A Citizen's 2% Solution

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

Archive for March, 2013

A Call for Comprehensive Structural Tax Reform

Originally published on BigThink.com (NOVEMBER 11, 2012)

Forced compromise is not enough: in order to reinvigorate our economy and change the trajectory of our unsustainable budget, America needs to confront fundamental flaws in its investment tax policies and implement comprehensive structural tax reforms.

It is broadly recognized that President Obama did not receive a mandate for action in the recent election, and that America remains bitterly divided.  What is less broadly recognized is that the choice we were confronted with at the polls was a false choice, a Devil’s Dilemma of mutually undesirable alternatives.  Both sides are correct about the flaws in their opponents’ platform.

  • Doubling down on the failed strategy of tax cuts for the wealthy (the Romney/Ryan plan) would accelerate wealth and income inequality, increase budget deficits, undermine social welfare programs, and eventually lead to social unrest.
  • But unless we modify existing structural misincentives, higher tax rates (the Obama plan) will encourage more aggressive tax avoidance efforts and thereby exacerbate economic stagnation and instability.

Obama’s administration may have survived the election, but they should understand they cannot simply Stay the Course.   Nor can we reasonably hope that forced compromise in response to the pending fiscal cliff will lead to some magical middle ground between the policy alternatives we have been battling over for the past two decades.  There is no magical middle ground between these flawed alternatives that will lead to economic growth and fiscal stability.  Compromising two bad ideas will not lead to a better one.  We need to broaden our perspective and look with fresh eyes at the challenges we face.  We need stop clinging to bad ideas, take the blinders off, and examine the unintended consequences of our current structural approach to taxing wealth and investments.

Observation: Current tax and monetary policies are subsidizing unproductive asset allocations and a flight to safety for private capital; thereby obstructing economic recovery.

Let that sink in.  There will be no sustainable economic rebound until we recognize that our tax and monetary policies have created structural misincentives and destabilized our economy.  An economy over-weighted toward trading and speculation, where investors receive preferential tax treatment while actively seeking shelter from uncertainty and risk, will not generate robust job growth.  If the productive deployment of capital is the key driver of economic growth and prosperity (the central tenet of capitalist theory) then, “Our political and economic leadership need to examine and address the ways our tax and monetary policies subsidize unproductive private capital.”  We offer preferential tax treatment to investment income with the stated objective of encouraging productive investment.  But the structure of our policies is inadvertently subsidizing unproductive, illiquid, and speculative investments – and penalizing capital allocations most directly responsible for job growth.

How so?  Let’s say I have $2 million of capital available to invest.  If I invest it directly as equity in a productive enterprise, generating jobs and profits, I become subject to substantial equity risks as well as multiple layers of taxation; on profits, dividends and capital gains.  Alternatively, I can minimize my tax obligations and in most cases my principal risk, by seeking a multitude of alternative asset allocations.  I can park my money in cash or Treasury bonds.  I can receive favorable tax treatment for debt instruments.  I can speculate in gold, real estate, or other tangible assets.  I can speculate in valuation fluctuations of publicly traded equities or complex structured securities and derivatives (which is distinct from investing in productive operations).  In nearly all cases, the lower my risk, the lower my taxes.  The only real exception to the low risk/low tax relationship is where I have actual losses; yet even there government steps in and subsidizes them with tax loss offsets, thus rewarding failure while taxing my successful competitor more heavily.  If I don’t need income, I can minimize taxes by sheltering profits and deferring gains, often to near perpetuity.  Our tax policies are skewed to favor and subsidize low-profit, unprofitable, and illiquid capital allocations.

America’s tax and monetary policies have made tax avoidance and manipulation of asset values far more profitable than productive enterprise.  Those policies have stimulated dangerous and unstable financial engineering and created recurring asset bubbles and collapses – while simultaneously triggering the transfer of billions of dollars in investment capital and millions of productive jobs overseas.    Offering preferential tax treatment to our investment class is not just inequitable, applying disparate treatment to our citizenry, more importantly those preferences distort investment incentives; and imposing them converts capitalism to cronyism.

If we desire to stimulate job growth, priority number one should be examining and correcting the structural flaws in our tax policies that distort investment decisions.  We have to stop trying to re-inflate the bubble and turn our attention to the underlying fundamental misincentives of tax policy.  The FED may be able to boost asset values and stock market indexes temporarily, but doing so will not produce a broad, sustainable, productive economy.

By favoring unproductive capital we have abandoned Adam Smith’s Invisible Hand – to our great detriment.  The key to robust job growth is comprehensive structural reform of investment tax policies and a return to the principle of equal treatment which lies at the core of both democracy and capitalism.

We tend to think of economic stimulus as requiring governmental disbursements.  I posit that if Governments would simply level the playing field and stop subsidizing unproductive capital with ill-conceived preferential tax and monetary policies the natural response would be an aggressive reallocation of private capital that would provide far greater economic stimulus than anything government can afford to offer directly.  How big might the potential impact be of such a policy shift?  The Fed reports aggregate Household and Nonprofit asset holdings total approximately $72 Trillion.  Reallocate 3% of that toward more productive activities and you will unleash $2.1 trillion of private stimulus investment.

If we eliminate misplaced biases and subsidies in existing tax policy private capital will flow naturally toward more productive investments, stimulating job growth and sustainable economic expansion.  If we simultaneously flatten and reduce earned income tax rates, that will stimulate real growth in wages for the working middle class and thus boost consumer demand.  I believe that structural reform of our investment tax policies would allow us to 1) equalize effective tax rates between labor and capital, while simultaneously 2) stimulating more productive capital investment and thereby job creation.

There is not space here to argue all the merits (or potential pitfalls) of the comprehensive structural tax reforms I envision.  Indeed, more important than arguing the merits of any particular proposal, my point is that fresh ideas and new solutions are urgently required.  The first step to finding them is weeding out the bad ideas.  Effective, equitable, growth-oriented tax reform will not come from cobbling together compromise over bad ideas.  But if we expand our view and debate outside the boundaries of those bad ideas this year might be different.

If we reevaluate the facts and acknowledge the flaws of our current policies and proposals, if we listen more carefully to criticism and open our minds to fresh ideas and alternative perspectives, then cooperation might be a path to a fresh and more promising approach to reform. The overlap of the pending fiscal cliff with a post-election lull in political bickering may offer us the best opportunity and incentive to do so, but our immediate challenge is more than just crafting political compromise.  We need to re-acknowledge the concept of a “loyal opposition,” and embrace our shared societal goals, set aside the hyper-partisan rancor that blinds us to weaknesses in our own ideas, and productively cooperate in assessing fresh alternatives.

We need to find a better path.  In order to achieve renewed growth and vitality, and preserve the American Dream, America needs to address fundamental structural flaws in tax policy and instability in our economy that neither party has yet even acknowledged.

I urge and invite you to read more about the questions and perspective I offer in the short post Want Job Growth? – Reinvigorate Capitalism or a longer Tax Notes’ article Factual Distortions Derail Productive Debate on Tax Reform.  A brief description of the specifics of the proposed structural reforms I envision and its perceived beneficial incentives is viewable at Premise.

Reactions and rebuttals will be gratefully received, either publicly as comment to this post, or privately via the contact form nearby.

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

Has ECON 101 turned Americans into Lemmings?

The following essay was originally published (December 12, 2012) on BigThink.com Lemmings

It’s hard to know what leads lemmings to race willfully to their own demise.  But I’ve come to believe that the suicidal tendencies embedded in American tax and fiscal policy arise directly from the teachings of modern economic theorists.

One of the first lessons of introductory economics is a simple truism:  Savings is Deferred Consumption.  It is intuitive and obvious.  Wealth is value; when one obtains or creates wealth one can choose to either consume it today, or save it for the future.

What is less obvious, at least to me, is the leap of faith that economists take in building upon that truism.  At what point and on what basis have modern economists concluded that savings requires and deserves government subsidy?  Perhaps it is simply a puritan ethic that sees virtue in self-denial and deferred gratification?  Whatever its rationale, I believe it represents group think and flawed dogma.

I have been advised that I will be unable to find a living economist anywhere who doesn’t believe that sound economic policy demands and deserves preferential tax treatment of savings over consumption.  Initially I found it hard to believe that any three economists could find complete consensus on any common principle.  I was incredulous at the idea that all economists could agree on a single principle.  But now, having researched the issue at some length, I posit that universal agreement on a flawed proposition may be the proximate cause of our progressive decline.

On what basis have we decided that individual self-interest is not an adequate incentive to ensure that people prepare for the future?  More pertinently, how have we come to construct incentives that seem so obviously to fly in the face of a key principle of both democracy and capitalism?  The concept of equal treatment is so integral to democracy that it hardly requires elaboration; but fair and equal treatment is fundamental to the efficient workings of capitalism as well.

“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 (of industry or capital) in which the wealthiest and most privileged among our society are subsidized with preferential tax rates. Yet modern economists who claim to be advocates of capitalism have flung the principle of equal treatment to the ground and are diligently attempting to stomp it to death.  Who would have believed that a society governed by majority vote would over-burden its working middle class in order to provide tax preferences to its privileged elite?

But that is exactly what we do when we offer preferential tax treatment to investment income.

There are only two arguments available to justify preferential treatment of the already privileged: Power or Efficiency.  Either the rich and powerful extract preferential treatment because they can, or society grants preferences to the rich in pursuit of a greater good.  Giving modern economists the benefit of the doubt I am prepared to accept that many believe we are pursuing a greater good, but objective analysis of actual effect argues strongly to the contrary.

As a simple matter of cost benefit, cursory examination of America’s wealth concentration should make it obvious that the bulk of current tax incentives are wasted; an enormous tax cost is aimed at the portion of our population who least need it and whose behavior is least changed by it.  Much of the preferential tax benefit of reduced rates on investments accrues to individuals who couldn’t possible consume all their wealth and income.  73% of the national wealth is held by the top 10% of our population; 35% is held by the top 1%.  A combination of high income and/or ample accumulated wealth among this contingent means that the Rich and High Earners are going to save regardless.  Are the Top 1%, or the top 10%, really going to spend down their assets if their marginal tax rate goes up?  Of course not.  What is the cost in reduced and deferred tax revenues that is allocable to a portion of the population upon whom it has no perceivable effect?

As importantly, the misguided incentives we build into our policies impose very serious distortions upon investment decisions.  As a result, much of the capital that is accumulated is inefficiently deployed.  We have inadvertently made tax avoidance and valuation manipulation far more profitable than productive enterprise, thereby destabilizing our economy.  We justify preferential tax policies aimed at savings and investment because we say they will lead to productive activity – but we avert our eyes and ignore the fact that structural subsidies in the form of preferential tax treatment are diverting capital and energy away from productive enterprise.  Intellectual capital runs to Wall Street and gambles on valuation manipulation (and over-compensated transactional extortion) and productive enterprise flows (largely unimpeded) offshore in a race to the lowest wage jurisdictions.

The tax preferences we intend to stimulate investments instead stimulate Asset Bubbles.  We deplete our treasury and debase our democracy bribing the rich – to no productive effect.

I perceive a need for fundamental structural reform of our tax code – starting with critical examination of the misguided preferential tax treatment that over-burdens our working middle class at the same time it distorts investment decisions.  It is easy to understand preferential tax treatment of investment income as self-interest among influential key campaign contributors who now hold sway over our political class – but I dispute it as sound economic logic.  If it is not possible to justify preferential treatment of the already privileged as a matter of economic efficiency and thereby a greater societal good, and I believe it objectively is not, then the starting point for comprehensive tax reform should be examination and elimination of those preferences – at least among those for whom such preferences are an unnecessary subsidy, not an effective incentive.

There is of course merit in policies that encourage and assist our struggling working classes to save for the future.  But today the benefits we shower upon our investment class require us to impose higher tax burdens upon our working class – thereby obstructing savings where they most need to be encouraged.  If we equalized effective tax rates between labor and investments we could reduce both our budget deficit and the tax rate on earned income.  Reducing the marginal tax rate on earned income and putting more discretionary income in the hands of laborers would be a far more effective method of stimulating savings where we most need it – than continuing to siphon money from the middle class into the hands of current wealth-holders.

Reactions and rebuttals will be gratefully received, either publicly as comment to this post, or privately via the contact form nearby.

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