A Citizen's 2% Solution

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

Archive for November, 2011

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