A Citizen's 2% Solution

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

“Principled Compromise” is Not the Path to Effective Tax Reform

On January 25th, in his annual State of the Union address, President Obama reaffirmed his commitment to bring fiscal discipline back to our Federal Budget, declaring “Now is the time for both sides and both houses of Congress – Democrats and Republicans – to forge a principled compromise that gets the job done.”   Of course, the hall resounded with applause, optimistically reaffirming the desirability of this recurring broken promise.    But does anyone really believe this year is going to be different? 

Let’s examine his call for “principled compromise” critically.  I see two potential implications in that statement.   Either 1) we all know what we need to do, so let’s get the leadership from both sides in a room and get it done.  Or 2), this is simply a political task; we can each give a little, get a little, and claim success.  If either of those perspectives was true, we would have had a tax reform agreement long ago. 

So I’m sorry Mr. President, but if you expect progress you’re going to have to provide better leadership than that.  This intractable problem will not respond to “principled compromise”…. because the tax reform debate is dominated by three distinct, highly principled perspectives, each entirely exclusive of the others.  That means the only path to progress is for someone to change their mind.  But American politics doesn’t welcome or reward people who change their minds. 

Does that mean our task is truly hopeless?  Actually I think not.  Because the three alternatives that currently dominate the debate are all nearly equally bad…  which means if we open our eyes and minds, and reassess the facts and the arguments, we ought to be able to discard these unworkable proposals and move forward and find a viable alternative.  If you will stay with me and keep an open mind I’m going to suggest what I think may be a viable alternative.  But first, let’s address the three bad ideas. 

One:  Higher marginal tax rates imposed through our existing dysfunctional structure.  Predictably, the last time the President sent leadership to the woodshed (Simpson/Bowles et al, only twelve months ago) this was the plan they came back with.  Despite at least fifty years of economic theory and practical evidence that higher marginal rates imposed through our existing structure will accelerate tax avoidance efforts and stifle economic growth, indeed without bothering to even discuss how they came to discard that evidence, the President’s Commission came back advocating raising rates. 

I describe this approach as predictable, because political solutions, emanating from forced compromise, have little chance to be anything but incremental in nature.  Nevertheless, it is a bad idea.  Unless we fundamentally restructure the form of our tax policies, particularly in relationship to investment income, higher rates will stimulate more defensive capital allocations and further slow the economy.   Raising marginal rates, without removing structural preferences toward wealth, is a futile exercise.  Despite our vaunted nominal progressive tax rates, misguided structural preferences in our tax code result in Warren Buffett paying a 17% tax rate while his staff pays 33%.  There is a lesson in this fact.  Reforming our tax structure is more important than modifying our tax rates. 

Two:  A return to consumption taxes.   Roughly 100 years ago, Americans realized that over-reliance upon consumption taxes was stifling economic growth and placing too great a burden upon its less fortunate citizens.  In response, Congress shifted focus toward taxing income, imposing a deliberately progressive structure.  But in recent years there has begun to be a call for renewed reliance upon consumption taxes: a Value-Added Tax, a National Sales Tax, or some hybrid combination. 

The rationale for this move backward varies depending on its source.  Over the intervening 100 years since its introduction our income tax structure has been bastardized and its rates have been inflated to the point where it seems designed to ensure that no two citizens receive equal treatment.  So some advocates of consumption taxes, reacting (I believe) largely in disgust toward the increasing dysfunction of our income tax policies, seek simplification at all costs and advocate total repeal of the income tax.  They suggest replacing it entirely with consumption taxes.  Others (like the Rivlin/Domenici alliance who broke with the Chairs of the President’s Commission to offer a competing proposal) seem to recognize the futility of higher income tax rates. So, recognizing the need for higher revenue but unwilling to advocate repeal of income taxes, they simply propose overlaying consumption taxes.  For them consumption taxes are an add-on tax, not a replacement tax. 

 But while they may seem to some a politically more palatable option – less likely to draw the ire of Congress’ wealthy and influential key campaign finance contributors – whether advocated as a supplement or replacement to existing taxes, consumption taxes are a bad idea.  They are by nature regressive.  They place a higher burden upon those at the bottom of the ladder of success than upon those at the top.  They take existing inequities in our current tax policies and make them worse.  They are a gift to the wealthy and an undue burden on the poor. 

But, say the advocates, we can fix that; and they offer a variety of complex credits or exceptions aimed at protecting the poor from that unfair burden.  The flaw here of course is that by combining a gift to the rich with protection for the poor, consumption taxes will fall heavily upon the working middle class.  They will raise the price of everything and further depress consumer demand.  I will repeat myself.  They are another very bad idea. 

Three:  Let’s keep cutting taxes.  Most Americans seem to share a common personality trait: an innate antipathy toward taxes.  We abhor taxes.  And we don’t feel much better about government in general.  So when our leaders tell us that government is the problem and if we just keep cutting taxes the government will eventually have to shrink, we want to believe that.  Get government out of the damn way and America’s entrepreneurial spirit will bring us back to Days of Glory!  Hallelujah Brother!!  [A point of disclosure:  Before I embarked last year on a personal journey of factual analysis – I subscribed to this view.]

But let’s face facts.  Maintaining a belief in Reaganomics today is simply making a religion of cognitive dissonance:  clinging to hope and wishful thinking despite overwhelming contradictory factual evidence.  No matter how logical and enticing it may have seemed to believe that reducing tax revenues would control the growth of government, Congress instead embraced deficits and went on an uncontrolled spending spree.  Artificially low tax rates, combined with preferential treatment of investments, did not bring us to the land of milk and honey.  They fueled repeated asset bubbles, an increasing concentration of wealth and income, and eventually triggered our current financial crisis.  Even in the boom times, the benefits did not trickle down. 

Today politicians and economists from the Right, Left and Center, all seem to be focused upon trying to re-inflate the bubbles – instead of rethinking false assumptions and broken models.  But denial is not a plan.  We should be learning from recent history.  We need to recognize that flaws in our tax policy aren’t just the source of our budget imbalance, they played an integral role in destabilizing our economy.  We need fundamental, comprehensive, structural tax reform.  We need tax policies that will both stimulate productive economic growth and pay for the services we demand. 

Now before I proceed, I need to acknowledge Speaker Boehner’s battle-cry.  On behalf of his conservative and Tea Party constituents Mr. Boehner has become fond of saying “We don’t have a revenue problem, we have a spending problem.”  I wish I could believe him.  I’ve tried to believe him.  But it’s a fairy tale.  Yes, we need to cut spending.  The aggressive move from many in Congress aimed at cutting spending is the one bright spot I see coming from that institution.  And there, on the disbursement side, the challenge of principled compromise is appropriate.  For the most part on the expense side we do know what to do.  Principles and priorities need to be defended, but belts need to be tightened.  Congress has to stop bribing its constituents with borrowed money.  But cost cuts aren’t enough.  We need revenue reforms. 

Back to my point:  principled compromise cannot reconcile these three bad ideas.  We need cooperation, not compromise.  We need to stop thinking of tax reform as a political competition and recognize that it is an important societal challenge to which we need to find a better answer.   Both sides and both houses of Congress – Democrats and Republicans – and all Americans are facing the same challenge.  We need to acknowledge and discard the flaws in these bad ideas which currently dominate the debate and develop some new, better ideas.  We need to explore the underlying facts more carefully, and critically, and seek not compromise, but a better path. 

Twice in the last twelve months we’ve tried principled compromise.  Taking that as their charge the President’s Commission split and came back with conflicting recommendations, both calling for shared pain and both going nowhere.  Then in December both sides in Congress acquiesced to their opponents’ dearest principles and we got a bill with lower taxes and higher spending.  Principled compromise isn’t leading us to fiscal responsibility.    

I said at the beginning that I would offer a proposed alternative approach to reform.  But I’ve run past my allotted space so I’ll offer just the bare bones outline.  As noted previously, I started out aligned with the Reaganomics/Tea Party contingent thinking flattening rates was the answer.  But I was troubled by the question raised by Warren Buffett’s disclosure.  If Buffett pays taxes at half the rate of his staff, why do we claim the rich are overtaxed?  My conclusion:  they aren’t. 

Inclusive of employment taxes the working middle class pays higher marginal tax rates than the wealthiest among us.  Our progressive tax rates apply to less than 25% of the overall federal/state/local tax burden.  The privileged tax treatment provided to the wealthy via caps on social security contributions and reduced rates on investment income far exceed the value extracted from our progressive income tax rates.  The wealthiest among us, those who do not need to consume the income accruing from their wealth, can structure their investments to generate nothing but unrealized gains and avoid any annual tax obligation.  Politicians and economists on the Right and the Left turn a blind eye to these realities and ignore what I perceive to be the most promising route to effective reform.   

My suggestion:  Re-structure investment income taxes to stimulate more productive capital allocations and remove preferential tax treatment currently provided to holders of existing wealth.  Repeal the corporate income tax, the estate tax, and preferential tax treatment of capital gains, dividends and all other taxes on capital and replace them with a simple, nominal 2% annual tax on net wealth.  This would remove the structural incentives in the tax code which allow wealthy investors to minimize or avoid current annual tax obligations and subsidize lower investment returns with lower taxes.  These reforms would immediately stimulate private sector hiring and job growth.  If we simultaneously flatten and reduce earned income tax rates, we could also stimulate real  growth in wages for the working middle class and thus boost consumer demand.   

There is not space here to argue all the merits (or potential pitfalls) of what I’m suggesting.  Indeed, more important than arguing the merits of this particular suggestion, my point is that fresh ideas and new solutions are required.  The first step to finding them is weeding out the bad ideas.  If Congress could focus less on scoring political points or extracting concessions from the opposition and more on cooperating with their counterparts to seek a better path, this year might be different.  

Effective tax reform will not come from cobbling together compromise over bad ideas.  But 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. 

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. ISBN 978-0-9828328-0-6

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