A Citizen's 2% Solution

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

Could Higher Taxes Stimulate More Productive Investments and Growth?

It is a popular truism that “we get less of whatever we tax.”  It is similarly true that we get more of whatever we subsidize.  So eliminating subsidies for undesirable activity is just as important as reducing taxes on those activities we value. 

Following the core truism, when we tax income, profits and labor – we get less of them.  By taxing corporate profits and investment returns we get less productive enterprise and investment.  Since we value savings and investment we attempt to stimulate them by applying lower tax rates to investment income and capital returns than to labor.  There are many voices offering sound arguments that further reducing taxes on investment income – including total repeal of the corporate income tax – would further stimulate economic activity and growth.   For the record, I share this belief. 

But there is an ongoing debate that rages over whether further reducing taxes on investment income is appropriate as a matter of equity.  I also share this view; if the result of preferential tax treatment of investment income is that we absolve our investment class from paying a fair share of the burden of government, I must oppose it.  It is a dilemma.  This impasse is where the popular argument typically stops. 

But let’s look at the subsidy aspects of our current policies.  Our attempts to stimulate investment and savings by providing our investment class with preferential tax treatment are not only an insult to democratic principles of equal treatment, placing an unequal burden upon middle class wage earners,  they result in a variety of consequences which run counter to our desired economic goals.  Perhaps the most obvious and egregious example: by not taxing unrealized gains, we get more unrealized gains – locking investments statically in place, often unproductively, both depressing tax revenues and dis-incenting more productive investments

Our leadership justifies this undemocratic preference as a necessary evil in order to stimulate investment and growth – but the actual impact of these preferences runs directly counter to their stated objective.   Tax preferences offered to holders of accumulated wealth aren’t simply undemocratic, they are anti-Capitalist.  The Invisible Hand extolled by Adam Smith was supposed to operate blind of managed objectives, like Lady Justice, establishing a level playing field and relying upon the aggregate decisions of many individuals seeking advancement and self-interest to drive collective progress and prosperity. 

“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

I’m confident Mr. Smith was not advocating an unequal competition in which the wealthiest and most privileged among our society are subsidized with preferential tax rates.  Preferential treatment for the already privileged is Cronyism, not Capitalism. 

My point here is twofold.  First, preferential treatment of our investment class is an undemocratic and anti-Capitalist practice.  It not only runs counter to core American principles, it imposes negative consequences on our economy.   Second, and more importantly, the solution to this problem is not simply a matter of adjusting existing tax rates; it will require us to re-think the structure which we use to tax investment returns.   So long as we maintain our current tax structure, then the “common knowledge” opinion that raising rates will stifle growth, remains true.  Higher rates imposed upon investment returns will exacerbate the existing disincentives. 

Warren Buffett, arguably our most prominent capitalist font of investment knowledge and insight, has quite commendably, and publicly, decried the fact that he and the rest of his fortunate fellow billionaires are under-taxed, paying lower tax rates than their office staff.  He has come out publicly in favor of repealing the so-called “Bush tax cuts”.  But simply repealing the Bush tax cuts won’t make a significant dent in the preferences Mr. Buffett and his peers now enjoy; because very little of their income is derived from wages or salaries. 

I should perhaps be expressly clear here: this is not a narrow partisan critique.  Yes, a certain faction of the Republican Party has been most adamant and vocal about its pledge for “No New Taxes”.   But I’ve not heard many liberal voices challenging the preferences toward wealth which permeate our tax code and benefit their well-heeled campaign contributors.  The liberals who publicly argue for higher progressive tax rates on income while they quietly support the structural preferences toward accumulated wealth that effectively strip our tax system of any real progressive impact, are just as complicit as the conservatives in undermining the position of the middle class.  If enacted, higher progressive tax rates would be counter-productive – because our tax structure is the cause of our greatest tax inefficiencies and inequities.  

So unequal tax rates are undemocratic and anti-capitalist, higher taxes on investment income stifle growth, and increasing marginal rates on earned income is ineffective.  That leads us to the question  “Is there an alternative structure we could use which would allow us to equalize tax rates between investments and earned income without stifling investment and growth?”  I think there is.  I think we need to take the blinders off and broadly reassess our approach to taxing investment returns in America. 

Today, we not only apply preferential rates to most forms of investment returns, we have constructed complex and self-contradictory definitions of what and whom is “taxable” – and have reached a point where “taxable investment returns” have become a very poor proxy for real returns.   We provide subsidies and preferences for unproductive capital allocations – and thus, back to my premise, we stimulate and obtain more unproductive capital allocationsBy punishing productive capital with taxes, and subsidizing non-productive capital we also distort valuation metrics – and stimulate asset valuation bubbles

It may at first sound heretical, but I believe we should shift our perspective toward wealth itself as an appropriate and far more even-handed basis for taxation.  If we want to unleash the full power and vitality of capitalism, we need to stop distorting decisions about capital allocations.  Certainly one way to do that would be to repeal all taxes on capital and investment returns.  That is essentially the position taken by advocates of consumption taxes.  But, as noted at the outset, that has the effect of absolving our investment class from paying a fair share of the burden of government.  The wealthy neither need nor deserve such absolution.  Utilizing consumption taxes as the primary source of government revenues  would shower unneeded benefits upon those among us who do not need to, indeed could not possibly, consume all their income. 

But there is an alternative.  We can remove the distorting influences we now impose upon capital allocations by simply applying equal treatment.  I believe we should apply a nominal tax directly upon accumulated net wealth, with the objective of taxing its earnings potential at a rate equivalent to that imposed upon earned income.   Such a policy would remove the fickle and discriminatory hands of Congress and the IRS from influencing investment decisions and unleash that Invisible Hand of Capitalism. 

Specifically, I propose We should combine and simplify our existing employment and income taxes into a single two-tiered income tax and supplement it with an annual 2% Tax on Net Assets.  Corporate income taxes, personal investment income taxes, estate and inheritance taxes and gift taxes should all be repealed.

Assuming a long term WACC (weighted average cost of capital, the earnings potential of capital) of 8%, a 2% tax on net assets represents a 25% effective tax rate.  If we simultaneously drop our maximum earned income tax rate to the same 25% (inclusive of all employment taxes, including the so-called employer portion) we will impose equal treatment across investments and salary and wages. 

Overall tax revenues would rise dramatically, because we would be removing the deep preferences toward wealth which have driven a massive increase in the concentration of both wealth and income over the past three decades – but the mis-incentives of our existing investment tax structure would also be removed. 

We do not need to make the working class subsidize our investment class in order to stimulate investment.  If we collectively believe in Democracy and Capitalism, as I do personally, we should recognize that imposing more equal treatment to the tax code and unleashing that Invisible Hand, would constitute a return to the core principles which act as the drivers of our American Dream of Equal Opportunity. 

Before closing, I’ll offer three more issues of perspective. 

1)            Making accumulated wealth the basis of taxation would admittedly change the dynamics of current valuations and moderate and suppress certain non-productive business and asset valuations.  But that would be a good thing, in that it would stimulate reallocation to more productive enterprises and ameliorate the bubble valuations we now alternately stimulate and regret. 

2)            Today we have enormous hidden “taxes” in the form of inflation.  So one way to think about what I am proposing is that we would be swapping the hidden taxes of inflation, the bulk of which do not flow to the Treasury for the use and benefit of government, for direct taxes which will flow through the Treasury, allowing us to balance the budget and stabilize the currency – thus maintaining the U.S. position as the world’s reserve currency and making America more attractive to all forms of investment.

3)            I am very supportive of current efforts to impose fiscal responsibility and a sense of reality upon our budget process.  But unless and until we address the issue of equity (real and perceived) in our tax revenue policies I believe we will be unable to marshal the collective public will to implement the important changes in entitlements and other program disbursements that we clearly and urgently need.  I believe that those who believe we can find a path to fiscal solvency by cost-cutting alone are deluding themselves. 

I would welcome any reply, observations or rebuttal you might care to offer, 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

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7 Responses to “Could Higher Taxes Stimulate More Productive Investments and Growth?”

  1. Lars says:

    Interesting article.

    I believe I am in favour of corporate tax being the prime revenue vehicle, and here are some disorganised impulses.

    The negative implications of all taxation are obvious (except for ‘healthy’ taxes regulating negative externalities). But I think they are more limited for tax on corporate profits, than on consumption (VAT) or on labour/salaries.

    It is easy to demonstrate that in the case of the latter, production costs and hence consumer price would be too high and quantity too low. But profit-optimal corporate behaviour doesn’t change when a tax is levied; the same actions are still required in order to maximise the profit even though the government steals a slice on it.

    So in the case of the latter, and assuming that the tax is broad and covers all sectors, the only place where the investor can excape would be own consumption instead of investment. This would have the positive side effect of increasing contemporary demand for certain (luxury?) goods. However, it would indeed be too bad if productive investments are not undertaken because the endeavour is no longer profitable enough to satisfy the investor’s required rate of return.

    But it is exactly today in the global economy where capital is volatile, that one may still be able to rely on all goods in demand being produced even if tax levels would discourage individual investors. A production no longer needs to rely on capital investments from the local community only; the entire globe is the domain where investments can be sought.

    Not the least would this be the case for goods and services which don’t need to consumed in the vicinity of where they are produced (e.g. electronic deliverables).

    Assuming 8% WACC, if you want to hand over the bill to the consumer, a corporate tax of 25% would in either case only imply a necessary price increase of 2% in order for the rate of return to be back to the pre-tax level and hence keep the investors. I believe this would have considerably more modest damaging effects for Adam Smith’s wet dream, than 25% tax on labour as production factor, or consumption.

    In a completely free and well-functioning market, corporate profits should in theory be close to zero (otherwise others would come in and take their share of them, so the profit potential is in essence limited to what can be obtained from economies of scale (increasing marginal costs of production). Something therefore malfunctions when corporate margins are too high. When that happens, Adam Smith might well be of the opinion that taxing them is only an appropriate corrective measure.

    Consequent to the often close substitutability between corporate profit and personal income, however, most countries apply a similar rate on the two.

    Indirect taxes have increased their importance over the last decade, consequent to tax competition and to investment capital being more prone to tax flight than what is the case for consumers. Corporate tax rates have in the meantime clearly dropped across the board. In my view, this development entails a movement towards a world where mechanisms for redistribution of wealth, a minimum of which is recognised as desirable in all societies, are getting weaker. This due to the inherently regressive nature of consumption taxes.

    Cheers,
    Lars

  2. JazzBumpa says:

    True – I did stop early on, at first. The phrase that stopped me in my tracks was the one I quoted, which I believe to be absolutely false. In my view, if that is your starting premise, than you are not going to arrive at a good result.

    Rather than taking your assumption as axiomatic, you ought to give it a critical evaluation, and back it up with facts and data. As a starting point, consider taxing labor. Do you believe that crossing into the next bracket, is a disincentive to making that extra money? Or that raising the capital gains tax from15 to 20%, or from 20 to 30% is going to keep someone from making a profitable investment? That is what you are suggesting.

    The first tier, at 15% up to $35,000, is essentially equal to the existing employment tax,

    Sorry, I see nothing about 15% in the post. Further, the marginal tax rate only applies to the next dollar earned, and your use of it is very misleading. As Bruce Bartlett pointed out about a year and a half ago: “According to calculations by the Joint Committee on Taxation, a congressional committee, tax filers with adjusted gross incomes between $40,000 and $50,000 have an average federal income tax burden of just 1.7%. Those with adjusted gross incomes between $50,000 and $75,000 have an average burden of 4.2%.

    http://www.forbes.com/2010/03/18/tea-party-ignorant-taxes-opinions-columnists-bruce-bartlett.html

    Almost 40% of the population pays nothing in federal income tax.

    Add in both the employees and employers FICA contributions, and you’re still significantly below the 25% I do see in the post.

    Our tax and monetary policies subsidize unproductive capital allocations, stimulating bubble valuations and speculative trading and driving productive job generating investments overseas.

    I agree with this part. There are remedies available by modifying the existing tax structure to penalize rent seeking and favor real investment. I do not agree that raising taxes on rentier activities discourages growth. It should discourage rent seeking and coax money into real investment.

    I place greater trust in Adam Smith’s Invisible Hand than in central planning.

    This is a false choice. Central planning was the program of the Soviet union, and we all know how well that worked out. We have never had anything like that here.

    I am an ardent free market capitalist and think we should try it. That is the crux of my position.

    We did try it. I was called the 19th century, and the cyclical recessions were devastating. We tried it again in the 20’s and got the great depression. Since Reagan, we moved in that direction with deregulation and tax cutting for 30 years and got the current melt-down – following a decade of zero private sector job growth.

    So you’re right. I’m not grasping this at all.

    Cheers!
    JzB

  3. JazzBumpa says:

    I would welcome any reply, observations or rebuttal you might care to offer

    Perhaps I took you too literally here. I offered you about 300 words of thoughtful discussion. The links I posted are relevant, and meant to continue that discussion.

    So long as we maintain our current tax structure, then the “common knowledge” opinion that raising rates will stifle growth, remains true. Higher rates imposed upon investment returns will exacerbate the existing disincentives.

    The economic history of the U.S. since WW II is totally inconsistent with this belief. Mike Kimel at Angry Bear has sliced the data every way imaginable, and even wrote a book about it. As a fairly recent example, the Republican congressional minority claimed the Clinton tax increases of 1993 (passed without a single Republican vote) would stifle the economy. Instead, we had the most robust GDP growth since the 60’s – when tax rates were far higher.

    Your alternate tax ideas have merit. However, a flat 25% tax on income would be devastating on the working poor – and indeed the middle class who pay far less than that now. I’ll refrain from providing a link.

    Cheers!
    JzB

    • admin says:

      Your initial reply indicated you had read three lines and then stopped. It isn’t clear to me yet that you’ve actually read the balance because there are several issues you haven’t grasped – but that may perhaps be a failure of my presentation.

      Regardless, the specifics of my proposal would not be (at least intentially and certainly not in the way you describe) “devastating to the poor.” I’ve proposed a two tiered earned income tax wich is inclusive of what are now speciously defined as employment taxes, though in practice our SS/Med “contributions” are functionally used as general revenues. The first tier, at 15% up to $35,000, is essentially equal to the existing employment tax, thus my proposal at the lowest earnings levels is no higher and in many cases lower than current taxes. Today an individual with only $34,000 of taxable income pays a marginal tax rate of roughly 40%, see chart in The Big Lie of Government: the Myth of Progressive Taxes which would drop to 25%. Thus for the core of the working middle class, the marginal tax rate on earned income would drop by 37.5% – though the elimination of tax expenditures and other manipulations make the overall impact less readily identifiable.

      I believe that higher tax rates in our existing structure do stifle growth. Our tax and monetary policies subsidize unproductive capital allocations, stimulating bubble valuations and speculative trading and driving productive job generating investments overseas. Though I’m not certain how to get at the data to quantify it, one of the flaws in our understanding of cause and effect between tax rates, revenues and growth, has been the failure to normalize data for our recurring “bubbles”. Much of the GDP growth at the end of the Clinton presidency was driven by the false stimulus of the DotCom Bubble. I perceive much of the accompanying revenue increase as a result of lower capital gains tax rates – which stimulated realization of gains flowing from those often phantom valuations. Similarly, the more recent Mortgage Bubble inflated GDP and tax revenues.

      A critical flaw in our existing response to the financial crisis has been government attempts to reinflate the bubble without recognizing that it reflected a false reality.

      I strongly agree with your assessment that “excessive finance sector growth, speculative bubbles, …. (are) … a root cause of the decline in GDP growth over the last 40 years.” My fundamental point is that those factors arise directly out of flaws in our tax and monetary policies.

      I don’t view taxes to be an absolute deadweight loss at all. But as long as our increasingly dysfunctional government representatives view tax and disbursement policies as tools with which to buy campaign contributions and votes I have little confidence in them to spend our taxes wisely. Even if I did, I place greater trust in Adam Smith’s Invisible Hand than in central planning.

      I am an ardent free market capitalist and think we should try it. That is the crux of my position. Preferential treatment of our investment class is counter to the core tenants of both democracy and capitalism. It has destablized our economy and is the direct cause of our stagnant job growth.

      As to your own focus on Higher versus Lower taxes, I try to avoid arguing the matter in those specific terms because I find the emotions stimulated when attacked on that front are not conducive to thoughtful consideration. I prefer to attack the question from the perspective of principle and efficiency; I seek removal of preferential tax treatment. Group think from the economics profession rationalizes preferential treatment of our investment class as the key to stimulating growth. I believe they’re wrong – as a matter of both principle and outcome. I posit that removing those existing preferences by implementing structural change in investment tax policy should result in significantly higher tax revenues coupled with broadly reduced tax rates and more productive investment incentives.

  4. [...] Could Higher Taxes Stimulate More Productive Investments and Growth? This entry was posted in Commentary, Tax Reform. Bookmark the permalink. Post a comment or leave a trackback: Trackback URL. « A Citizen’s 2% Solution [...]

  5. admin says:

    If your interest is in engaging in a thoughtful discussion, not just posting links to your site, I invite you to read past the first three lines and then get back to me.

  6. JazzBumpa says:

    Hi Doug –

    I clicked over from your comment at Aymptosis. It’s late, I’m tired, and I’m not going to get through your post tonight. You invited reactions and rebuttals, so I’ll give you one.

    Right up front (and this is as far as I read):
    By taxing corporate profits and investment returns we get less productive enterprise and investment.

    This assumption is simply false. Consider depreciation schedules, and you’ll realize that taxation should encourage increased investment, and raising taxes (at reasonable levels) encourages an increase in the incentive to invest*.

    Further, you are taking taxation to be a total and absolute dead weight loss. The government doesn’t throw tax receipts into a black hole – it spends them. Give some thought to spending on education, infrastructure, technology development, the many advantages of the extremely expensive space program of the 60’s when we had the highest GDP growth of the post WWII era (or even St Ronnie’s ridiculous SDI program).

    In fact, in U.S history, periods of higher taxation are correlated with greater business success, GDP growth, stock market performance, and general prosperity.

    http://jazzbumpa.blogspot.com/2011/03/republicans-all-wrong-all-time-pt-25.html

    You should give serious, critical thought to the assumption that free markets allocate resources better than government can. I believe looking at the 60’s vis-vis the 80’s, or the 90’s vs the most recent decade belies that notion.

    * By “invest” I mean in physical plant, equipment, and human resources, not financial instruments of any kind – that, under most circumstances, is speculation, rent-seeking, or simply parking money in a presumably safe place in the absence of an investment opportunity. This gets into the whole area of excessive finance sector growth, speculative bubbles, and rents, which siphon off money from the real economy. I have come to believe that this is a leading root cause of the decline in GDP growth over the last 40 years.

    http://jazzbumpa.blogspot.com/2011/06/where-has-all-money-gone-part-151-even.html

    http://jazzbumpa.blogspot.com/2011/06/low-interest-rates-and-rntier-class.html

    Further, low taxation is the primary root cause of large budget deficits.

    http://jazzbumpa.blogspot.com/2010/12/history-of-federal-deficits.html

    I invite you to visit my blog and offer your thoughts.

    I’m going to be up to my eyeballs and semi out of touch for parts of the next couple of weeks, but will try to respond to any comments.

    Cheers!
    JzB

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