A Citizen's 2% Solution

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

Archive for February, 2011

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