net assets represents a 25% effective tax rate.  If we simultaneously drop our maximum earned income tax rate to the same 25% (inclusive of all employment taxes, including the so-called employer portion) we will impose equal treatment across investments and salary and wages. 

Overall tax revenues would rise dramatically, because we would be removing the deep preferences toward wealth which have driven a massive increase in the concentration of both wealth and income over the past three decades – but the mis-incentives of our existing investment tax structure would also be removed. 

We do not need to make the working class subsidize our investment class in order to stimulate investment.  If we collectively believe in Democracy and Capitalism, as I do personally, we should recognize that imposing more equal treatment to the tax code and unleashing that Invisible Hand, would constitute a return to the core principles which act as the drivers of our American Dream of Equal Opportunity. 

Before closing, I’ll offer three more issues of perspective. 

1)            Making accumulated wealth the basis of taxation would admittedly change the dynamics of current valuations and moderate and suppress certain non-productive business and asset valuations.  But that would be a good thing, in that it would stimulate reallocation to more productive enterprises and ameliorate the bubble valuations we now alternately stimulate and regret. 

2)            Today we have enormous hidden “taxes” in the form of inflation.  So one way to think about what I am proposing is that we would be swapping the hidden taxes of inflation, the bulk of which do not flow to the Treasury for the use and benefit of government, for direct taxes which will flow through the Treasury, allowing us to balance the budget and stabilize the currency – thus maintaining the U.S. position as the world’s reserve currency and making America more attractive to all forms of investment.

3)            I am very supportive of current efforts to impose fiscal responsibility and a sense of reality upon our budget process.  But unless and until we address the issue of equity (real and perceived) in our tax revenue policies I believe we will be unable to marshal the collective public will to implement the important changes in entitlements and other program disbursements that we clearly and urgently need.  I believe that those who believe we can find a path to fiscal solvency by cost-cutting alone are deluding themselves. 

I would welcome any reply, observations or rebuttal you might care to offer, 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

Our Current Tax Debate is Intellectually Dishonest

I believe we cannot and will not make progress on tax reform as long as our leadership allows the conversation to be framed by the intellectually dishonest claim that “nearly 50% of Americans pay no taxes”. 

Whether it is self-delusion, or willful distortion, the only way that allegation is true is if you close your eyes, hold your nose and pretend employment taxes aren’t taxes.  Instead of using smoke, mirrors and semantic nonsense to hide the fact the rich pay lower marginal tax rates than the working middle class, we need to confront that reality head-on.  If we would, I believe we could find a more equitable alternative. 

If the investment class paid tax rates comparable to what the working class now pays – we would have a balanced budget today.[1]  Make that your new perspective, and suddenly the challenge changes.  It is no longer, “How do we hide (or justify) the fact the rich are paying less?”  Or, “How do we raise taxes without affecting the investment classes and thereby slowing growth?”  It becomes, “Is there a different tax structure we could use which would allow us to normalize tax rates between labor and investments without resulting in recession or slow growth?” 

I believe there is such an alternative structure, one that taxes accumulated wealth with a nominal constant assessment – effectively taxing its earnings potential at a rate consistent with existing earned income tax rates.  It removes the subsidies paid for non-productive or lower return investments and rewards the most efficient and profitable allocations of capital – thus, hopefully, stimulating more rapid growth.  My proposal may not be the best solution, but at least it addresses the challenge.  But so long as our major reform efforts are guided by insiders who seek to hide the inequities that now exist – don’t expect them to either embrace my proposal or discover a better solution. 

I’m not surprised that our political class is unresponsive to my attempts to stimulate a new perspective on this critical challenge.  We do not reward politicians who change their mind.  We have made politics a competitive team sport.   Once the participants pick a side they put their future in jeopardy every time they diverge from the approved party line or daily talking points. 

But where are the media and academic thought leaders who should be actively seeking out potential new lines of reasoning and alternative solutions to our widely acknowledged fiscal challenges? 

Effective fiscal reform cannot be achieved by focusing on just the expense side of the equation.  We must demand Congress address the revenue side of our tax policies, not just because we need to generate more revenue, but more importantly because our current policies are deeply inequitable and riddled with misguided incentives.    

I would welcome any reply, observations or rebuttal you might care to offer, 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 


[1] House Speaker John Boehner and Wisconsin Congressman Paul Ryan are half right.  We do have a very serious spending problem.  But denying the fact we have a revenue problem, regarding the magnitude of legitimate needs, the inequitable distribution of the burden, and the misguided incentives imbedded in current policy, is dangerously irresponsible. 

Want Job Growth? – Reinvigorate Capitalism

As I observe America’s current dysfunctional policy and budget debates I scratch my head in bewilderment, franticly searching the braincells and bookshelves where I store lessons and concepts about the theory of capitalism in fruitless search for justification of current tax and monetary policies.  I find no such justification.  When was capitalism redefined to become a system that provides favored treatment to the privileged few? 

I’m sure some will say it was always thus.  But that certainly isn’t what I remember being taught in school.  As I remember it, the twin pillars upon which capitalism relies are 1) property rights which allow one the ability to accumulate and retain the fruit of one’s own labor, and 2) fair and open competition in pursuit of personal self-interest.   So how did we come to corrupt and undermine our central economic theory by imbedding undeserved and unnecessary preferences toward wealth in our tax code?    When and why did we decide that savings and investments are inadequately incented by self-interest and thus require and deserve government subsidy?   Why do Warren Buffett and his fellow billionaires pay tax rates only half as high as the working middle class? 

Justification certainly can’t be found in theories of Adam Smith, who advocated, “Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest in his own way, and to bring both his industry and capital into competition with those of any other man or order of men.”  I’m confident Mr. Smith wasn’t contemplating an unequal competition in which the wealthiest and most privileged among our society are subsidized with preferential tax rates.  So why have the laws which constitute our tax code diverged so sharply from the simple principles of justice and equity? 

True believers in capitalism, who understand the power that entrepreneurial vitality in pursuit of competitive self-interest has to stimulate economic growth, should recognize that preferential tax policies offered to an elite class of citizens are incompatible with the core premise of capitalism.  It constitutes cronyism; and cronyism is not just ethically wrong – it destroys the vitality and benefits of capitalism. 

The American ideal of equal opportunity for all citizens is based upon the principles of liberty and personal responsibility.  Our tax code infringes upon both.  We impinge upon the liberties of the working middle class and constrict their opportunity for advancement by making them bear a disproportionately large portion of the burden of government.  We then exempt our investment class from responsibility for shouldering their fair portion of the cost of government – and in so doing, we inadvertently impose perverse financial incentives that act against our collective interests.  We are subverting the fundamental features of our government and social structure that have been the source of our strength for over two hundred years. 

Back to my primary point:  Why is job growth so slow?  I have a hypothesis.  I believe it is because our tax and monetary policies have made tax avoidance and valuation manipulation more profitable than productive enterprise. 

Specifically, America’s political leadership and financial gurus became so focused on wealth as the measure of prosperity, that they began showering privileges upon the financial services industry.  In hot pursuit of Alan Greenspan’s “wealth effect”, they created policies which stimulated asset valuation bubbles and destabilized the economy.  Yes, when people felt wealthier, they spent more, and stimulated a consumer driven economic boom.  Had the wealth that supported that boom been “real”, that would have been fine.  But to the extent it was the phantom effect of irrational, speculative valuations in dot-com’s and mortgage securities, it was unsustainable and destabilizing in its effect.  How have we responded to the resulting recession?  By trying to re-inflate the asset bubbles.  By propping up the financial institutions that caused the debacle and ignoring the structural imbalances and mis-incentives at the core of our problem.  By bailing out the at-risk investors on the backs of middle class taxpayers and future generations. 

Despite Lloyd Blankfein’s proud proclamation, “I am doing God’s work”, and the popular pretence that finance is the engine of economic energy, annual IPO proceeds into publicly traded firms are less than 1% of annual trading value.  The vast preponderance of transactions generated by the financial services industry is aimed at manipulating valuations and shuffling and re-shuffling ownership interests – not stimulating productive enterprise.  

Yet we let Wall Street guide Washington.  I think we need to restructure our tax and monetary policies with regard to returns on capital to refocus energies on creating more productive enterprises. 

Incentives matter.  And the incentives currently imbedded in our tax code are stimulating speculative, non-productive trading activities, driving jobs and investment overseas, and obstructing the fluid reallocation of capital to more productive uses.   High nominal corporate tax rates discourage domestic hiring and investment and encourage tax avoidance activities, including off-shore transfer of profitable operations.  Reduced tax rates on investment returns and deferral of taxes on “unearned income” subsidize low profit and loss operations, discourage capital reallocation and actively stimulate asset valuation bubbles.  We are crippling our economic engine. 

The budget debate in Washington is presently focused exclusively upon disbursements – driven by an angry populist energy that screams out at our political class demanding government reform its profligate spending.  It is understandable and appropriate.  It is commendable.  But it attacks only one side of the problem – and perhaps the less important side. 

Where is the rage against the inequitable assessment of our tax burden?  Where is the rage against the unintended consequences of subsidizing unproductive capital?  It has been diverted by intellectual dishonesty among our political and economic leadership.  Our federal government has crafted a remarkably Byzantine structure of incentives and preferences; taxing revenues differently based upon their varying source and magnitude, pretending employment taxes aren’t really a part of the general revenues, using exclusions, deductions, multiple rate schedules,  alternative minimum calculations, surcharges, phantom trust accounting, etc., etc. etc., ad infinitum, all apparently designed to provide politicians tools with which to fractionalize and bribe their constituents  and reward their campaign contributors.    It appears designed to ensure that no two citizens receive equal treatment.  It is crippling our economic engine. 

We lie to ourselves and pretend we have a progressive tax system but, inclusive of employment taxes, the working middle class bears a marginal tax burden twice as high as that imposed upon their more affluent neighbors.  Washington beware.  Some day the public will wake up to this fact and the resulting demands for change will be far louder and insistent than anything seen from the Tea Party so far.    

Effective fiscal reform cannot be achieved by focusing on just the expense side of the equation.  And economic vigor cannot be optimized unless we stop subsidizing unproductive behavior.  The preferential treatment offered to holders of great wealth not only deprives government of needed revenues, the unintended consequences of those structural preferences has been instrumental in destabilizing our economy. 

We need to reform and impose more equal treatment upon our revenue policies.  If we acknowledge and remove the preferential treatment toward holders of pre-existing wealth, and eliminate the subsidies and mis-incentives that currently distort investment decisions, we can normalize tax rates between labor and investments while simultaneously stimulating more productive investment in America.  We can once again unleash the full entrepreneurial energy of capitalism. 

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. ISBN 978-0-9828328-0-6

Related posts:

The Big Lie of Government: the Myth of Progressive Taxes

Re-thinking Investment Income Taxes

Social Security: Trust? Or Ponzi Scheme?

I recognize that some readers may think that comparing a government Trust Fund to a Ponzi Scheme is too harsh; and it certainly is not going to make me many friends among the powerful present, past and future Trustees of the Social Security program.  But one of my life lessons (absorbed through nearly thirty years of crisis management and business workouts – a field ripe with willful denial of inconvenient facts) is that people have an astounding ability to hear what they want to hear.   So it’s important to be very clear and direct, particularly when challenging long-held beliefs.  It is my observation and opinion that the semantic misrepresentations and confusion surrounding social security, specifically with regard to employment taxes and the “Trust Fund,” are a serious obstacle to productive debate about tax reform and governmental fiscal responsibility. 

Our current tax debate is framed around the allegation that “nearly one-half of the population does not contribute to the costs of government”.  When it is most carefully framed, the specific charge is they “pay no federal income tax” – but whether it is carefully or carelessly framed the implication is clear: it is an accusation that nearly half the population is composed of deadbeats who shirk their responsibilities.  But the only way this allegation, which has become a central polarizing theme in the debate, is true, is if you close your eyes,  hold your nose, and pretend that employment taxes aren’t taxes. 

Last year, for the first time, the social security program turned cash flow negative: it paid out more in benefits than it collected in “contributions”.   Although our political leadership and the Social Security Trustees assure us that this change isn’t critical, that the Trust remains adequately funded at least until 2037, if you’ve been paying attention you might have noticed that those same Trustees have begun squirming a little bit more uncomfortably every time they are trotted out in front of the klieg lights to provide that reassurance.  They should.  Because their claim is essentially hogwash. 

If you want to hear somebody else tell you the same thing in kinder and gentler terms, I urge you to go read the post “No Nest Egg in the Trust Funds” on the Concord Coalition website.  They will cite the same facts, as they have done for years, but they will do it in such soft and gentle tones that you may miss the point.  The social security trust fund is composed of pieces of paper in a drawer at Treasury which essentially say “I Owe Me”.   They do not represent invested assets held in Trust as a source of funding for future obligations.  They simply represent acknowledgment that the government uses your contributions to social security to fund its general operations. 

As it comes time to honor those paper obligations the only available resources from which to do so are future taxes, or future borrowings.  Understand that clearly.  Those notes in the drawer at Treasury document the diversion of contributions to use for other purposes – they do not represent assets available to support future funding needs.  

It is notable that when the Congressional Budget Office (“CBO”) reports our annual deficits they treat employment taxes the same as they treat all other general revenues.  For decades our financial stewards have netted the surplus collections from employment taxes against overall disbursements when calculating and reporting our annual deficits.  Similarly, when the CBO reports the national debt, they focus on Debt Held by the Public, pointedly excluding social security trust obligations in a tacit acknowledgement the accounting entry represented by the trust fund has no meaningful impact upon the national balance sheet.  Thus, if I ignore the semantic legerdemain used with regard to the social security trust, and focus strictly upon the underlying facts, I am forced to conclude that the only functional purpose of differentiating between employment taxes and income taxes is to hide the fact that the working middle class pays higher marginal tax rates than their wealthier and more privileged neighbors

High earnings (currently any in excess of $106,800) and all investment income are shielded from social security tax assessments.  Why is that?  Do we really think the most fortunate among us 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.  Are we going to continue shielding high earnings and investment income as those programs advance toward and rapidly exceed 50% of overall outlays?  Our tax policies assess the vast bulk of the obligation for these important social programs upon low and middle income wages and salaries.  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. 

Another life lesson absorbed over the years is that sound decisions cannot rely upon inaccurate facts or intellectually dishonest mischaracterizations.  This is, of course, the crux of the problem.  For at least thirty years our leadership has publicly acknowledged and widely bemoaned the fact that our budget policies have placed us on “an unsustainable path” – but the debate about reform has been derailed by mischaracterization of the facts. 

There is a deep divide between what social security is, and was intended to be, and what the public believes it is and demands from it.  Whether caused by gross and deliberate deceptions, or actively encouraged misconceptions, the lack of understanding among the public that exists related to social security is a serious obstacle to the tax reform debate.   

Social security was sold to the American public as a “savings program”.  But it is not a savings program.  If it were, contributions made today would be segregated and invested and future benefits would be reliant upon and funded by those contributions and the investment earnings accruing thereupon.  That does not happen. 

Social security is a social program.  It represents a collective decision by society to provide certain benefits and protections to its citizens.   We confuse the issue by pretending it is a savings program.  We confuse the issue by pretending that the contributions we diverted yesterday to other uses will somehow still be available for use again tomorrow.  We distort our tax debate by pretending employment taxes aren’t taxes.  We argue about marginal income tax rates, and claim the rich are bearing too high a burden; but as argued more fully nearby, our progressive income tax policies are more illusion than fact.  See Myth of Progressive Taxes.  Progressive rate schedules apply to less than 25% of the overall federal/state/local tax burden.  Inclusive of employment taxes, the working middle class pays higher marginal tax rates than the very wealthy.    

There are presently multiple proposals under consideration aimed at modifying (i.e. reducing) the benefit provisions of the social security program.  Based upon the trajectory of its program disbursements there should be no dispute that some modifications are necessary, indeed critical.  But there is essentially no debate underway about the fundamental logic (illogic) of funding those important programs solely on the backs of the working middle class or the outright duplicity of pretending the “I Owe Me’s” held by the Trust represent anything more than an accounting exercise. 

I consider it irresponsible to attempt to roll back the entitlement promises of social security without even acknowledging or addressing the irrationalities and inequities we have built into our tax revenue policies.  Conservative Republicans will tell you that we don’t have a revenue problem, we have a spending problem.  They are half right.  We do have a spending problem.  But we also have severe revenue problems.  We are burdening future generations with mountains of debt while we provide holders of existing wealth with favored tax treatment they neither need nor deserve. 

Until and unless we stop misconstruing the facts, I don’t believe we can make meaningful progress on placing either social security or our overall budget policies back on a responsible and sustainable path.   If we really want to make progress in resolving our fiscal challenges we need to stop all the pretending.  First and foremost we need to stop pretending the rich are over-taxed while the middle class pays higher marginal rates.  That fundamental intellectual dishonesty derails our productive debate – and the shell game we play by mischaracterizing employment taxes and the trust fund is the central point of that deception

We have some very difficult and painful choices to make.  We need to acknowledge the conflicts between what we have, what we want and what we can afford to do.  We ought to be making those choices based upon an honest assessment of the facts. 

By failing to acknowledge or address the flaws of our revenue policies and focusing solely upon cost cuts, 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 choose to believe 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. 

Why do I believe that?  Because it would be just too depressing to believe that they are engaged in a willful conspiracy against the middle class.  However, based upon the facts, such a conspiracy would be easier to argue. 

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. ISBN 978-0-9828328-0-6

Taxing the Rich

In its weekend edition of January 29th the Wall Street Journal published two articles about taxing the rich, a “How to” challenge from cartoonist Scott Adams and a historical survey authored by Joseph Thorndike, director of the Tax History Project of the non-profit Tax Analysts organization.  Interestingly, it was the tongue-in-cheek cartoonist who offered the more positive and productive food for thought.  Without laying aside his entertaining irreverence Adams started with the indisputable observation that “rich people have enough clout to block higher taxes on themselves”, and challenged the public to use its imagination to seek new and better ideas.  In contrast Thorndike, from the very title of his article, “Soaking the Wealthy: An America Tradition” reiterated the intellectual dishonesty that has stymied and stalled current tax reform efforts. 

 We have never soaked the wealthy.  (Yes, at post WWII peaks we certainly had very high marginal tax rates on wages and salaries, but even then we left substantial protections and loopholes available to holders of pre-existing wealth.)  Nor should we try to soak the wealthy.  Pretending that we do, or that that is a desirable goal, does not advance the debate. 

 Inclusive of employment taxes, today the working middle class pays higher marginal tax rates than the very wealthiest among us.  Our treatment of employment taxes seems deliberately designed to obscure this fact.  The progressive tax rates that Thorndike claims we rely upon apply to less than 25% of our overall national/state/local tax burden.  I don’t, and we shouldn’t, advocate trying to make the rich pay higher tax rates than the middle class.  But the working middle class should not be subsidizing low tax rates for the wealthiest among us.  Thus, Adams’ question of “how to tax the rich,” cuts right to the core of the challenge.   We think we should, we pretend we do, but we currently don’t effectively tax the rich

 There is a key insight that has been overlooked in our current debate about tax reform alternatives:  income (at least taxable investment income) is a poor proxy for wealth.  Our investment income tax policies have built in rate preferences and tax avoidance mechanisms.  Our tax policies impose lower rates on investment income than upon salary and wages, subsidize loss and low return investments, and obstruct the fluid reallocation of capital to more productive uses.  These misplaced preferences are the driving energy behind the asset bubbles which have undermined the stability of our economy.  Income deferrals and re-characterizations, and valuation manipulation strategies have become more profitable than pursuing productive job-creating investments.  Furthermore, the structure which we use relative to investment income makes it impossible to raise rates without stifling growth.  The structure of our current investment tax policies, particularly the corporate income tax, is a drag on economic growth.

 If you acknowledge these facts a potential answer begins to emerge:  we should tax wealth directly instead of pretending that taxing investment income is a viable proxy.  We should repeal the corporate income tax, capital gains and dividend taxes, estate and inheritance taxes, taxes on interest and any other mechanisms aimed at taxing returns on capital, and replace them with a nominal annual tax on accumulated net assets – at a rate consistent with the rate applied to earned income.  If you assume a WACC of 6% to 8% (weighted average cost of capital, the blended return on assets) a 2% asset tax equates to 25% to 33% of investment income – roughly equivalent to the range of marginal rates currently applied to wages and salaries. 

 Simultaneously flatten and reduce earned income rates to a maximum of 25% (inclusive of employer and employee SS/Med contributions) and you will return more equal treatment to the tax code and stimulate both hiring and real wage growth for the working middle class – thus stimulating consumer demand (supported by real wages not asset bubbles).   

Some may worry that an 8% return on capital is too high a target.  But I would posit that putting a practical floor under interest rates (precluding the Fed from continuing to pursue zero interest rate policies which benefit financial institutions to the detriment of investors) and moderating bubble valuations would make the long-term 8% target reasonable.  Or you could make it a 1.75% tax? 

Comments, replies and rebuttals are invited and will be welcomed – either privately via email or publicly as comments on this website. 

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

“Principled Compromise” is Not the Path to Effective Tax Reform

On January 25th, in his annual State of the Union address, President Obama reaffirmed his commitment to bring fiscal discipline back to our Federal Budget, declaring “Now is the time for both sides and both houses of Congress – Democrats and Republicans – to forge a principled compromise that gets the job done.”   Of course, the hall resounded with applause, optimistically reaffirming the desirability of this recurring broken promise.    But does anyone really believe this year is going to be different? 

Let’s examine his call for “principled compromise” critically.  I see two potential implications in that statement.   Either 1) we all know what we need to do, so let’s get the leadership from both sides in a room and get it done.  Or 2), this is simply a political task; we can each give a little, get a little, and claim success.  If either of those perspectives was true, we would have had a tax reform agreement long ago. 

So I’m sorry Mr. President, but if you expect progress you’re going to have to provide better leadership than that.  This intractable problem will not respond to “principled compromise”…. because the tax reform debate is dominated by three distinct, highly principled perspectives, each entirely exclusive of the others.  That means the only path to progress is for someone to change their mind.  But American politics doesn’t welcome or reward people who change their minds. 

Does that mean our task is truly hopeless?  Actually I think not.  Because the three alternatives that currently dominate the debate are all nearly equally bad…  which means if we open our eyes and minds, and reassess the facts and the arguments, we ought to be able to discard these unworkable proposals and move forward and find a viable alternative.  If you will stay with me and keep an open mind I’m going to suggest what I think may be a viable alternative.  But first, let’s address the three bad ideas. 

One:  Higher marginal tax rates imposed through our existing dysfunctional structure.  Predictably, the last time the President sent leadership to the woodshed (Simpson/Bowles et al, only twelve months ago) this was the plan they came back with.  Despite at least fifty years of economic theory and practical evidence that higher marginal rates imposed through our existing structure will accelerate tax avoidance efforts and stifle economic growth, indeed without bothering to even discuss how they came to discard that evidence, the President’s Commission came back advocating raising rates. 

I describe this approach as predictable, because political solutions, emanating from forced compromise, have little chance to be anything but incremental in nature.  Nevertheless, it is a bad idea.  Unless we fundamentally restructure the form of our tax policies, particularly in relationship to investment income, higher rates will stimulate more defensive capital allocations and further slow the economy.   Raising marginal rates, without removing structural preferences toward wealth, is a futile exercise.  Despite our vaunted nominal progressive tax rates, misguided structural preferences in our tax code result in Warren Buffett paying a 17% tax rate while his staff pays 33%.  There is a lesson in this fact.  Reforming our tax structure is more important than modifying our tax rates. 

Two:  A return to consumption taxes.   Roughly 100 years ago, Americans realized that over-reliance upon consumption taxes was stifling economic growth and placing too great a burden upon its less fortunate citizens.  In response, Congress shifted focus toward taxing income, imposing a deliberately progressive structure.  But in recent years there has begun to be a call for renewed reliance upon consumption taxes: a Value-Added Tax, a National Sales Tax, or some hybrid combination. 

The rationale for this move backward varies depending on its source.  Over the intervening 100 years since its introduction our income tax structure has been bastardized and its rates have been inflated to the point where it seems designed to ensure that no two citizens receive equal treatment.  So some advocates of consumption taxes, reacting (I believe) largely in disgust toward the increasing dysfunction of our income tax policies, seek simplification at all costs and advocate total repeal of the income tax.  They suggest replacing it entirely with consumption taxes.  Others (like the Rivlin/Domenici alliance who broke with the Chairs of the President’s Commission to offer a competing proposal) seem to recognize the futility of higher income tax rates. So, recognizing the need for higher revenue but unwilling to advocate repeal of income taxes, they simply propose overlaying consumption taxes.  For them consumption taxes are an add-on tax, not a replacement tax. 

 But while they may seem to some a politically more palatable option – less likely to draw the ire of Congress’ wealthy and influential key campaign finance contributors – whether advocated as a supplement or replacement to existing taxes, consumption taxes are a bad idea.  They are by nature regressive.  They place a higher burden upon those at the bottom of the ladder of success than upon those at the top.  They take existing inequities in our current tax policies and make them worse.  They are a gift to the wealthy and an undue burden on the poor. 

But, say the advocates, we can fix that; and they offer a variety of complex credits or exceptions aimed at protecting the poor from that unfair burden.  The flaw here of course is that by combining a gift to the rich with protection for the poor, consumption taxes will fall heavily upon the working middle class.  They will raise the price of everything and further depress consumer demand.  I will repeat myself.  They are another very bad idea. 

Three:  Let’s keep cutting taxes.  Most Americans seem to share a common personality trait: an innate antipathy toward taxes.  We abhor taxes.  And we don’t feel much better about government in general.  So when our leaders tell us that government is the problem and if we just keep cutting taxes the government will eventually have to shrink, we want to believe that.  Get government out of the damn way and America’s entrepreneurial spirit will bring us back to Days of Glory!  Hallelujah Brother!!  [A point of disclosure:  Before I embarked last year on a personal journey of factual analysis – I subscribed to this view.]

But let’s face facts.  Maintaining a belief in Reaganomics today is simply making a religion of cognitive dissonance:  clinging to hope and wishful thinking despite overwhelming contradictory factual evidence.  No matter how logical and enticing it may have seemed to believe that reducing tax revenues would control the growth of government, Congress instead embraced deficits and went on an uncontrolled spending spree.  Artificially low tax rates, combined with preferential treatment of investments, did not bring us to the land of milk and honey.  They fueled repeated asset bubbles, an increasing concentration of wealth and income, and eventually triggered our current financial crisis.  Even in the boom times, the benefits did not trickle down. 

Today politicians and economists from the Right, Left and Center, all seem to be focused upon trying to re-inflate the bubbles – instead of rethinking false assumptions and broken models.  But denial is not a plan.  We should be learning from recent history.  We need to recognize that flaws in our tax policy aren’t just the source of our budget imbalance, they played an integral role in destabilizing our economy.  We need fundamental, comprehensive, structural tax reform.  We need tax policies that will both stimulate productive economic growth and pay for the services we demand. 

Now before I proceed, I need to acknowledge Speaker Boehner’s battle-cry.  On behalf of his conservative and Tea Party constituents Mr. Boehner has become fond of saying “We don’t have a revenue problem, we have a spending problem.”  I wish I could believe him.  I’ve tried to believe him.  But it’s a fairy tale.  Yes, we need to cut spending.  The aggressive move from many in Congress aimed at cutting spending is the one bright spot I see coming from that institution.  And there, on the disbursement side, the challenge of principled compromise is appropriate.  For the most part on the expense side we do know what to do.  Principles and priorities need to be defended, but belts need to be tightened.  Congress has to stop bribing its constituents with borrowed money.  But cost cuts aren’t enough.  We need revenue reforms. 

Back to my point:  principled compromise cannot reconcile these three bad ideas.  We need cooperation, not compromise.  We need to stop thinking of tax reform as a political competition and recognize that it is an important societal challenge to which we need to find a better answer.   Both sides and both houses of Congress – Democrats and Republicans – and all Americans are facing the same challenge.  We need to acknowledge and discard the flaws in these bad ideas which currently dominate the debate and develop some new, better ideas.  We need to explore the underlying facts more carefully, and critically, and seek not compromise, but a better path. 

Twice in the last twelve months we’ve tried principled compromise.  Taking that as their charge the President’s Commission split and came back with conflicting recommendations, both calling for shared pain and both going nowhere.  Then in December both sides in Congress acquiesced to their opponents’ dearest principles and we got a bill with lower taxes and higher spending.  Principled compromise isn’t leading us to fiscal responsibility.    

I said at the beginning that I would offer a proposed alternative approach to reform.  But I’ve run past my allotted space so I’ll offer just the bare bones outline.  As noted previously, I started out aligned with the Reaganomics/Tea Party contingent thinking flattening rates was the answer.  But I was troubled by the question raised by Warren Buffett’s disclosure.  If Buffett pays taxes at half the rate of his staff, why do we claim the rich are overtaxed?  My conclusion:  they aren’t. 

Inclusive of employment taxes the working middle class pays higher marginal tax rates than the wealthiest among us.  Our progressive tax rates apply to less than 25% of the overall federal/state/local tax burden.  The privileged tax treatment provided to the wealthy via caps on social security contributions and reduced rates on investment income far exceed the value extracted from our progressive income tax rates.  The wealthiest among us, those who do not need to consume the income accruing from their wealth, can structure their investments to generate nothing but unrealized gains and avoid any annual tax obligation.  Politicians and economists on the Right and the Left turn a blind eye to these realities and ignore what I perceive to be the most promising route to effective reform.   

My suggestion:  Re-structure investment income taxes to stimulate more productive capital allocations and remove preferential tax treatment currently provided to holders of existing wealth.  Repeal the corporate income tax, the estate tax, and preferential tax treatment of capital gains, dividends and all other taxes on capital and replace them with a simple, nominal 2% annual tax on net wealth.  This would remove the structural incentives in the tax code which allow wealthy investors to minimize or avoid current annual tax obligations and subsidize lower investment returns with lower taxes.  These reforms would immediately stimulate private sector hiring and job growth.  If we simultaneously flatten and reduce earned income tax rates, we could also stimulate real  growth in wages for the working middle class and thus boost consumer demand.   

There is not space here to argue all the merits (or potential pitfalls) of what I’m suggesting.  Indeed, more important than arguing the merits of this particular suggestion, my point is that fresh ideas and new solutions are required.  The first step to finding them is weeding out the bad ideas.  If Congress could focus less on scoring political points or extracting concessions from the opposition and more on cooperating with their counterparts to seek a better path, this year might be different.  

Effective tax reform will not come from cobbling together compromise over bad ideas.  But if we reevaluate the facts and acknowledge the flaws of our current policies and proposals, if we listen more carefully to criticism and open our minds to fresh ideas and alternative perspectives, then cooperation might be a path to a fresh and more promising approach to reform. 

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. ISBN 978-0-9828328-0-6