U.S. tax policy is extremely foolish on several counts. One
of the most important, it now appears, is creating perverse
financial incentives and thereby contributing to last year's
economic crisis.
The International Monetary Fund has completed a study of the U.S.
economy and crash.
Reports former Reagan Treasury official Bruce Bartlett:
The most important problem identified by the IMF is the
favorable tax treatment of debt and the punitive taxation of
corporate equity in our system. This problem is exacerbated by
a higher corporate tax rate in the U.S. than exists in most
other countries, which magnifies the benefits of debt relative
to equity.
The basic problem is that corporate profits are taxed twice:
first by the corporate income tax and then again by the
personal income tax when net profits are paid out to the
corporation's owners, the shareholders. As a consequence, the
total tax rate on corporate profits is very high.
At the margin, profits earned by a corporation face a tax as
high as 44.75%: 35% at the corporate level and another 15% at
the individual level on the paid-out profits. But the maximum
rate of 15% on individuals is only temporary and will expire at
the end of next year. When that happens, dividends may be taxed
as high as 39.6%, raising the combined tax on corporate profits
to 60.74%. (The current top rate of 35% on individual incomes
also expires next year.)
The Obama administration has proposed capping the tax on
dividends at 20%, but this measure is not yet in law and may
end up being sacrificed to pay for health reform or deficit
reduction. The maximum tax rate on corporate profits would rise
to 48% if it is enacted.
Some economists would say that the true rate is even higher
because the capital gains tax is another layer of taxation. If
we assume that the value of a share of stock is just the
capitalized value of the future flow of dividends, then a stock
price rise mainly results from a belief by investors that
future dividends will be higher. Since those dividends will be
taxed twice, one can argue that the capital gains tax is really
a third tax on the same profits.
By contrast, debt is much more lightly taxed because interest
payments are fully deductible against the corporate income tax.
Moreover, purchasers of corporate debt are often tax-exempt
entities such as pension funds, charitable institutions and
sovereign wealth funds.
The result is that while corporate equity is heavily taxed, the
tax system provides an effective subsidy for debt-financed
investments. According to the study, the average effective tax
rate on equity is 24%, but the rate on debt is -46%.
This wide spread led to the creation of exotic financial
instruments designed to capture the tax benefits of debt while
retaining the ownership rights of equity. These hybrid
instruments are necessarily highly complex, making it hard for
investors to judge their value and credit-worthiness. Thus, tax
considerations helped fuel the growth of debt and the creation
of difficult-to-price assets that are at the heart of the
economic crisis.
There's more to the economic crash, obviously, but this is just
further evidence of the need for systematic tax reform and
relief. We need to reduce and symplify taxes. Alas,
that isn't likely, to put it mildly. to be on the agenda
over the next four years.
