A Citizen's 2% Solution

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

Why the wealthy should willingly pay higher taxes. 

Long ago Milton Friedman quipped, “Inflation is taxation without legislation.”  His underlying observation:   our real total tax burden is not limited to government tax collections; it is defined by the amount of government spending.  Today, many people describe inflation as a “tax” on financial assets.  But while inflation is a penalty and a burden, it is not a tax; at least not in the sense of funds that flow through the Treasury to support the operations of government.  This leads to what should be an obvious choice:  Is it better to have inflation?  Or taxes? 

At heart, habitual deficit spending and the inflation it fuels, is just an invidious form of cost shifting:  part of the increasingly complex shell game of misdirection and outright deception our government plays as it selectively doles out services and tax preferences among its favored constituencies.  Once again, I will quote Milton Friedman, “When a man spends someone else’s money on someone else, he doesn’t care how much he spends or what he spends it on. And that’s government for you.”  The truth behind that observation is the source of much of the public’s anger at government – government has become a game of commerce in which our leadership willfully seeks to provide benefits to one party while they extract funding from another.    While the public may be angry about it, we’re also complicit. 

Government’s attempt to provide services funded by Other People’s Money, and the public’s persistent demands that they do so, sit at the root of our fiscal dysfunction and profligacy.  The first step toward more responsible disbursement policies is to stop trying to make someone else pay our bills. 

For roughly four decades now the battle to control spending has focused upon constricting tax revenues… and it has very conspicuously failed.  Regardless of how logical it may have seemed; Starving the Beast has not worked.  Part of the reason it hasn’t worked is that we pretend someone else is paying the bill:  Tax Corporations!  Tax the Rich!  Tax Imports!  Tax Consumption!  Tax the Working Class!  Tax Future Generations!  Tax the Man Behind that Tree!  Until and unless we impose more equitable revenue policies so that every citizen pays a fair share of the full burden of government spending, America will never marshal the collective will to make difficult decisions about spending priorities. 

Today our leaders in Washington, responding to the demands of their constituents, shower the public with services while they play a game of musical chairs with the bill: shifting the costs, hiding the future obligations, and pretending the music is never going to stop.  In response the public moans and groans, complains about irresponsible politicians… and reelects whoever delivers the most pork.  As an alternative, imagine what would happen if, for one single election cycle, every American citizen received a tax bill for a fair allocation of the full government operations during the preceding year?  We would have 100% turnover in the following election.   

Decoupled from spending restraints, as it now is, Grover Norquist’s Anti-Tax Pledge is an inducement to theft.  It is, not coincidentally, the driver for a massive wealth transfer from the working middle class to the privileged and lucky few who stand at the very top of the ladder of success.  But that wealth transfer cannot continue; the structural imbalances created by preferential tax treatment of investment income and wealth have destabilized our productive economy and ultimately threaten those at the top as well as the bottom. 

Thus, the question: Is there a grand bargain to be made, converting the burden of inflation which stealthfully erodes the value of financial assets, into a legitimate tax that funds the current operations of government?  I believe there is.  By restructuring our approach to taxing investments and wealth we could improve both the equity and efficiency of our tax policies. 

Economists and central bankers keep trying to tell us that they have inflation under control.  But anyone who’s been near a restaurant, grocery store or gas pump in the last three decades has objective cause to question the legitimacy of that claim.  Admittedly, there’s been little recent wage inflation, at least among the working class.  But the cost of living increases that weigh most heavily upon the poor and middle class are real and painful… and assuming continuation of current monetary policy, soon to get much, much worse.     Inflation is an insidious burden upon investors and consumers alike.  It subsidizes borrowers, encourages speculation and distorts investments.  

The long term cost of inflation exceeds 2% per year.  A 2% annual assessment on net assets, as a replacement for all the various inefficient and inconsistently applied mechanisms now used to tax investments, could balance the budget almost immediately.  Assume a long term WACC of 8%, and a 2% asset tax is the equivalent to a 25% effective tax rate on the income potential of capital.  Drop peak earned income tax rates to the same 25% and you will have balanced the budget while simultaneously equalizing effective tax rates between labor and capital.  As a practical matter, it would also force the FED to put a floor under interest rates. 

A balanced budget and more equitable tax distribution are both desirable objectives; but they pale beside the potential benefit of economic stimulus that could arise from removing subsidies to unproductive capital. 

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.  If we level the playing field and stop subsidizing unproductive capital with preferential tax and monetary policies the natural response will be an aggressive reallocation of private capital that would provide far greater economic stimulus than anything government can afford to offer.  The key to job growth is comprehensive structural reform of investment tax policies. 

I offer this suggested revenue reform not as an alternative to government spending reductions, but because I perceive it is a prerequisite to imposing fiscal discipline upon our budget process.   Unless and until we address the issue of equity (real and perceived) in our tax revenue policies 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. 

Those who believe we can find a path to fiscal solvency by cost-cutting alone, while continuing to down-stream tax burdens onto the working middle class, are deluding themselves.  We already impose the penalty of high government spending via the burden of inflation.  It seems intuitively obvious that converting that hidden and unproductive burden to real taxes that flow through the treasury would allow us to both a) distribute it more equitably and b) manage it more efficiently. 

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

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 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. 

If we desire to stimulate job growth, priority number one should be examining and correcting the structural flaws in our tax policies that inadvertently 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. 

Unfortunately, instead of addressing this fundamental challenge our current public tax debate is A BATTLE OF BAD IDEAS.  America is headed to the polls in November faced with a false choice. 

• Doubling down on the failed strategy of tax cuts for the wealthy (the conservative choice) will 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 liberal choice) will encourage more aggressive tax avoidance efforts and thereby exacerbate economic stagnation and instability. 

Neither party is addressing the fundamental structural flaws and misincentives in our investment tax policies.   By inadvertently favoring unproductive capital we have abandoned Adam Smith’s Invisible Hand and are distorting investment incentives – to our great detriment. 

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.   The key to job growth is comprehensive structural reform of investment tax policies aimed at restoring the principle of equal treatment which lies at the core of both democracy and capitalism. 

I believe that by fundamentally re-thinking the structure we use to tax capital and investments, and eliminating misplaced biases and subsidies, private capital will flow naturally toward more productive investments, stimulating job growth and sustainable economic expansion.  As a secondary effect, it also provides the opportunity to reduce marginal tax rates on earned income and equalize tax rates between labor and capital; an opportunity which is both a) a desirable objective in and of itself, and b) a useful and compelling argument that could generate broad public support for reform. 

 I urge you to read the short post Want Job Growth? – Reinvigorate Capitalism or the longer Tax Notes’ article Factual Distortions Derail Productive Debate on Tax Reform.   A brief description of the specifics of the proposed structural reforms 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

The Best Kept Secret In America

Open any general interest newspaper or periodical published in the last two years and you are likely to see the same question:  “Why is this a jobless recovery?”  While professional pundits and media talking heads treat this question as a deep dark mystery, I suggest the answer is all too obvious.  It is the same reason why job growth stalled over the last two decades and the middle class stagnated while wealth and income increased its concentration at the top.  

Our tax and monetary policies have been aimed at protecting and increasing wealth, not stimulating productive enterprise.

Too-eager pursuit of Alan Greenspan’s “wealth effect” has inadvertently stimulated recurring asset bubbles and destabilized our economy.  Regardless of how well-meaning those policy choices may have been – they have been extremely damaging. 

*******

Conservative economists argue that incrementally higher tax rates discourage investment and work, and cause people to horde their pennies (presumably in lumpy mattresses) while they saunter off to sulk on the beach.  There is, of course, an active debate about how high is too high, and what might be an optimal balance.  But the dominant voices on both sides of the spectrum seem to me to be missing the more important and most destabilizing aspect of our existing tax structure and policies.   

The issues that keep me awake nights are -

1)      Existing structural tax preferences, intended to stimulate savings and investment, inadvertently subsidize unproductive capital allocations and stifle growth.    

• We’ve made tax avoidance and valuation manipulation far more profitable than productive enterprise. 
• Our tax and monetary policies have stimulated dangerous and unstable financial engineering and created recurring asset bubbles and collapses – while simultaneously subsidizing the transfer of billions of dollars in investment capital and millions of productive jobs overseas. 

2)      America is headed toward the polls in November faced with a false choice between two mutually flawed options. 

• The hyper-partisan battle in Washington is a power struggle of bad ideas in which both sides turn a blind eye to the underlying structural flaws that have destabilized our economy. 
• Unless we modify existing structural misincentives, higher tax rates (the liberal choice) will encourage more aggressive tax avoidance efforts and thereby exacerbate economic stagnation and instability. 
• Doubling down on the failed strategy of tax cuts for the wealthy (the conservative choice) will accelerate wealth and income inequality, increase budget deficits, undermine social welfare programs, and eventually lead to social unrest.   

Alternative:  Evaluate and Implement Structural Tax Reforms 

• We need to stop subsidizing unproductive capital with preferential tax treatment – so that holders of private capital will be incentivized to put their money more productively to work. 
•  We need to eliminate the Crony Capitalism through which government focuses on protecting wealth – to allow the free workings of legitimate capitalist theory to stimulate more productive private investment and economic growth. 
• I believe it is possible to equalize effective tax rates between labor and capital while simultaneously stimulating more productive investment. 

But political and economic theorists have abandoned capitalism’s core principle of the Invisible Hand in favor of preferential tax treatment for holders of wealth.   

If we desire to make progress toward broadly shared prosperity and growth, we need to illuminate the discrepancies between fact and dogma on both sides of the argument – and seek to reconcile the strengths and weaknesses of opposing positions.   Our investment incentives have become distorted.  We cannot simply argue about the rate schedules utilized in a flawed structure.  We need to be analyzing and evaluating structural changes that will stimulate more productive capital allocations. 

I believe the place to start that analysis is by assessing the factual misperceptions and outright distortions that characterize our current public debate and obscure the path to more equitable and efficient policies.  I urge you to consider the discussion and analysis on this topic published 6/18/12 in Tax Notes under the title Factual Distortions Derail Productive Debate on U.S. Tax Reform.  

Our rigidly polarized debate upon tax reform is built upon erroneous facts and assumptions that offer flawed options and false choices.  I invite you to consider a fresh perspective aimed at reconciling the strengths and weaknesses of the opposing arguments into a viable alternative path.  See  A Confluence of Benefits posted nearby.

Advocates for tax reform typically seize upon one of three alternative objectives which they treat as though they are, of necessity, mutually exclusive.  The proposal outlined in detail upon the pages of this site is designed to offer simultaneous stimulus toward all three of those equally worthy objectives. 

 1.       ECONOMIC GROWTH

• 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

2.       EQUAL TREATMENT

• 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 “pretence 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

3.       FISCAL RESPONSIBILITY

• Increased tax revenues 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

The long-term cost of inflation exceeds the cost of a 2% asset tax which could control deficit spending and stabilize the currency.  Any benefit from 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. 

By improving the perceived equity of tax revenue policies we can 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.

Your “fairness” arguments are falling on deaf ears.  I suggest a more effective argument would be the inefficiency of our current investment tax policies.   

A fundamental precept of capitalist theory is that productive deployment of capital is the driver of economic growth, and building upon that precept the consensus of economic teaching today assumes that tax policies must affirmatively encourage savings and investment. That is the perspective economists (and politicians) use to justify offering preferential tax rates to investment income. By nature, most economists are pragmatists. So, operating in the belief that a “rising tide lifts all boats”, most economists today are ready and willing to accept inequality (even deep and increasing income and wealth concentration) as the Darwinian cost of a “greater good”. They are largely unmoved by fairness arguments.

If preferential tax policies subsidizing capital actually were stimulating productive investment, economic growth and job creation, then we could perhaps afford to be pragmatic about some level of resulting inequity.

But our tax and monetary policies are encouraging over-leverage and stimulating valuation bubbles.   Our policies have made tax avoidance and valuation manipulation far more profitable than productive enterprise, thereby destabilizing our economy. I do not challenge the core theory that productive investment is a driver of economic growth and prosperity. But I dispute the idea that speculation on valuation inflation constitutes productive deployment of capital. It is on that basis that I believe we need to fundamentally reexamine the structure and incentives embedded in our treatment of investment income.

Look carefully at how our tax policies treat alternative capital allocations. We a) penalize productive investments with our highest tax rates, (equaling and occasionally exceeding earned income tax rates via the “double taxation” of dividends and capital gains distributions), b) offer speculative trading activities substantially reduced tax rates, and c) subsidize illiquid and wholly unproductive capital allocations with perpetual tax deferrals. Perpetual deferral of unrealized gains is a strong and compelling obstacle to the rapid and fluid reallocation of capital to more productive uses – thus opposing a key tenet of capitalist theory. The actual incentives of existing policy are diverting capital away from the productive investments we intend to be encouraging. 

Too much of what we call investing, and incent and subsidize with preferential tax treatment, is simply gambling. I’m largely libertarian in my views, so I don’t want to preclude people from gambling. But I certainly think we ought to stop subsidizing it with preferential tax treatment.

Betting on whether a stock price or index fund is going to go up or down is not the same as investing in the development and operations of a productive business.  Nailing $2 million dollars of potentially productive capital on my wall in the form of a Picasso may well be a choice I choose to make, but I can’t justify it as an efficient deployment of capital generating much societal benefit – and I therefore don’t believe that tax policies should be providing me a financial incentive to do so.

Unfortunately, the bulk of our current debate on tax reform either ignores these structural challenges entirely, or threatens to exacerbate these problems by shifting our tax base to greater reliance on consumption taxes which are deeply regressive and would actually make our existing problems worse. 

There is an alternative which I believe deserves to become part of the public debate.  I believe if we would withdraw the subsidies that now obstruct the free and fluid flow of capital to higher and better uses, the natural influence of personal self interest would incent holders of capital to pro-actively seek out more productive investments; and thereby stimulate economic growth and job creation.  The structure I propose would simultaneously defuse increasing anger against the so-called “1%” by equalizing tax rates assessed upon labor and capital income. 

Specifically, I propose that corporate income taxes, personal investment income taxes, estate and inheritance taxes and gift taxes should all be repealed and replaced with an annual 2% tax on net assets (subject to a reasonable minimum threshold). Simultaneously, we should flatten and reduce taxes on earned income to a maximum of 25%, inclusive of all employment taxes (employee and employer). At these levels, the effective tax rate upon labor and investment income potential would be approximately equal:  assuming a long term target return on capital of 8%, a 2% annual tax is the equivalent of a 25% income tax rate.  This substantial reduction of earned income tax rates would stimulate middle class earnings, savings and consumer spending. 

This is not an anti-capitalist proposal.  It is a call to return to core principles of equal treatment and fair competition which are the foundation of capitalist theory. 

“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 in which the wealthiest and most privileged among our society are subsidized with preferential tax rates. 

America is approaching a tipping point, as more and more of its capital is being diverted away from productive enterprise by ill-considered and counter-productive incentives embedded in our tax treatment of investment income.  It is time to evaluate and implement structural changes in those policies. 

Self-interest is a much more efficient motivator than guilt.  Our political leadership and most of the influential media are members of the 1%.  Advocating change by trying to make them feel guilty about their positions of privilege is unlikely to be an effective argument.  But preferential treatment of the already privileged has put our economic stability at risk.  Our top-heavy house of cards is threatening to collapse.  Convince leadership of that real and compelling risk – and perhaps then they will begin to evaluate meaningful alternative tax and budgetary reforms.  A good place to start would be purging our system of the counter-productive, undemocratic and anti-capitalist influences of cronyism that distort investment incentives. 

Replies, observations or rebuttals are welcomed, 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

It is accepted dogma of economic theory that higher taxes on business profits and investment income discourage investment and stifle growth.  That is the justification for allowing the richest and most privileged Americans to pay lower taxes on investment returns than the working stiff pays on wages and salaries. 

I don’t challenge that dogma.  It is indisputably true. 

But, taken to its logical conclusion, that suggests that the best way to stimulate investment, hiring, and economic growth, would be to repeal all corporate profit and investment income taxes.  So why don’t we do that?  Why don’t we repeal all corporate profit and investment income taxes? 

Presumably because we (society) think that it would be unreasonable to allow the already privileged to accumulate still greater wealth without contributing a fair share to the costs of government and society.  Here again, I share the collective opinion.  I think the rich derive great benefits from society and I think they should fairly share the burden of supporting that society.  In fact, I think it is unfair and unreasonable that the wealthy pay lower tax rates than the working class – even though I understand the dogmatic and pragmatic rationale. 

Which raises a conundrum:  How do we repeal investment income taxes to stimulate economic activity without giving the wealthy a free ride?  And since we’re addressing a modification of existing tax policy, can we restructure policies in a manner that removes distorting incentives and encourages the “invisible hand” of Adam Smith’s capitalist theory to operate more efficiently? 

FlatTax advocates argue that we should replace corporate profit and investment income taxes with some variation of a consumption tax:  a Value-Added Tax, or a National Sales Tax, or some alternative variation or combination of regressive transactional taxes which would penalize that portion of the population who consumes all their income annually and favor the privileged and lucky few who are already accumulating an increasingly large percentage of the national wealth.  (To give credit to their benevolent natures, most FlatTax proponents do argue they would provide credits or adjustments for the poor to offset the inherent regressive nature of consumption taxes.   However, as I see it, taxes which favor the rich and favor the poor are still regressive toward the working middle class.) 

So I have a different alternative.  How about if we tax wealth instead of investment income?  Just like real estate.  (Actually, not like real estate.  Because we tax real estate on gross value, but I think we should only tax wealth on a net basis.)

Think about it.  Why don’t we repeal corporate and investment income taxes, and estate and gift taxes, and instead tax accumulated net wealth at a flat 2% annually? 

Our efforts to tax investment profits generate a multitude of undesirable unintended consequences.  In the first place, as per the old accountant’s axiom, “profit is just an opinion”.  Our tax laws have stimulated an entire industry revolving around manipulating “profit” for the purposes of tax avoidance.  The higher the rates, the harder and more aggressively businesses work to shelter their income from the tax man.  Worse yet, Congress conspires with them to do it.  The existing rat’s nest of complex laws and regulations all emanate from Congress’ efforts to manipulate the system.   Special treatment under the tax code is the tool they use to buy and sell power and influence.  Why don’t we take that tool away from them and return equal treatment to the tax code? 

Capitalist theory suggests that economic efficiency is achieved when the market blindly rewards individual self-interest.  Note, that invisible hand of the market is supposed to be blind of managed objectives, just like Lady Justice, devoid of favoritism, operating with its thumb clear of the scale and allowing the market freedom to accumulate the benefits of unfettered commerce.  But our existing tax code imposes penalties that obstruct that efficiency and discourage productive investments. 

You don’t believe it?  Let’s look at three simplified examples.  Alan, Bob and Charlie each have two million dollars in accumulated net wealth. 

Alan invested his entire $2 million in a sole proprietorship.  He works exceptionally hard and runs a profitable business.  He draws a small salary but takes most of his income as return on his invested capital.  Let’s assume a 12% return on assets, or $240,000 per year.  If he doesn’t shelter his operations through some tax advantaged ownership structure it’s taxed as ordinary income – with a top marginal rate of 35%.  If he structures the business as a corporation and leaves the money in the corporation he will have more flexibility to shelter some of it from taxes by manipulating “profit”, but corporate taxes will still take a nominal marginal bite of 39%. 

Bob invests his entire $2 million in publicly traded equities.  Unless it’s a loss position (so he can use it to shelter other gains) Bob never sells anything in less than 365 days.  For arguments sake let’s say Bob earns the same 12% annual return on his investments, an equal $240,000.  So the portion of his portfolio which turns over each year is subject to a long term capital gains tax, currently set at 15%, less than half Alan’s marginal tax rate.  To the extent Bob doesn’t need his investment income to support his current expenditures, and doesn’t churn his portfolio, he can defer his capital gains and pay zero tax on a current basis.  Thus, Bob, the passive investor, pays far less toward the support of society than his equally wealthy entrepreneurial neighbor, Alan.  In rough, round figures let’s say at least 50% less.  Depending upon just how infrequently he churns his investments, his annual tax bill could be much less than that. 

Charlie took his entire $2 million and bought a painting by Picasso.  He keeps it on the wall in his paneled office for his personal viewing pleasure.  Although he doesn’t intend to ever sell it, for symmetry ’s sake let’s assume it is appreciating in value by 12% per year, providing Charlie with the same annual investment return as Alan and Bob.  Yet Charlie pays zero annual tax.  Yes, he may eventually pay something in estate taxes.  It’s hard to tell how much because Congress has been manipulating estate taxes like a yo-yo.  (If he dies this year, he pays nothing because the estate tax has expired.  If he died last year he would have paid nothing because his assets were under the $3.5 million exemption.  If he dies next year he could pay 55% of any value in excess of $1 million – unless Congress changes the law again – which it almost certainly will.)  But as long as he lives, and maintains ownership of his Picasso, he will pay no annual tax on its appreciating value. 

So there you have it.  Three men of equal wealth pay three entirely dissimilar tax bills.  Certainly, if there is justice or rationality in our system the man who pays the lowest tax bill is being rewarded for activity which represents the highest benefit to our society.  Yes? 

Look again.  Charlie took $2 million out of economic circulation.  The primary benefit of his investment is the private smile that comes over his face when he sits quietly in his office.  Our tax code favors his choice.  Alan, the entrepreneurial businessman, actively building the economy, pays the highest tax bill. 

In my scenario, they would all three receive an equal tax bill, 2% of $2 million, or $40,000.  The Invisible Hand of capitalism would operate freely.  The distorting influence of investment profit taxes would be removed.  Each man would benefit from the wisdom of his own decisions.   At my posited 12% annual return, their 2% of assets would convert to the equivalent of 16.7% of income.  If, alternatively, they invested more conservatively in bonds paying a 5% return, their tax bill would be equivalent to 40% of income.  As a percent of their accumulated wealth and ability to pay, each investor’s tax bill would be entirely equal.  In contrast to existing policies, where the tax man reduces one’s bill in response to cautious decisions or poor returns, under my proposed system each investor would retain the full benefit (or risk) of their respective choices. 

Isn’t that how a free market is supposed to work? 

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. 

PS – for the FlatTaxers out there – Abolishment of employment taxes and establishment of a modified flat tax applied to all earned income is an accompanying feature of my proposed 2% Solution.  (For the record, I believe characterizing social security “contributions” as anything other than general tax revenues is simply a polite fiction, conveniently hiding the fact that the working middle class pays higher marginal tax rates on earned income than their more affluent and successful neighbors.  See Social Security: Trust? Or Ponzi Scheme?.)