When did modern economists (and politicians) abandon the teachings of Adam Smith? When did we lose faith in his famous Invisible Hand and decide that the most privileged and wealthy among us deserve preferential tax treatment?
Until America stops subsidizing unproductive capital with structural tax preferences and inflating asset bubbles with monetary policy – we will not stimulate robust job creation.
But if we remove the misguided preferences that currently distort investment incentives – we could unleash a $2 Trillion stimulus program funded entirely with private capital.
A Policy White Paper
President – Kestrel Consulting, LLC
Structural tax preferences aimed at wealth have been inadvertently diverting capital away from productive deployment and encouraging speculation in serial asset valuation bubbles. Attempts to stimulate the economy by inflating asset valuations and encouraging debt are not only inefficient and economically unsustainable, they are contrary to key principles of democracy and capitalism and one of the proximate causes of our increasing income and wealth inequality. Structural reform, replacing investment income taxes with an annual wealth tax, could equalize effective tax rates between labor and capital while simultaneously stimulating more productive investments – and thereby job creation.
Structural Tax Reform Offers a Path to Growth and Equity
It has become popular since our Great Recession to blame the anemic recovery upon our banks’ reluctance to lend. Similarly, it has been popular for a couple decades now to assert that the path to stimulating growth is simply a matter of reducing our tax burden. Conservative dogma, attractive in its simplicity, insists that leaving more money in the hands of our citizenry, particularly our investment class, is all we need do to fuel economic growth and prosperity. Yet four years and counting after the crisis our recovery remains stalled. Our investment class has done quite well, with stock indexes recently reaching new all-time highs and corporations and high-worth individuals sitting on mountains of cash. But the percentage of our population actively participating in the workplace remains at historic lows – and working class wages have been stagnant for decades.
Our political class (pundits included) remain stubbornly locked in a battle of bad ideas:
- Should we bribe businesses to create jobs by increasing government subsidies in public/private partnerships?
- Can we keep interest rates near zero forever? And if we do, will that force productive investments and increase employment?
- Should we double down on the strategy of reduced tax revenues and preferential treatment of investment income?
- Or do we increase taxes, perpetuate deficit spending, and embark on a government jobs program?
I suggest that these competing options are not only politically deadlocked, they are each substantively flawed. If helping the rich get richer was the simple path to growth we wouldn’t be struggling with our current malaise. The massive increase of income and wealth concentration of the last three decades, to levels not seen since the Gilded Age, has not been accompanied by sustainable growth or broad-spread prosperity. But while flooding the market with low interest funds may be a great way to inflate asset valuation bubbles, it is an exceptionally inefficient way to stimulate productive enterprise and job creation. Despite persistent and prolonged support among conservative economists and politicians, preferential tax treatment of investment income has resulted in benefits at the top of our economic pyramid while undermining its foundations. Unfortunately, the simple converse approach, raising tax rates on high earnings is more likely to stimulate aggressive tax avoidance and income sheltering activities than economic growth – unless we incorporate fundamental changes in our tax structure.
In our current hyper-partisan environment, where politics is a competitive team sport and politicians are publicly pilloried for deviating from approved party talking points, it is difficult to introduce fresh perspectives and innovative ideas. But I propose we need to do exactly that. We need to reexamine the real drivers of sustainable prosperity and challenge the flawed structure of current investment income tax policies. The issues and answers are not all intuitively obvious. But it’s not rocket science either. If one applies discipline in evaluating the facts, and sets aside the flawed dogma of wishful thinking and political intransigence, I believe the causes of our current malaise come pretty quickly into focus.
I offer four core observations:
- Demand is the primary driver of economic activity.
- The Productive Deployment of Capital is an important secondary driver.
- Structural tax preferences aimed at wealth have been inadvertently diverting capital away from productive deployment and encouraging speculation in serial asset valuation bubbles.
- The artificial demand created by building asset bubbles is unsustainable and destabilizing in its effect.
Tax and monetary policies that attempt to stimulate the economy by inflating asset valuations and encouraging debt are not only unsustainable, they are one of the proximate causes of our increasing income and wealth inequality. Our struggling middle class uses private savings and debt to chase the bubble to the top, and when it bursts they bear the brunt of the pain.
Examine the recent mortgage debacle. Mortgage brokers, lenders and government policies encouraged people to treat home ownership as a leveraged investment opportunity:
“Borrow as much as you can and invest in a housing market that will only go up. Don’t worry if you are over-extending yourself and relying upon artificially low teaser rates – you can ultimately rely upon the asset appreciation to refinance again next year. You can’t afford not to own your own home.”
Likewise, during the prior decade, though many including Alan Greenspan clearly foresaw the “irrational exuberance” of an over-heated market in which valuations became disconnected from operational earnings, economists and politicians alike touted a new paradigm, a market that would only go up. They disavowed regulatory controls and hyped retail investment products which promised to give the middle classes access to the same opportunities and advantages as high-net-worth individuals and institutional investors.
In too eager pursuit of the so-called wealth effect, America’s middle class was encouraged to borrow against their appreciating homes and stock holdings, both of which were being inflated by easy money interest rate policies, in order to fuel a consumer driven economic boom. While private equity funds and sophisticated investors fanned the speculative fires with complex structured investment products, and hedged with derivatives, the financial media cheered markets ever upward. When the collapses came, it was the homeowners and unhedged retail investors that bore the brunt of the decline. Heaping injury on top of injury, following the mortgage collapse the government stepped in and propped up the lending institutions while leaving homeowners on the hook for the full principal amount of their borrowings. Unlike business bankruptcies, where borrowers are provided opportunities to restructure obligations at fair market value and “work their way out,” home mortgage borrowers were in many cases expressly prohibited by the government from bidding at auction to repurchase/refinance their own homes at fair market value.
The game is structurally unsound and stacked against our once-rising middle class. By sheltering unrealized gains, leveraged investments and illiquid holdings from taxation, while over-burdening earned income and profitable enterprise, our policies distort investment incentives, encouraging speculation and stimulating recurring asset bubbles. Retail investors are encouraged to over-pay during the booms, while secured lenders and more sophisticated investors receive tax advantaged returns during the run-ups, followed by post-collapse bailouts during the inevitable busts. Chasing bubble valuations is rather like playing musical chairs; as the game progresses more and more players are sent permanently to the sidelines.
The lesson here, which should be obvious to all careful observers, is that building valuation bubbles does not create sustainable economic growth. Where does sustainable growth come from? It comes from productive enterprise. It comes from expanding the workforce, not culling it. Demand is the primary driver of economic activity. But the artificial, temporary demand that is stimulated by low interest rates and easy monetary policy is not sustainable. Loaning money to consumers so they can fuel the economy only works if those consumers are simultaneously provided with adequate and stable incomes.
At its best, business enterprise creates a virtuous cycle: in order to produce goods and services businesses hire people; the wages those employees earn fuel increased demand for goods and services. Henry Ford famously observed that the key to building a thriving economy was a productive workforce with both adequate pay and sufficient leisure time to create demand for the products they made. It is the underlying justification for the modern consumer society and was the primary engine of growth for the bulk of the twentieth century.
America’s challenge today is that we need to examine, challenge and correct the policy flaws that obstruct that virtuous cycle. We need to stop stimulating and subsidizing the creation of valuation bubbles and implement reforms that will encourage productive domestic enterprise to rebuild the stable working middle class which is the only truly sustainable source of economic growth and prosperity.
Efficient and productive allocation of capital both a) facilitates production of goods and services to fulfill demand and b) generates jobs and increases disposable incomes that fuel demand. But policies that subsidize the unproductive allocation of capital encourage speculation and undermine our productive economy. Over the past several decades we have had a shrinking workforce with stagnant incomes. Productive jobs have been steadily moving offshore while a financial services industry that primarily manipulates the value of paper has grown by leaps and bounds. An economy in which a progressively smaller portion of the population is actively engaged in the workforce will eventually implode.
Recently George Mason University economist Tyler Cowen wrote that the new battleground of politics and policy is going to be Wealth Taxes – claiming that “that is where the money is”. He points to the right idea, but cites the wrong reason. Comprehensive structural tax reform, incorporating an annual tax on wealth (as replacement for current investment income taxes), should indeed be the new battleground; but not as a revenue grab, as a matter of efficiency and equity, and a return to the guiding principles of both democracy and capitalism. It should be obvious how preferential treatment of an elite class of citizen is contrary to the core precepts of democracy. What is less obvious, but even more important, is how such preferences are antithetical to capitalism.
Capitalist theory posits that economic efficiency arises as the aggregate decisions of many individuals seeking advancement and self-interest drive collective progress and prosperity. But Adam Smith’s famous Invisible Hand, like Lady Justice, is supposed to operate blind of managed objectives – and requires a level playing field.
“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
There is nothing in that core tenet of capitalism that supports preferential treatment of the investment class which has come to permeate our tax code – indeed preferential treatment, which distorts those private decisions undermines the entire concept. I’m confident Mr. Smith didn’t contemplate an unequal competition where the already privileged were granted preferential tax treatment and note that “the laws of justice” offer a different threshold than “the whims of Congress or the IRS”.
The preferential treatment accorded to wealth and investments which has become embedded in our tax code constitutes cronyism, not capitalism, and it has distorted investment incentives to the point where tax avoidance and valuation manipulation have become far more profitable than productive enterprise. It is the source of the misguided incentives that stimulate valuation bubbles and has fueled the increasing concentration of income and wealth in America. A properly structured wealth tax offers the opportunity the reform our tax code to restore compliance with democratic and capitalist ideals and eliminate those misguided and inequitable preferences.
I conceive comprehensive reform should incorporate the following components:
- Reduction of the top marginal tax rate on earned income to no more than 25% (inclusive of what are now characterized as employment taxes), resulting in a meaningful rate reduction at all income levels.
- Replacement of all current investment income taxes, including the corporate income tax and personal taxes on interest income, dividends, and capital gains, and all estate, inheritance and gift taxes with
- A nominal annual tax, between 1 ½ % and 2 % of the fair market value of accumulated net wealth in excess of a reasonable threshold.
- Assuming the WACC (Weighted Average Cost of Capital, i.e. average earnings capacity of invested capital) to range between 6% and 8%, the targeted tax rate is intended to be equivalent to the 25% tax rate assessed on earned income.
- Reform and elimination of essentially all preferential targeted tax expenditures.
A structure such as hypothesized above would have a confluence of beneficial effects related to key objectives which are often treated as though they are mutually exclusive:
- Repealing corporate income taxes will stimulate business hiring and make U.S. corporations more competitive
- Flattening and reducing earned income taxes will stimulate growth in middle class disposable income and thus consumer demand
- Removing the tax bias toward unrealized gains will stimulate more fluid and productive reallocations of private capital
- Proposal normalizes effective tax rates between earned income and investment returns
- Avoids regressive VAT or consumption taxes
- Eliminates “double taxation” of corporate income and dividends/capital gains
- Eliminates preferential treatment of the already privileged
- Replaces the “pretense of progressivity” as depicted in our income tax rate schedules with equal treatment toward holders of wealth that will allocate a greater portion of the tax burden based upon a citizen’s real ability to pay.
- Repealing the corporate income tax and reforming existing tax expenditures, thereby eliminating the morass of special treatment policies and loopholes now written into our tax code, will take investors’ and business’ hands out of our government’s pockets
- A reduction in earned income tax rates will increase the ability of lower and middle-class families to accumulate savings and achieve greater financial independence
- Increased tax revenues generated by eliminating preferential subsidies to investors are a required step toward a balanced budget
- A balanced budget will convert the hidden taxes of inflation and debt imposed on future generations to a current tax burden, which can thus be more readily and responsively monitored, managed and matched to expenditures
- A balanced budget will stabilize the currency
It is notable that the long-term cost of inflation exceeds the cost of an annual asset tax which could control deficit spending and stabilize the currency. It is often argued that inflation is a hidden tax upon the wealthy, but the grand bargain offered by the structure outlined above is that, if implemented in conjunction with sound monetary policies, the hidden penalty of inflation could be replaced by tax revenues flowing through the coffers of government to support the functions and services we require. Any benefit from continuing willful inflation on the Public Debt is overwhelmed by the cost imposed upon Private Debt Holders, whose aggregate holdings are four times the amount of our national public debt.
Importantly, by improving the perceived equity of tax revenue policies through reforms such as these we should be able to minimize the divisive lobbying for government programs funded with Other People’s Money – and hopefully thereby also impose greater discipline upon disbursement programs and priorities. We cannot marshal the collective will required to control growth in disbursements until we implement more equitable revenue policies.
Nearly two years ago Tax Notes published a more extensive and data-intensive analysis of how factual distortions that populate the public debate have obstructed consideration of a wealth tax such as conceived here. The only substantive rebuttal offered to this proposed structure in the interim has been the prohibition of direct federal property taxes as incorporated by the founders in the Constitution. Yet, arguably, it is that prohibition and the structural preferences and misincentives which it creates, that has set us upon our current unsustainable path.
Misguided preferences toward wealth have destabilized our economy and threaten our society. Regardless of potential constitutional obstacles, I suggest that returning to the long term historic norm and utilizing property taxes as a component of our federal tax base offers an opportunity to put America’s fiscal future back in order.
The FED reports $72 trillion of accumulated wealth is held by the private sector. If removing tax preferences that currently subsidize low-profit and unproductive asset allocations resulted in reallocation of 3 percent of that capital toward more productive investments, it would trigger $2 trillion of stimulus spending – far more than any stimulus program government could initiate – while simultaneously increasing governmental tax revenues.
If there is an alternative reform which could eliminate preferential treatment and correct current misincentives without facing a constitutional challenge by all means we should pursue it. However, I perceive Mr. Cowen is right; taxing wealth may be, indeed should be, the new battleground. Properly implemented, it offers an opportunity to remove distorting incentives and reinvigorate our economy. Existing policies and preferences have been responsible for an extraordinary and increasing concentration of wealth and income in America. Our current system of taxation is both inequitable and unsustainable. It is not just a matter of finding the optimal tax rates, we need to be reforming the misincentives embedded in our tax structure.
(C) S. Douglas Hopkins 2014