I’m not an economist, but you don’t have to be one to understand taxes. I am frequently asked about tax policy, so it might be useful to go through the basics here. We’ll cover three tax categories—the capital gains tax, the corporate tax, and the income tax.
Before we start, I should comment on the Laffer Curve, popularized by Reagan economic advisor Arthur Laffer. The underlying concept of the Laffer Curve is that every tax has an optimal rate for maximizing government revenues. Decrease the tax rate below this optimal rate and government revenues will decline as a result because of the lower rate. Increase the tax rate above the optimal rate and government revenues will also decline because of the adverse effect the higher rate has on incentives. Of course, it is not easy to identify the optimal rate and the objective of a tax system is not necessarily to generate maximum government revenues anyway. However, the take-home point is simple: When the tax rate is too high, neither the taxpayer not the government wins. It is a great political irony that big-spending politicians seem preoccupied with raising taxes when cutting them might generate the funds necessary to pay for their programs!
A CAPITAL GAINS tax is imposed on profit from investments. The mere existence of such a tax is dubious because the amount originally invested was presumably already taxed as income. Perhaps the most serious problem with the capital gains tax is the fact that some of the “gains” it taxes are the result of inflation. Let’s say you invested $1000 ten years ago and you cash it in today for $1400. You are responsible for a capital gains tax based on the $400 profit. If the annual inflation rate was 5% during the ten years, however, then the spending power of your $1400 today is actually less today than $1000 was when you made the initial investment. In other words, you really lost money on your investment, but you will be required to pay a tax anyway.
I won’t detail the numbers here, but historical data provided by the Tax Foundation (www.taxfoundation.org/publications/show/2089.html) demonstrates that increases in the capital gains tax rate have been followed by decreases in government revenues. Likewise, capital gains tax cuts have increased government revenues. Although there are other factors involved, the evidence is compelling. A low capital gains tax not only encourages investments that create private sector jobs, but can also increase government tax revenues. MY ASSESSMENT: THE CAPITAL GAINS TAX SHOULD BE SUBSTANTIALLY REDUCED, IF NOT ELIMINATED ALTOGETHER.
A CORPORATE TAX assesses business profits. The top US rate is currently 35%, resulting in an average top rate of 39.27% when state rates are added. The US is second highest among developed nations only to Japan (39.54%). Ireland has the lowest rate, 12.5% (again, see the data at the Tax Foundation site, (http://www.taxfoundation.org/publications/show/22917.html). Leaders of multinational firms consider a number of factors when establishing headquarters for their companies. The tax rate is a key consideration. The high US corporate tax rate encourages companies that might otherwise locate in the US to do so abroad. This not only reduces government tax receipts, but sends jobs overseas as well.
Of course, corporations don’t really pay taxes; shareholders do. This means that individual investors are taxed twice for profits generated by companies they own stock in, first at the corporate level and again at the individual level when dividends are declared. Taxing corporations for the benefits associated with corporate status makes sense, but punitive taxation doesn’t. Compliance costs associated with the current system are staggering, especially at the corporate level. MY ASSESSMENT: REDUCING THE TOP US CORPORATE TAX RATE FROM 35% TO AROUND 20-25% WOULD DO WONDERS FOR US COMPETITIVENESS.
An INCOME TAX assesses personal income. As with the capital gains tax, history tells us that lower tax rates often increase government tax receipts by spurring economic activity.
Who pays individual income taxes? Collectively, the top 10% of wage earners pay about 70% of the income taxes, while the bottom 40% pay nothing. Obama campaigned on increasing the earned income tax credit, thereby using the tax system to redistribute income from wage earners to those who don’t pay income taxes. He calls this a “tax cut,” but you can’t give an income tax cut to someone who doesn’t pay income taxes. Such a plan is preposterous, to say the least.
The current redistribution scheme was call the tax system has emerged from the various tax cuts and hikes over the years. To be politically expedient, tax cuts must favor those with lower incomes and tax hikes must soak the rich. Collectively, these cuts and hikes have transformed our tax system into one whose central purpose is to redistribute income, promoting a welfare state and stifling the American work ethic. While I favor tax cuts, a complete overhaul of the system is sorely needed. MY ASSESSMENT: SCRAP THE CURRENT SYSTEM IN FAVOR OF A LOW FLAT TAX RATE, WITH A STANDARD DEDUCTION WELL ABOVE THE CURRENT “POVERTY LINE.” Some phasing in would be necessary with such a change, but the sooner we start moving in this direction the better. For the record, I prefer a national sales tax (AKA, the “fair tax”) to an income tax, but I will leave that discussion for another day.
Where do we go from there? Taxes are a necessary evil, but our tax system should be SIMPLE, FAIR, AS LOW AS POSSIBLE, AND SHOULD NOT SEEK TO REDISTRIBUTE INCOME. Of course, SPENDING CUTS that reduce the size of government to a level consistent with the spirit of the Constitution are also necessary. We’ll discuss this topic later.