What’s Wrong and How to Fix It, Part 6: Tax Reform
Published on: January 2, 2013
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  • Shaun

    Regarding a VAT, another thing that I don’t think I heard you mention is that it can also boost the stock of savings within a country assuming we eliminate the payroll tax and drastically shrink or eliminate income taxes. You’d have to do some sort of tweaking to keep it from regressively hitting the poor the hardest, but it’s much more desirable than the current system. What would happen to all the Accounting and Tax Law jobs if it happened would still be another issue to work out as well.

  • Brendan Doran

    “First, it would be disastrous to add a VAT tax on top of the current system, even a significantly reformed current system.”

    Well Sir they will. And it will be whacky all on it’s own..and probably regressive.

  • Mark Jamison

    Complexity breeds obfuscation which ultimate results in advantage. This pretty much explains why the tax code is so complicated; the well-off who can manipulate its provisions love the level of complexity.
    The income tax ought to be simple, straightforward, progressive and designed to raise revenue as its first and primary vehicle. If we want to have disagreements about how we spend money that’s fine but currently the argument really is about taxes; and for the wrong reasons.
    With a few exceptions social and economic policy ought to be run through legislation not hidden in the tax code. The major exception I would make is for the EITC which is more efficient and more effective within the income tax code.
    The VAT is an unnecessarily complex system. I would much prefer to see taxes like the financial transactions tax which directly treat negative behavior and raise significant money relatively painlessly.
    If the corporate tax could be simplified that would be preferable but it likely cannot be for long as various accounting tricks become temptation. One solution may be in making GAAP and tax accounting synonymous. Another might be a revenues tax would be a relatively small percentage and much easier to administer.

  • Jay

    “If we must have a corporate tax at all—and under a VAT system we could more easily eliminate it altogether—it ought to be designed so that short-term investments are taxed at higher rates than long-term ones.”

    Actually, the current tax code does attempt to do this to some extent. The lower tax rate on capital gains applies only to gains on assets that have been held for more than one year. Capital gains on assets held for less than a year (“short-term capital gains”) are taxed at the higher ordinary-income rate. With respect to corporate stock, capital gains reflect the *after-tax* return on the corporation’s investments, which is why the capital gains tax is often viewed as a “double tax” on top of the corporate income tax. This is one of the major policy arguments for taxing capital gains (and dividends) at a lower rate than ordinary income. If corporate profits were taxed on a flow-through basis to shareholders rather than at the corporate level (i.e., the way partnerships and S corporations are taxed), the appearance of wealthy individuals paying a lower tax rate would largely disappear. (Having said that, it’s certainly true that the definition of capital gains is problematic and creates some loopholes.)

    Incidentally, a much larger factor than business tax credits in the decline of corporate tax revenue is the fact that many more businesses are organizing as partnerships, LLCs, S corporations, and other forms that are taxed under the individual (rather than corporate) income tax. As you note, all taxes are ultimately paid by people, not abstract corporate entities, so this trend is probably a good thing for transparency.

  • Brendan Doran

    Mr. Jamison you contradict yourself. You would like a simple progressive system that doesn’t socially engineer [sure.right] that only keeps complexity you like [EITC] and punishes negative behavior [financial] that you don’t like.

    We already have all that.

  • Yisroel Markov

    This article has much with to agree, but also some contradictions. First it says about tax code as an incentive structure: “The idea was simple (and wrong): People were individual value-maximizing decision units, so if you made it worth their while to act one way and not another, they would.” Then it says: “…quite rightly, if you want more of something, don’t tax it, and if you want less of something, do tax it” and proceeds to lay out tax incentive proposals. Huh?

    The rationale for taxing capital gains at a lower rate is of a dual nature. First, the idea is to incentivize saving and investment, AKA capital formation. Second, it is to recognize that the capital gains on securities are fueled, aside from speculation that corrects itself in the long run, by two factors: profitability of underlying corporate assets and inflation. The former has already been taxed at the corporate level; the latter is just plain immoral to tax. (Incidentally, a major reason corporate tax revenue has declined as a share of receipts is the massive switch from C to S corporations that happened in the 1970s – in response to changes in the code, of course.)

    So yes, let’s slay the IRS-code dragon, mandate a flat tax via Constitutional amendment (like in Massachusetts), eliminate the corporate tax, and index capital gains to inflation. Then all income can be fairly taxed at the same rate. And let’s not tilt the playing field towards anything, including labor. That way, as always, lies inefficiency and less prosperity for all.

  • Walter Sobchak

    “Even more basically, it is equally strange that we tax capital gains at a lower rate than we tax income itself. What is the rationale for that?”

    There 6 arguments that I can think of for the differential treatment of earned income and capital gains.

    1. In a system of annual graduated rates, capital gains, which represent income deriving over long periods, will be taxed at a higher rate than they would have been if they had been spread out. This argument had more force in the pre-Reagan era when rates went as high as 70%

    2. Capital gains are income with no limit, but capital losses in excess of capital gains can only be deducted up to a maximum of $3,000, a number that has not changed in a very long time.

    This asymmetry in treatment of losses and gains would be totally unacceptable if it were not for the favorable treatment of gains.

    3. The constitution authorizes Congress to tax income. It does not authorize Congress to tax capital. Furthermore, taxing capital is eating the seed corn. Always a bad idea. admittedly, there is boundary line issue between income and capital. A day trader in stocks has no particular claim that his gains are capital. They are the rewards of his labors, the very definition of income. At the same time, and by the same token, a man who builds a business over a lifetime of hard work has created capital. Distinctions need to be made and lines need to be drawn, but the first example does not justify taxing the second.

    4. The IRC provides no adjustment for inflation. The capital gains tax was not invented to mitigate that issue. It arose at a time when the US used a constitutional currency and inflation was not a major problem. But, it does mitigate the impact of inflation.

    We bought our house for $300,000 in 1986 when the CPI was 110. If we sold it today for $900,000 while the CPI is 230. we would have a gain of $600,000 in raw numbers, but it would be an economic gain of only $273,000. Paying tax at the lower rate mitigates the lack of an adjustment for inflation.

    5. The system of corporate taxation is based on a illusion that corporations are persons apart from their owners and managers. Thus if a corporation makes $1 of taxable income, it keeps $0.65. If it pays the $1 dividend in when there is no preference for dividends, the stockholder gets to keep $0.42. The lower rates for dividends and for capital gains mitigate the over-taxation of corporate profits.

    6. Capital gains are usually optional. Property owners can hold their property instead of selling it. Taxing capital gains at high rates will discourage owners from selling and reduce revenue. Lowering capital gains rates encourages sales and increases revenues.

    I am sure there a couple of other arguments, and that they will come to me after I hit the publish button.

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