A Citizen's 2% Solution

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

Archive for May, 2011

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