Tag: capital gains tax

Debunking Fiscal Myths: There Is No Loophole for “Carried Interest”

I’m a big fan of the flat tax because a low tax rate and no double taxation will result in faster growth and more upward mobility.

I also like the flat tax because it gets rid of all deductions, credits, exemptions, preferences, exclusions, and other distortions. And a loophole-free tax code would be a great way of reducing Washington corruption and promoting simplicity.

Moreover, keep in mind that eliminating all favors from the internal revenue code also would be good for growth because people then will make decisions on the basis of what makes economic sense rather than because of peculiar quirks of the tax system.

Sounds great, right?

Well, it’s not quite as simple as it sounds because there’s a debate about how to measure loopholes. Sensible people want a tax code that’s neutral, which means the government doesn’t tilt the playing field. And one of the main implications of this benchmark is that the tax code shouldn’t create a bias against income that is saved and invested. In the world of public finance, this means they favor a neutral “consumption-base” tax system, but that’s simply another way of saying they want income taxed only one time.

Folks on the left, however, are advocates of a “Haig-Simons” tax system, which means they believe that there should be double taxation of all income that is saved and invested. You see this approach from the Joint Committee on Taxation. You see it from the Government Accountability Office. You see it from the Congressional Budget Office. Heck, you even sometimes see Republicans mistakenly use this benchmark.

Higher Tax Rates and Lower Revenues 1925-36

My recent Wall Street Journal op-ed, “Hillary Parties Like It’s 1938,” is not just about FDR’s self-defeating “tax increases” in 1936-37.  It is also about the particularly huge across-the-board increase in marginal tax rates the Herbert Hoover pushed for and enacted retroactively in 1932.   The primary motive in 1932, as in 1936, was to raise more revenue.   Federal spending under President Hoover doubled from 3.4% of GDP in 1930 to 6.8% in 1932, and he believed that unprecedented spending spree required that tax rates be even more than doubled to “restore confidence.”

Unfortunately, things did not quite work out as planned.  Total federal revenues fell dramatically to less than $2 billion in 1932 and 1933 – after all tax rates had been at least doubled and the top rate raised from 25% to 63%.  That was a sharp decline from revenues of $3.1 billion in 1931 and more than $4 billion in 1930, when the top tax was just 25%.  

Some may object that this is unfair, arguing that revenues should be expressed as a share of GDP because GDP fell so sharply in 1932 and 1933.  But that begs a key question.  Comparing the drop in revenues to the even deeper drop in GDP would make sense only if the depth and duration of the 1932-33 drop in GDP had absolutely nothing to do with higher tax rates (including Smoot-Hawley tariffs).  Yet neither Keynesian nor supply-side economics would consider huge tax hikes are so harmless (though Keynesians, seeing no revenue gain, might come to the paradoxical conclusion the Hoover actually cut taxes).  

In any case, dividing weak revenues by even weaker GDP doesn’t help support the conventional wisdom that higher tax rates always bring higher revenues. Revenues fell even as a share of falling GDP –  from 4.1% in 1930 and 3.7% in 1931 to 2.8% in 1932 (the first year of the Hoover tax increase) and 3.4% in 1933. That illusory 1932-33 “increase” was entirely due to less GDP, not more revenue. 

Grading Perry’s Flat Tax: Some Missing Homework, but a Solid B+

Governor Rick Perry of Texas has announced a plan, which he outlines in the Wall Street Journal, to replace the corrupt and inefficient internal revenue code with a flat tax. Let’s review his proposal, using the principles of good tax policy as a benchmark.

1. Does the plan have a low, flat rate to minimize penalties on productive behavior?

Governor Perry is proposing an optional 20 percent tax rate. Combined with a very generous allowance (it appears that a family of four would not pay tax on the first $50,000 of income), this means the income tax will be only a modest burden for households. Most important, at least from an economic perspective, the 20-percent marginal tax rate will be much more conducive to entrepreneurship and hard work, giving people more incentive to create jobs and wealth.

2. Does the plan eliminate double taxation so there is no longer a tax bias against saving and investment?

The Perry flat tax gets rid of the death tax, the capital gains tax, and the double tax on dividends. This would significantly reduce the discriminatory and punitive treatment of income that is saved and invested (see this chart to understand why this is a serious problem in the current tax code). Since all economic theories - even socialism and Marxism - agree that capital formation is key for long-run growth and higher living standards, addressing the tax bias against saving and investment is one of the best features of Perry’s plan.

3. Does the plan get rid of deductions, preferences, exemptions, preferences, deductions, loopholes, credits, shelters, and other provisions that distort economic behavior?

A pure flat tax does not include any preferences or penalties. The goal is to leave people alone so they make decisions based on what makes economic sense rather than what reduces their tax liability. Unfortunately, this is one area where the Perry flat tax falls a bit short. His plan gets rid of lots of special favors in the tax code, but it would retain deductions (for those earning less than $500,000 yearly) for charitable contributions, home mortgage interest, and state and local taxes.

As a long-time advocate of a pure flat tax, I’m not happy that Perry has deviated from the ideal approach. But the perfect should not be the enemy of the very good. If implemented, his plan would dramatically boost economic performance and improve competitiveness.

That being said, there are some questions that need to be answered before giving a final grade to the plan. Based on Perry’s Wall Street Journal column and material from the campaign, here are some unknowns.

1. Is the double tax on interest eliminated?

A flat tax should get rid of all forms of double taxation. For all intents and purposes, a pure flat tax includes an unlimited and unrestricted IRA. You pay tax when you first earn your income, but the IRS shouldn’t get another bite of the apple simply because you save and invest your after-tax income. It’s not clear, though, whether the Perry plan eliminates the double tax on interest. Also, the Perry plan eliminates the double taxation of “qualified dividends,” but it’s not clear what that means.

2. Is the special tax preference for fringe benefits eliminated?

One of the best features of the flat tax is that it gets rid of the business deduction for fringe benefits such as health insurance. This special tax break has helped create a very inefficient healthcare system and a third-party payer crisis. It is unclear, though, whether this pernicious tax distortion is eliminated with the Perry flat tax.

3. How will the optional flat tax operate?

The Perry plan copies the Hong Kong system in that it allows people to choose whether to participate in the flat tax. This is attractive since it ensures that nobody can be disadvantaged, but how will it work? Can people switch back and forth every year? Is the optional system also available to all the small businesses that use the 1040 individual tax system to file their returns?

4. Will businesses be allowed to “expense” investment expenditures?

The current tax code penalizes new business investment by forcing companies to pretend that a substantial share of current-year investment outlays take place in the future. The government imposes this perverse policy in order to get more short-run revenue since companies are forced to artificially overstate current-year profits. A pure flat tax allows a business to “expense” the cost of business investments (just as they “expense” workers wages) for the simple reason that taxable income should be defined as total revenue minus total costs.

Depending on the answers to these questions, the grade for Perry’s flat tax could be as high as A- or as low as B. Regardless, it will be a radical improvement compared to the current tax system, which gets a D- (and that’s a very kind grade).

Here’s a brief video for those who want more information about the flat tax.

Last but not least, I’ve already received several requests to comment on how Perry’s flat tax compares to Cain’s 9-9-9 plan.

At a conceptual level, the plans are quite similar. They both replace the discriminatory rate structure of the current system with a low rate. They both get rid of double taxation. And they both dramatically reduce corrupt loopholes and distortions when compared to the current tax code.

All things considered, though, I prefer the flat tax. The 9-9-9 plan combines a 9 percent flat tax with a 9 percent VAT and a 9 percent national sales tax, and I don’t trust that politicians will keep the rates at 9 percent.

The worst thing that can happen with a flat tax is that we degenerate back to the current system. The worst thing that happens with the 9-9-9 plan, as I explain in this video, is that politicians pull a bait-and-switch and America becomes Greece or France.

Explaining the Perverse Impact of Double Taxation With a Chart

Whether I’m criticizing Warren Buffett’s innumeracy or explaining how to identify illegitimate loopholes, I frequently write about the perverse impact of double taxation.

By this, I mean the tendency of politicians to impose multiple layers of taxation on income that is saved and invested. Examples of this self-destructive practice include the death tax, the capital gains tax, and the second layer of tax of dividends.

Double taxation is particularly foolish since every economic theory—including socialism and Marxism—agrees that capital formation is necessary for long-run growth and higher living standards.

Yet even though this is a critically important issue, I’ve never been satisfied with the way I explain the topic. But perhaps this flowchart makes everything easier to understand.

There are a lot of boxes, so it’s not a simple flowchart, but the underlying message hopefully is very clear.

  1. We earn income.
  2. We then pay tax on that income.
  3. We then either consume our after-tax income, or we save and invest it.
  4. If we consume our after-tax income, the government largely leaves us alone.
  5. If we save and invest our after-tax income, a single dollar of income can be taxed as many as four different times.

You don’t have to be a wild-eyed supply-side economist to conclude that this heavy bias against saving and investment is not a good idea for America’s long-run prosperity.

There are various ways to protect yourself from double taxation, particularly by using IRAs and 401(k)s. You lock up your capital until retirement, but it is protected from double taxation.

Also, you cannot accumulate enough savings and investment to be subject to the death tax, though that’s not exactly aiming high.

But these strategies—and others—are not economically optimal. There should not be a tax bias against capital formation.

Too bad we can’t be more like Hong Kong, which has eliminated all extra layers of taxation.

That’s the benefit of real tax reform such as a flat tax. You get a low tax rate and you get rid of corrupt loopholes, but you also get rid of double taxation so that the IRS only gets one bite at the apple.

A Clever British Campaign against Higher Capital Gains Tax Rates

Here are a handful of the posters being used in the United Kingdom to fight the perversely-destructive proposal to increase tax rates on capital gains. (for an explanation of why the tax should be abolished, see here)

Which one is your favorite? I’m partial to the last one because of my interest in tax competition.

But this isn’t just a popularity contest. With Obama pushing for higher capital gains rate in America, it’s important to find the most persuasive ways of educating people about the damage of class-warfare tax policy.

By the way, “CGT” is capital gains tax, and “Vince” and “Cable” refers to Vince Cable, one of the politicians pushing this punitive class-warfare scheme.

Overhauling CBO and JCT Is a Real Test of GOP Resolve, not the ‘Pledge to America’

While I’m glad Republicans are finally talking about smaller government, I’ve expressed some disappointment with the GOP Pledge to America. Why “reform” Fannie and Freddie, I asked, when the right approach is to get the government completely out of the housing sector. Jacob Sullum of Reason is similarly underwhelmed. He writes:

In the “Pledge to America” they unveiled last week, House Republicans promise they will “launch a sustained effort to stem the relentless growth in government that has occurred over the past decade.” Who better for the job than the folks who ran the government for most of that time? …Republicans, you may recall, had a spending spree of their own during George W. Bush’s recently concluded administration, when both discretionary and total spending doubled – nearly 10 times the growth seen during Bill Clinton’s two terms. In fact, says Veronique de Rugy, a senior research fellow at George Mason University’s Mercatus Center, “President Bush increased government spending more than any of the six presidents preceding him, including LBJ.” Republicans controlled the House of Representatives for six of Bush’s eight years.

Redemption is a good thing, however, so maybe the GOP actually intends to do the right thing this time around. One key test is whether Republicans do a top-to-bottom housecleaning at both the Congressional Budget Office and the Joint Committee on Taxation.

These Capitol Hill bureaucracies are not well known, but they have enormous authority and influence. As the official scorekeepers of spending (CBO) and tax (JCT) bills, these two bureaucracies can mortally wound legislation or grease the skids for quick passage.

Unfortunately, that clout gets used to dramatically tilt the playing field in favor of bigger government. It was CBO that claimed that Obama’s stimulus created jobs, even though the head of CBO was forced to admit that the jobs-created number was the result of a Keynesian model that was rigged to show exactly that result . You would think that would shame the bureaucrats into producing honest numbers, but CBO continues to produce absurd job creation estimates regardless of the actual rate of unemployment.

CBO favors deficits and debt when it is asked to analyze proposals for more spending, but it rather conveniently changes its tune when the discussion shifts to tax increases. Since we’re on the topic of twisted economic analysis, CBO actually relies on a model which, for all intents and purposes, predicts that economic performance is maximized with 100 percent tax rates.

The Joint Committee on Taxation, meanwhile, is infamous for its assumption that taxes have no impact - at all - on economic output. In other words, instead of showing a Laffer Curve, JCT would show a straight line, with tax revenues continuing to rapidly climb even as tax rates approach 100 percent.  This creates a huge bias against good tax policy, yet JCT is impervious to evidence that its approach is wildly flawed.

And don’t forget that CBO and JCT both bear responsibility for Obamacare since they cranked out preposterous estimates that a giant new entitlement would lead to lower budget deficits.

Not that we need additional evidence, but the head of the CBO just repeated his higher-taxes-equal-more-growth nonsense in testimony to the Senate Budget Committee. With this type of mindset, is it any surprise that fiscal policy is such a mess?

Douglas Elmendorf said extending breaks due to expire at year’s end would increase demand in the next few years by putting more money in consumers’ pockets. Over the long term, he said, the tax cuts would hurt the economy because the government would have to borrow so much money to finance them that it would begin competing with private companies seeking loans. That, in turn, would drive up interest rates, Elmendorf said.

I’ve already written once about how the GOP sabotaged itself when it didn’t fix the problems with these scorekeeping bureaucracies after 1994. If Republicans take power and don’t raze CBO and JCT, they will deserve to become a permanent minority party.