A Citizen's 2% Solution

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

Archive for October, 2011

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?.)