I’m a big fan of the flat tax because a low tax rate and no double taxation will result in faster growth and more upward mobility.
I also like the flat tax because it gets rid of all deductions, credits, exemptions, preferences, exclusions, and other distortions. And a loophole-free tax code would be a great way of reducing Washington corruption and promoting simplicity.
Moreover, keep in mind that eliminating all favors from the internal revenue code also would be good for growth because people then will make decisions on the basis of what makes economic sense rather than because of peculiar quirks of the tax system.
Sounds great, right?
Well, it’s not quite as simple as it sounds because there’s a debate about how to measure loopholes. Sensible people want a tax code that’s neutral, which means the government doesn’t tilt the playing field. And one of the main implications of this benchmark is that the tax code shouldn’t create a bias against income that is saved and invested. In the world of public finance, this means they favor a neutral “consumption-base” tax system, but that’s simply another way of saying they want income taxed only one time.
Folks on the left, however, are advocates of a “Haig-Simons” tax system, which means they believe that there should be double taxation of all income that is saved and invested. You see this approach from the Joint Committee on Taxation. You see it from the Government Accountability Office. You see it from the Congressional Budget Office. Heck, you even sometimes see Republicans mistakenly use this benchmark.
Let’s look at three examples to see what this means in practice.
Example #1: Because they don’t want a bias that encourages people to spend their income today rather than in the future, advocates of a neutral tax code want to get rid of all double taxation of savings (Canada is moving in that direction). So that means they like IRAs and 401(k)s since those vehicles at least allow some savings to be protected from double taxation.
Proponents of Haig-Simons taxation, by contrast, think that IRAs and 401(k)s are loopholes.
Example #2: Another controversy revolves around the tax treatment of business investment. Advocates of neutral taxation believe in expensing, which is simply the common-sense view that investment expenditures should be recognized when they actually occur.
Proponents of Haig-Simons, however, think that investment expenditures should be “depreciated,” which means companies are forced to pretend that most of their investment costs which are incurred today actually take place in future years.
Example #3: Supporters of neutral taxation think capital gains taxes should be abolished because there already is tax on the income generated by assets such as stocks and bonds. So the “preferential rates” in the current system aren’t a loophole, but instead should be viewed as the partial mitigation of a penalty.
Proponents of Haig-Simons, not surprisingly, have the opposite view. Not only do they want to double tax capital gains, they also want them fully taxed, which would mean an economically jarring jump in the tax rate of more than 15 percentage points.
Now, having provided all this background information, let’s finally get to today’s topic.
If you’ve been following the presidential campaign, you’ll be aware that there’s a controversy over something called “carried interest.” It’s a wonky tax issue that seems very complicated, so I’m very happy that the Center for Freedom and Prosperity has produced a video that cuts through all the jargon and explains in a very clear and concise fashion that it’s really just an effort by some people to increase the capital gains tax.
There are four points from the video that deserve special emphasis.
- Partnerships are voluntary agreements between consenting adults, and both parties concur that carried interest helps create a good incentive structure for productive investment.
- Capital formation is very important for growth, which is one of the reasons why there shouldn’t be any capital gains tax.
- A capital gain doesn’t magically become labor income just because an investor decides to share a portion of the gain with a fund manager.
- An increase in the tax on carried interest would be the camel’s nose under the tent for more broad-based increases in the tax burden on capital gains.
By the way, I liked that the video also took a gentle swipe at some of the ignorant politicians who want to boost the tax burden on carried interest. They claim they’re going after hedge funds, when the tax actually is much more targeted at private equity partnerships.
But what really matters is not the ignorance of politicians. Instead, we should be focused on whether tax policy is being needlessly destructive because of high – and duplicative – taxes on saving and investment.
Such levies would reduce investment. And that means lower levels of productivity and concomitantly lower wages.
In other words, ordinary people will suffer a lot of collateral damage if this tax-the-rich scheme for carried interest is implemented.
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Dan
If I walk a dog (or dawg if you prefer) for a hedge fund manager whose sole income is carried interest shouldn’t I be taxed at capital gains rates since I am facilitating his ability to make those investment returns?
Jay
You are correct, given the parameters you provided. However, the results change for those in higher tax brackets.
A 10% return (which I’m sure you used to simplify calculations) implies a return on equity investment. That brings in both the capital gains tax rate and timing issues as to when and if returns are taxed at all.
I’m sure we can agree that the best approach is to tax earnings once and eliminate taxes on investments that encourage economic growth. Note that I would tax high frequency trading, short selling, and derivatives at earned income rates.
nedlandp: Actually, no. Do the math, and even if your tax rate is the same when you take the money out of an IRA as it was when you put it in, you pay less total tax then if you’d put the money in an ordinary investment account. In effect, you don’t pay taxes on the earnings, only on the original principal.
For example, suppose you have an investment that earns 10%, you pay 20% in taxes, and you keep the money in for 2 years (and then withdraw with no tax penalty). Suppose you have $1000 of income to invest.
Scenario 1: Ordinary investment: Initial: $1000-20%=$800 initial investment. After 1 year: +10% of $800=$80, -20% of $80=$16. Net $864. Year 2: 864+86-17=$933.
Scenario 2: 401k: Initial $1000, untaxed. Year 1: +$100=$1100. Year 2: +$110=$1210. Then withdraw and pay 20% tax leaves $1210-242=$968.
Scenario 3: Pay taxes on principal but not on profits: Initial $1000-20%=$800. Year 1: $880. Year 2: $968.
Note scenarios 2 and 3 give exactly the same results, and both are $35 better than scenario 1. With a little algebra you can prove that this is true regardless of the exact numbers, but I think it’s easier to show with an example.
Scenario 3 is basically a Roth IRA, by the way.
Example 2:
The reason a capital asset can be written off at all is that taxes have already been paid by the entity that produced the item. Of course it should be written off immediately.
The only rational for doing it the way it is done is that some value is preserved on the balance sheet to give a more accurate view of the net worth of the company. Of course that could still be done without affecting the tax status of the asset.
Example 1:
IRAs and 401k’s do not avoid taxes, they defer them, until a time when the individual’s tax rate is presumably less. If tax rates are the same, there is no net benefit.
My understanding of “carried interest” is that it is a performance fee for managing a successful investment fund. It is not a capital interest which is provided as a return on investment when the individual has put funds at risk.
Since it is a fee for services rendered, it should be taxed at normal earned income rates.
I do am not a proponent of increasing capital gains taxes, but I think that you are missing the point on carried interest. The carried interest is not a “sharing of capital gains,” it is the compensation of the fund manager for doing a good a good job, and therefore should be taxed as income. This is not money that the fund manager put up and is increasing in value, and just because the compensation is tied to results should not make it capital gains for the fund manager. The fund manager does all sorts of active activities to earn the carried interest like diligence on investments, creation and disbursement of marketing material, accounting for the fund, and etc. All of which should earn the ordinary income stamp. Lets call the carried interest what it really is and lower the ordinary income tax.
…so, you really still have to convince people with logic that Washington is full of crooks taking their money?
Hi
I am interested to obtain the presentation that Mr. Dan Mithcell, Senior Fellow of The Cato Institute made in Miami on October 20. Could you tell me if I could obtain. I attend the Private Wealth latin American Forum
Regards
Ismael Velez
PICAVAL S.A.