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.
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