A Citizen's 2% Solution

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

Archive for November, 2010

Rivlin/Domenici: Political Insiders deliver another Regressive Tax Proposal

In the past month two highly respected, extremely experienced alliances of leaders have set forth competing, yet similar, proposals to reform tax policy.  Alan Simpson and Erskine Bowles, Co-Chairs of the President’s Commission on Fiscal Responsibility and Reform and Pete Domenici and Alice Rivlin, Co-Chairs of the Bipartisan Policy Center’s Debt Reduction Task Force have brought forward plans they claim address our fundamental problems.  I believe both groups have demonstrated the same failing: an unwillingness to confront the deep inequities in our existing tax revenue policies.  I could lapse into anger here and accuse them all of being Crony Capitalists.  But instead perhaps I should take a more generous and forgiving attitude and attribute their failings to too much experience

It is much, much easier for someone who is curious and uninformed to accurately evaluate new facts than it is for someone who brings preconceived opinions to the task – particularly when those preconceptions have been developed based upon erroneous or misrepresented facts.  The reason is simple:  human nature.  As a species we have a remarkable capacity for forcing new facts into our preconceived view of the world.  Changing a fundamental precept of one’s world view is extraordinarily difficult – particularly when doing so requires one to admit personal complicity (whether witting or unwitting) in a longstanding problem.    

Both groups have undertaken to address the elephant in the room – America’s unsustainable budget policies.  Before I become too critical I should note that it is a worthy task and they both appear to have done a commendable job evaluating the disbursement side of the equation – discussing at length the irrational and irresponsible choices that our Executive and Congressional leadership have been making about how to spend our money.  Here their experience appears to have served them well.  Certainly their understanding of the intricacies of specific disbursement programs is much better than mine and while I’m sure there is room for argument and tweaking, I am confident that their cost reduction recommendations are fundamentally reasonable.  I could, of course, complain that there is really nothing new in their proposals; our government’s irresponsible lack of discipline on the spending side is very widely understood.  The absence of disbursement controls does not arise from lack of awareness; it is the result of Congressional irresponsibility and dysfunction.  But a complaint like that might seem churlish.  So I commend the Commissions.  Yet I fear that absent an even-handed approach to reforming our revenue policies their efforts will seem unbalanced and thus will fail to collect required support. 

Unfortunately, in my opinion both groups have formulated revenue proposals which are deeply flawed.  The revenue flaws in both plans, though different between them, arise from the failure to acknowledge or address the Myth of Progressive Taxes, defined and discussed nearby in a separate post.  In fact, both plans make existing policies worse. 

I’ve previously covered my assessment of the Simpson/Bowles plan (see here), so I will focus now on Rivlin/Domenici Bi-Partisan Policy Center’s (“BPC”) proposal – which is, in any event, the more interesting of the two revenue plans. 

Commendably, BPC has recognized that recovery from the recession is a goal that deserves at least equal priority with debt reduction.  However, it appears that they view the recession as a temporary decline in GDP – and thus make the mistake of believing that a temporary stimulus can lift us back to a viable “normal”.  I conclude that to be their belief because their stimulus response is the politically popular “payroll tax holiday”.  The payroll tax holiday proposal has acquired many supporters who believe that by quickly and widely putting more cash in the hands of the working public and operating businesses it will lead to a prompt increase in consumer spending and business hiring without either a) encountering the delay of government implementation planning or b) risking creation of new government spending programs which have a well-known history of self-perpetuation.  If I believed the recession was a temporary blip, I too might favor prompt temporary stimulus.  But I do not.  Let me explain my reasoning. 

As a long time consultant to troubled companies one of the first tasks I generally undertake when stepping into a fiscal crisis is to examine what the true historic norm has been.  All too frequently, particularly when booms suddenly turn into busts, re-evaluation of the facts suggests that reported history has been either misstated or misinterpreted. 

I’ve not seen anybody yet do that with our economic data.  I don’t have the data available at my fingertips to make that analysis in detail, nor the space to illuminate it here if I could.  But the broad strokes are pretty self-evident.  For at least a decade and a half we have been living beyond our means, using artificially inflated real estate equity (created by government and mortgage market policies and practices) to fuel spending.  That artificially inflated spending overstated normalized GDP but the structural under-pinnings of the economy were unsound.  For two years the bulk of our government’s reactive policies toward our recession have been aimed at trying to re-inflate the bubble.  Stimulus programs today are inflating current GDP.  In my opinion we’ve actually prolonged the problem with our reluctance to recognize the need for structural change.  The popular complaint that our problem persists because banks aren’t lending money is largely hogwash.  Most businesses don’t need more credit, they need more customers – and with unemployment at just a hair under 10% it doesn’t require an advanced math degree to see that one out of every ten potential customers is standing forelornly outside on the sidewalk, unable to enter the store.  One out of seven, if you include the “under-employed”. 

So, that being the case, explain to me why we should believe a “temporary” policy which puts more money in the hands of the people who do have jobs is going to change that dynamic?  Do we think they won’t notice that their personal situation and our collective situation both remain tenuous?  Do we think that the employer portion of the employment tax holiday, which will reduce payroll costs this year, will induce employers to add staff now while ignoring the normalized future costs of doing so?   If so, are we prepared to deal with the layoffs that will result as soon as we attempt to end the “holiday”?  Do we think either or both the employers and employees who receive these temporary income boosts will fail to notice they are only temporary in nature?   Temporary programs are not likely to lead to fundamental strength.  We need to be focused on reliable long-term policies.  There are some today who pooh pooh the “uncertainty” argument as explanation for a slow recovery.  But there is no uncertainty about the fact that costs are rising now and taxes are going to rise soon. 

Which of course brings us to the core of the BPC tax proposal – its 6.5% national sales tax which they characterize with a feel-good “debt reduction” designation.  Sales Taxes are regressive in nature – regardless of how you try to characterize them.  They fall heavily upon those among us who consume all their income, while the more fortunate and successful among us who do not need to consume all their earnings are shielded from the obligation.  Thus, the civic sacrifice of contributing to “debt reduction” is to be allocated heavily toward the less fortunate among us.  Rates across the board will fall, tax expenditures will fall, but the benefit of both these changes will tend to also skew most favorably toward the higher earners.  Provision for some protections for the lowest income earners appear to be incorporated in the plan, but by my perspective, if you favor the rich and favor the poor, you must be squeezing the middle class.  If I’ve missed something, please let me know.  But that’s how I interpret the proposal. 

Today, despite a great deal of semantic posturing, we have a very regressive tax system.  Our “progressive” rate schedules, which are subject to more exceptions than compliance, apply to no more than 20% – 25% of the total federal/state/local tax burden.  The wealthy receive far more benefit from social security contribution caps and treatment of investment income than is extracted by those progressive income tax rates.  (I won’t cite my full arguments here, but again will urge you to look at the analysis nearby.)  Rivlin/Domenici on behalf of the BPC have published a proposal I can only interpret as making our policies even more regressive. 

The BPC summary claims its plan is realistic and “politically viable”.  The hope, apparently, is that the temporary gift of a payroll tax holiday for the working middle class (which I believe will be ineffective in stimulating structural economic improvements) will garner broad support.  But I believe the real political viability of the proposal resides in the fact that it offers new long-term permanent preferences for existing holders of accumulated wealth – who (coincidentally?) comprise the politically influential. 

Nearly a century ago, America discerned the fact that over-reliance upon consumption taxes was an obstacle to growth and resulted in an inequitable burden upon the lower classes.  In response our leadership championed a constitutional amendment which led to the implementation of and our current reliance on income taxes.  Today, our tax policies once again are obstructing growth and placing an inequitable burden upon the lower classes.  Balancing the budget by imposing a national sales tax (or a VAT) would be a step backward, not forward. 

I believe that effective reform will require a substantial re-thinking of the existing preferential treatment provided to holders of accumulated wealth and a structural change in tax policies toward investments and investment income.  But unless and until our leaders are willing to confront the facts of those preferences, I see little hope of meaningful progress.  The collective economic judgment that higher taxes on investment income will result in slow growth has been used as justification for allowing our wealthiest and most successful citizens to pay lower tax rates on investment returns than the working middle class pays on the fruit of its hard physical and intellectual labor.  Instead of using smoke, mirrors and semantic nonsense to hide the fact the rich pay lower rates, 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.  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?” 

Elsewhere on this site you will see that 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. 

If someone from the economics field would like to step forward and instruct me in the error of my perspective, I’d be happy to listen.  If someone can explain to me the benefit of consumption taxes that overrides their fundamental regressive nature, I’d love to hear it.  If someone can explain to me why the wealthy really should be paying lower tax rates than the working middle class, I’m all ears.  Explain to me if you can, please, why the American public should be expected to support reforms that move toward even more regressive policies.  

Absent such explanations, I would like to urge our leadership to go back and confront the inequity of our current tax structure.  I don’t advocate imposing higher tax rates on the rich than on the middle class.  I’m just tired of subsidizing their lower tax rates – and suggest our leadership ought to be addressing that reality.   

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

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.