A Citizen's 2% Solution

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

Is our American Democracy being subverted by Cronyism?

“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.”

The American Founders were deeply suspicious of democracy, and structured a constitution designed to protect both personal liberties and property from the tyranny of the majority.  But the critical problem confronting America today is not the majority using its popular vote to seize property from the rich; it is structural tax preferences aimed at privileged elite holders of wealth that are obstructing the efficient workings of capitalism and thereby the American Dream and its Promise of Equal Opportunity.

Of course you won’t learn that if you listen to our leadership in politics, economics or the media.  Half of our leadership claims that the wealthy are currently overtaxed and threaten that any attempt to further increase the burden upon the most affluent and successful among us will cause those so-called job-creators to go on strike and stop working and/or investing.  The other half argues that the wealthy simply aren’t taxed enough and seeks to impose “higher tax rates on the rich”, framing their argument in discriminatory terms that make much of our population react instinctively in sympathy with the first half.  A respect for fairness and equal treatment is deeply ingrained as part of the American psyche;  so the call for higher tax rates imposed upon a select group of citizens enflame an emotional debate about “class warfare”… and who really wants to go to war against a class we all aspire to join?

But the simple truth is that both sides are conducting their analysis and debate from a flawed fact base.  The very wealthy currently pay much lower tax rates than the working middle class – and allowing the top marginal tax rate to revert to 39.6% is not going to change that fact.  Increasing tax rates on capital gains and dividends without addressing structural flaws and preferences in tax policy that encourage the wealthy to shelter and suppress investment income is a pointless and flagrantly counter-productive exercise.  Most importantly, cronyist preferences aimed at wealth distort investment decisions and are an obstacle to economic vitality and job creation.

But if we can’t, or won’t, acknowledge the simple facts of current policy, why is there any surprise that our public debate generates more emotional heat than intellectual light?  A large portion of our population argues and votes against their own strongly held principles and personal self-interest because our leadership has turned our public policy debate into a shell game of misdirection and deception.

Perhaps the most concise and cogent analysis of the cause of our recent financial crisis came from an insider at Merrill who observed “We fell for our own scam.”  I believe America’s political and economic leadership has done the same thing.  We’ve played so fast and loose with the facts that we’ve lost track of reality.

The reality is that the progressivity of our tax code, which we so energetically debate, is more illusion than fact.  Even our most respected analysts, like the CBO, JCT, and Tax Policy Institute understate effective tax rates paid by the poor (by characterizing social benefit and income support programs as income) and overstate the tax rates paid by the wealthy (suppressing the real income of the rich by ignoring unrealized gains and other shelters).  The more disingenuous sources distort it further by pretending employment taxes are functionally distinct from general tax revenues and that 47% of the population pays no taxes.  When we frame our conversation with such obvious and flagrant distortions, how can we possibly expect to have a productive debate?

It’s impossible in the short space available here to illuminate the full scope of the distortions and delusional beliefs that guide our policy debate.  In a society where public debate is increasingly conducted in 140 character bytes it may be impossible to improve the quality of our debate in any forum.  But I offer a handful of key data points for consideration:

  1. 44% of U.S. tax-filers live on a combination of income and government subsidies of less than $30,000 per year.  The difference between the average overall federal tax burden within this group and that of all taxpayers is an aggregate $141 billion, a modest $1,995 per person.
  2. A mere 0.6% of tax filers (958,000) have incomes greater than $500,000 per year.  The marginal tax rate of the Upper Middle Class (incomes between $75,000 and $500,000) is 34.9%, but the marginal rate for the Rich (incomes greater than $500,000) is only 23.7%, largely the impact of reduced taxes on realized capital gains.  In aggregate, the cost of providing the Rich with this reduced tax rate is $112 billion, or $116,840 per person.
  3. Our Trust Funds hold no stored value.  Social Security and Medicare are pay as you go social support programs.  The only functional result of calling employment taxes “contributions” is that it hides the fact marginal tax rates on middle class earned income are higher than rates paid on high earnings and investment income.
  4. There are roughly $1.1 billion per year of targeted preferences buried within our voluminous tax code, commonly called “tax expenditures” because they arguably are indistinguishable from spending programs.  A very modest portion of these are aimed at the poor and included in the figure cited in item 1 above.   A somewhat larger, but similarly modest portion, perhaps as much as 20% are aimed the Rich, those with incomes in excess of $500,000.  But the vast majority of tax expenditures represent benefits distributed unequally among the working middle and upper-middle class.
  5. Analysis of data reported by the Federal Reserve suggests that in the 20 year period between 1988 and 2008 an aggregate $37 Trillion in unrealized gains were sheltered from taxation.  Ranged between a 15% to 25% tax rate the aggregate cost to the Treasury of sheltering unrealized gains was $5.5 to $9.2 trillion or $275 – $460 billion per year.  It is estimated that 73% of the national wealth is held by 10% of the population (35% is held by the top 1%); thus the benefit of these tax policies was similarly concentrated among the lucky and privileged few at the top of our increasingly steep economic pyramid.

Conservative Republicans seem to believe that the cause of our fiscal and social problems is that 47% of our population doesn’t pay income taxes and are a burden on society.  But the burden of employment taxes, imposed on the first dollar of wages, is higher than Mitt Romney’s average overall tax rate and the reason nearly half our population doesn’t pay income taxes is that our economy is so unbalanced half our population has almost no income to tax.  If Conservatives really believe our problem is the burden of social programs aimed at the weakest and most vulnerable among us, they should stop pretending it’s a tax revenue issue, and examine the actual outlays aimed at that struggling cohort.  They would quickly be forced to recognize that the problem is a lack of jobs, not an encroaching welfare state.  Efforts to fuel anger at the “non-taxpayers” struggling to get a grip on the American Dream are not just despicable they are a willful distraction from the issues that need to be addressed if we are to reinvigorate our economy.  We won’t stimulate economic prosperity by increasing the tax burden on the poor, or reducing social support services provided to them.  We need to focus on increasing their opportunities and ability to work, save and invest.

We need to stop pretending that social security and medicare are self-funded savings and investment programs.  Contributions are not saved and invested.  Workers’ contributions aren’t funding their own future retirement; current taxpayers are funding benefits for current retirees and excess “contributions” have been consumed by other current government outlays.  The debate about rationalizing our entitlement programs cannot be conducted in a rational manner until we acknowledge those facts.  Social support programs are important national choices.  But we do not fund our own individual benefits, we choose as a group to fund benefits for others.  Our promises have exceeded our ability, or at least our willingness, to pay and we need to reevaluate those promises.  The first step is to acknowledge the fact that the Trusts contain no stored value.

Conservative Republicans would like us to believe that the only fair and reasonable path to revenue reform is elimination of tax expenditures, which they characterize as discriminatory and wasteful.  There is some real truth in that characterization.   But it is intellectually dishonest to pretend equal treatment is the goal while simultaneously protecting the preferences toward wealth and investment income that accrue to the most privileged among us.   Reforming the morass of often contradictory and counter-productive preferences in our tax code as a path to reducing tax rates and imposing more equal treatment is a worthy goal.  But eliminating tax expenditures without reforming structural preferences toward investments would impose a still higher portion of the burden upon the middle and upper-middle working class.

On the other side Obama and his Democrat allies insist the rich must pay higher tax rates.  But while they frame that proposal with populist rhetoric they ignore the structural preferences toward investments that allow and encourage the rich to shelter and suppress taxable income.  Imposing higher rates without correcting structural preferences and misincentives will not change the fact that the Rich pay lower tax rates than a laborer in a minimum wage job.  Indeed, higher rates imposed within our existing structure will inevitably increase tax avoidance efforts – and by doing so, further discourage productive investment and job creation.

Our media widely report the fact that a large majority of Americans believe the “rich” need to pay higher taxes.  But you can’t efficiently tax the Rich by taxing “income”.  Look it up in a dictionary.  Rich relates to wealth, an accumulation of resources, not income.  But our leadership class on the Left ignores that fact just as studiously as their brethren on the Right.

Neither conservatives nor liberals publicly acknowledge or address the tax shelter for unrealized gains.

The facts are quite clear.  Our tax code is riddled with targeted preferences – and despite protestations of populist intentions from both sides of the spectrum, the aggregate benefits of those preferences skew very heavily toward the already privileged holders of accumulated wealth.    America’s prosperity has not been threatened by the tyranny of the majority.  It has been imperiled by cronyism among the rich and powerful.

The shell game of factual distortion and delusion through which our leadership conducts public debate is the process by which this cronyism is allowed to flourish and expand.  But the problem is not merely the inequity of the result – it is the inefficiency.

The path to renewed, sustainable economic growth and job creation is the productive deployment of capital.  That is the central concept behind capitalist theory, which also posits that the impetus for productive deployment of capital arises from fair and diverse competition in pursuit of individual self-interest: the famous “Invisible Hand” posited by Adam Smith.  Cronyism tilts the playing field and distorts investment decisions and valuation metrics.  Our tax and monetary policies have made tax avoidance and valuation manipulation far more profitable than productive enterprise.

So why is anyone surprised that we are creating recurring asset bubbles instead of jobs?

The path to more efficient tax policies would be obvious if we would spend less time and energy distorting the facts.  We need to stop subsidizing unproductive capital.  If we stop sheltering wealth from direct taxation, and impose a nominal and even-handed assessment upon the earnings potential of capital, essentially returning to the long-term historic norm of taxing property, we would free the Invisible Hand to stimulate more productive capital deployments.    The primary objective and rationale of such structural tax reforms should be the increased economic efficiency, prosperity and job creation that would follow.  By simply removing the current misplaced subsidies that distort investment incentives we could expect to stimulate an aggressive reallocation of private capital into more productive uses.

More equitable distribution of the cost burden of government would, of course, be a secondary benefit.   But the more compelling arguments for structural tax reform are the principles of capitalism which suggest freeing the Invisible Hand offers a path back to growth and prosperity.

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

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