President Obama has repeatedly called for a fairer tax system.
Last month he told a crowd, “Keep in mind, a quarter of all
millionaires pay lower tax rates than millions of middle class
households. You’ve heard me say it: Warren Buffett pays a lower tax
rate than his secretary.” This is, of course, a political stunt
rather than a serious proposal, but we should learn from it. If you
really want to tax all income at the same tax rate independently of
how it is earned — whether via dividends from a company you invest
in or wages from your employer — the last thing you should do is
hike the tax rate on capital gains.
Here’s why. Let’s start from a simple, unarguable premise: A
business doesn’t pay taxes any more than your front door does.
People pay taxes. Taxes on corporate profits are actually
paid by customers through higher prices, workers through lower
wages, and stockholders through lower dividends.
Now suppose you hold company stock. That stock is a claim on the
company’s future dividends, when it distributes future profits.
Inventing new products or capturing new markets opens up new
possibilities to make profits. That should increase the value of
your shares.
Unfortunately the tax system takes a bite out of those returns
in at least three ways: 1) a share of the profits, 2) another share
when what is left is paid out in dividends, and 3) a final share
when the prospect of those dividends leads to an increase in the
share price. That increase in the share price is smaller than it
would have been without the taxes on profits and dividends, but it
still produces a capital gain and yet another tax bill.
Growing business profits lie at the heart of the free market’s
mechanism for economic growth. They provide the vital reward for
innovation and the investment needed to bring it to market. Yet we
tax that vital process repeatedly and then wonder why the economy
doesn’t produce more new jobs and higher wages. Lazily, we often
blame “corporate greed” instead, and look to tax it more as
punishment. But yet more damage could be done.
Policy makers could easily compound the existing error by
setting the capital gains tax alone at the same rate applied to
labor income. It was fortunate that the Buffett Rule failed.
However, that doesn’t necessarily mean the basic idea of tax equity
is bad in itself.
If you really want to ensure everyone pays the same
rate, then you need to ensure that they are paying the
same tax as well. To do that we need to get rid of taxes
on corporate profits and capital gains and instead apply a single
tax when money is distributed — however it is distributed. That is
easier said than done, but across the Atlantic, the TaxPayers’ Alliance and the
Institute of Directors in London have set out a plan to achieve
it as part of their 2020 Tax Commission project.
Their Single Income Tax would merge all the different taxes into
a single, comprehensive, and equitable tax on capital income that
ensures no one pays more or less than their fair share. They also
consider ways to achieve the same with labor income. The reforms
would produce a far simpler tax code — no more worrying about
depreciation schedules or anything of the sort. They would also be
a huge boost to competitiveness. And the same principles apply to
America.
Importantly, the Commission came to one crucial conclusion when
looking at how to achieve a fairer and simpler tax system: You
can’t do it while raising taxes. The lesson of major tax reforms
from Kennedy to Thatcher and Reagan is that they can be successful
and last, but only when they cut the rates paid by ordinary
people.
That won’t satisfy politicians who want to plug huge deficits
caused by excessive and wasteful spending with ever higher taxes.
But it is the right objective for those who want to foster
innovation and growth, and who don’t see leaving more money in the
pockets of the taxpayers who earned it as a bad thing.
