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Posts Tagged ‘Double Taxation’

For months, I’ve been arguing that the big reduction in the corporate tax rate is the most important part of Trump’s tax agenda.

But not because of politics or anything like that. Instead, my goal is to enable additional growth by shifting to a system that doesn’t do as much damage to investment and job creation. A lower rate is consistent with good theory, and there’s also recent research from Australia and Germany to support my position.

Especially since the United States is falling behind the rest of the world. America now has the highest corporate tax rate in the developed world and arguably may have the highest rate in the entire world.

Needless to say, this is a self-inflicted wound on U.S. competitiveness.

But since the numbers I’ve been sharing are now a few year’s old, let’s now update some of this data.

Check out these four charts from a new OECD annual report on tax policy changes (the some one that I cited a few days ago when explaining that European-sized government means a suffocating tax burden on the poor and middle class).

Here’s the grim data on the corporate income tax rate (the vertical blue bars). As you can see, the United wins the booby prize for having the highest rate.

But here’s some “good news.” When you add in the second layer of tax on corporate income, the United States is “only” in third place, about where we were back in 2011.

France imposes the highest combined rate on corporate and dividend income (no surprise since the nation’s national sport is taxation), while Ireland is in second place (the corporate rate is very low, but personal rates are high and dividends receive no protection from double taxation).

For what it’s worth, I think it’s incredibly bad policy when governments are skimming 30 percent, 40 percent, 50 percent, and even 60 percent of the income being generated by business investment.

Particularly since high rates don’t translate into high revenue. Check out this third chart. You’ll notice that revenues are relatively low in the United States even though (or perhaps because) the tax rate is very high.

But our final chart provides the strongest evidence. Just like the IMF, the OECD is admitting that tax revenues have remained constant over time, even though (or because) corporate tax rates have plunged.

In other words, the Laffer Curve is alive and well.

Incidentally, the global shift to lower tax rates hasn’t stopped. I wrote back in May about plans for lower corporate tax burdens in Hungary and the United Kingdom and I noted last November that Croatia was lowering its corporate rate.

And, thanks to liberalizing effect of tax competition, more and more nations are hopping on the tax cut bandwagon.

Consider what’s happening in Sweden.

Sweden’s center-left minority government is proposing a corporate tax cut to 20 percent from 22 percent, Finance Minister Magdalena Andersson and Financial Markets Minister Per Bolund said on Monday… “With the proposals we want to strengthen competitiveness and create a more dynamic business climate,” they said… The proposed corporate tax cut would be…implemented on July 1, 2018.

Or what’s taking place in Belgium.

…government ministers finally reached agreement on a number of reforms to the Belgian tax and employment systems. …Belgium is to slash corporation tax from 34% to 29% next year. By 2020 corporation tax will have been cut to 25%. …Capital gains tax on the first 627 euros of dividends from shares disappears, a measure intended to encourage share ownership.

Or what’s looming in Germany.

Germany will likely need to make changes to its corporation tax system in coming years in response to growing tax competition from other countries, Finance Minister Wolfgang Schaeuble said on Wednesday… “I expect there will be a need to take action on corporation tax in coming years because in some countries, from the U.S. to Britain, but also on other continents, there are many considerations where we can’t simply say we’ll ignore them,” Schaeuble told a real estate conference.

This bring a smile to my face. Greedy politicians are being pressured to cut tax rates, even though they would prefer to do the opposite. Let’s hope the United States joins this “race to the bottom” before it’s too late.

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While I realize there’s zero hope of ripping up America’s awful tax code and getting a simple and fair flat tax, I’m nonetheless hopeful that there will be some meaningful incremental changes as part of the current effort to achieve some sort of tax reform.

A package that lowers the corporate rate, replaces depreciation with expensing, and ends the death tax would be very good for growth, and those good reforms could be at least partially financed by eliminating the state and local tax deduction and curtailing business interest deductions so that debt and equity are on a level playing field.

All that sounds good, and a package like this should be feasible since Republicans control both Congress and the White House (especially now that the BAT is off the table), but I warn in this interview that there are lots of big obstacles that could cause tax reform to become a disaster akin to the Obamacare repeal effort.

Here’s my list of conflicts that need to be solved in order to get some sort of plan through Congress and on to the President’s desk.

  • Carried interest – Trump wants to impose a higher capital gains tax on a specific type of investment, but this irks many congressional GOPers who have long understood that any capital gains tax is a form of double taxation and should be abolished. The issue apparently has some symbolic importance to the President and it could become a major stumbling block if he digs in his heels.
  • Tax cut or revenue neutrality – Budget rules basically require that tax cuts expire after 10 years. To avoid this outcome (which would undermine the pro-growth impact of any reforms), many lawmakers want a revenue-neutral package that could be permanent. But that means coming up with tax increases to offset tax cuts. That’s okay if undesirable tax preferences are being eliminated to produce more revenue, but defenders of those loopholes will then lobby against the plan.
  • Big business vs small business – Everyone agrees that America’s high corporate tax rate is bad news for competitiveness and should be reduced. The vast majority of small businesses, however, pay taxes through “Schedule C” of the individual income tax, so they want lower personal rates to match lower corporate rates. That’s a good idea, of course, but would have major revenue implications and complicate the effort to achieve revenue neutrality.
  • Budget balance – Republicans have long claimed that a major goal is balancing the budget within 10 years. That’s certainly achievable with a modest amount of spending restraint. And it’s even relatively simple to have a big tax cut and still achieve balance in 10 years with a bit of extra spending discipline. That’s the good news. The bad news is that there’s very little appetite for spending restraint in the White House or Capitol Hill, and this may hinder passage of a tax plan.
  • Middle class tax relief – The main focus of the tax plan is boosting growth and competitiveness by reducing the burden on businesses and investment. That’s laudable, but critics will say “the rich” will get most of the tax relief. And even though the rich already pay most of the taxes and even though the rest of us will benefit from faster growth, Republicans are sensitive to that line of attack. So they will want to include some sort of provision designed for the middle class, but that will have major revenue implications and complicate the effort to achieve revenue neutrality.

There’s another complicating factor. At the risk of understatement, President Trump generates controversy. And this means he doesn’t have much power to use the bully pulpit.

Though I point out in this interview that this doesn’t necessarily cripple tax reform since the President’s most important role is to simply sign the legislation.

Before the 2016 election, I was somewhat optimistic about tax reform.

A few months ago, I was very pessimistic.

I now think something will happen, if for no other reason than Republicans desperately want to achieve something after botching Obamacare repeal.

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Since I’ve written that the International Monetary Fund is the Dumpster Fire of the Global Economy” and “the Dr. Kevorkian of Global Economic Policy,” I don’t think anyone could call me a fan of that international bureaucracy.

But I’ve also noted that the real problem with organizations like the IMF is that they have bad leadership. The professional economists at international bureaucracies often produce good theoretical and empirical work. That sensible research doesn’t make much difference, though, since the actual real-world policy decisions are made by political hacks with a statist orientation.

For instance, the economists at the IMF have produced research on the benefits of smaller government and spending caps. But the political leadership at the IMF routinely ignores that sensible research and instead has a dismal track record of pushing for tax increases.

Hope springs eternal, though, so I’m going to share some new IMF research on tax policy that is very sound. It’s from the second chapter of the bureaucracy’s newest Fiscal Monitor. Here are some excerpts, starting with an explanation of why the efficient allocation of resources is so important for prosperity.

A top challenge facing policymakers today is how to raise productivity, the key driver of living standards over the long term. …The IMF’s policy agenda has therefore emphasized the need to employ all policy levers, and in particular to promote growth-friendly fiscal policies that will boost productivity and potential output. Total factor productivity (TFP) at the country level reflects the productivity of individual firms…aggregate TFP depends on firms’ individual TFP and also on how available resources (labor and capital) are allocated across firms. Indeed, the poor use of existing resources within countries—referred to here as resource misallocation—has been found to be an important source of differences in TFP levels across countries and over time. …What is resource misallocation? Simply put, it is the poor distribution of resources across firms, reducing the total output that can be obtained from existing capital and labor.

The chapter notes that creative destruction plays a vital role in growth.

Baily, Hulten, and Campbell (1992) find that 50 percent of manufacturing productivity growth in the United States during the 1980s can be attributed to the reallocation of factors across plants and to firm entry and exit. Similarly, Barnett and others (2014) find that labor reallocation across firms explained 48 percent of labor productivity growth for most sectors in the U.K. economy in the five years prior to 2007.

And a better tax system would enable some of that growth by creating a level playing field.

Simply stated, you want people in the private sector to make decisions based on what makes economic sense rather than because they’re taking advantage of some bizarre quirk in the tax code.

Potential TFP gains from reducing resource misallocation are substantial and could lift the annual real GDP growth rate by roughly 1 percentage point. …Upgrading the design of their tax systems can help countries chip away at resource misallocation by ensuring that firms’ decisions are made for business and not tax reasons. Governments can eliminate distortions that they themselves have created. …For instance, the current debt bias feature of some tax systems not only distorts financing decisions but hampers productivity as well, especially in the case of advanced economies. …Empirical evidence shows that greater tax disparity across capital asset types is associated with higher misallocation.

One of the main problems identified by the IMF experts is the tax bias for debt.

And since I wrote about this problem recently, I’m glad to see that there is widespread agreement on the economic harm that is created.

Corporate debt bias occurs when firms are allowed to deduct interest expenses, but not returns to equity, in calculating corporate tax liability. …Several options are available to eliminate the distortions arising from corporate debt bias and from tax disparities across capital asset types, including the allowance for corporate equity system and a cash flow tax. …In the simplest sense, a CFT is a tax levied on the money entering the business less the money leaving the business. A CFT entails immediate expensing of all investment expenditures (that is, 100 percent first-year depreciation allowances) and no deductibility of either interest payments or dividends. Therefore, if it is well designed and implemented, a CFT does not affect the decision to invest or the scale of investment, and it does not discriminate across sources of financing.

By the way, regular readers may notice that the IMF economists favor a cash-flow tax, which is basically how the business side of the flat tax operates. There is full expensing in that kind of system, and interest and dividends are treated equally.

This is also the approach in the House Better Way tax plan, so the consensus for cash-flow taxation is very broad (though the House wants a destination-based approach, which is misguided for several reasons).

But let’s not digress. There’s one other aspect of the IMF chapter that is worthy of attention. There’s explicit discussion of how high tax rates undermine tax compliance, which is music to my ears.

Several studies have shown that tax policy and tax administration affect the prevalence of informality and thus productivity. Colombia provides an interesting case study on the effect of taxation on informality. A 2012 tax reform that reduced payroll taxes was found to incentivize a shift of Colombian workers out of informal into formal employment. Leal Ordóñez (2014) finds that taxes and regulations play an important role in explaining informality in Mexico. For Brazil, Fajnzylber, Maloney, and Montes-Rojas (2011) show that tax reductions and simplification led to a significant increase in formal firms with higher levels of revenue and profits. While a higher tax burden contributes to the prevalence of informality… For 130 developing countries, a higher corporate tax rate is found to increase the prevalence of cheats among small manufacturing firms, lowering the share of sales reported for tax purposes.

In closing, I should point out that the IMF chapter is not perfect.

For instance, even though it cites research about how high tax rates reduce compliance, the chapter doesn’t push for lower rates. Instead, it endorses more power for national tax authorities. Makes me wonder if the political folks at the IMF imposed that recommendation on the folks who wrote the chapter?

Regardless, the overall analysis of the chapter is quite sound. It’s based on a proper understanding that growth is generated by the efficient allocation of labor and capital, and it recognizes that bad tax policy undermines that process by distorting incentives for productive behavior.

The next step is convince Ms. Lagarde and the rest of the IMF’s leadership to read the chapter. They get tax-free salaries, so is it too much to ask that they stop pushing for higher taxes on the rest of us?

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There are many powerful arguments for junking the internal revenue code and replacing it with a simple and fair flat tax.

  1. It is good to have lower tax rates in order to encourage more productive behavior.
  2. It is good to get rid of double taxation in order to enable saving and investment.
  3. It is good the end distorting preferences in order to reduce economically irrational decisions.

Today, let’s review a feature of good tax reform that involves the second and third bullet points.

Under current law, there is double taxation of corporate income. This means that companies must pay a tax on income, but that the income is then taxed a second time when distributed to the owners of the company (i.e., shareholders).

This means that the effective tax rate is a combination of the corporate income tax rate and the tax rate imposed on dividends. And this higher tax rate is an example of why double taxation discourages capital formation and thus leads to lower wages.

But this double taxation of dividends also creates a distortion because there isn’t double taxation of corporate income that is distributed to bondholders. This means companies have a significant tax-driven incentive to rely on debt, which is risky for them and the overall economy.

Curtis Dubay has a very straightforward explanation of the problem.

In debt financing, a business raises money by issuing debt, usually by selling a bond. In equity financing, a business raises funds by selling a share in the business through the sale of stock. The tax system provides a relative advantage to financing capital expenditures through debt because under current tax law, businesses can deduct their interest payments on the debt instruments, but dividend payments to shareholders are not deductible. Thus, equity is disadvantaged because it is double taxed while debt correctly faces only a single layer of taxation.

By the way, when public finance people write that something is “not deductible” or non-deductible, that simply means it subject to the tax (much as the non-deductibility of imports under the BAT is simply another way of saying there will be a tax levied on all imports).

But I’m digressing. Let’s get back to the analysis. Curtis then explains why it doesn’t make sense to create an incentive for debt.

The double tax on equity makes debt a relatively more attractive way for businesses to finance themselves, all else equal. As a result, businesses will take on more debt than they otherwise might. …This is a serious problem because carrying significant amounts of debt can make businesses less stable during periods when profitability declines. Interest payments on debt are a fixed cost that businesses must pay regardless of their performance. This can be onerous and endanger a business’s solvency when profits fall.

He points out that the sensible way of putting debt and equity on a level playing field is by getting rid of the double tax on dividends, not by imposing a second layer of tax on interest.

…it does not make sense to equalize their tax treatment by eliminating interest deductibility for businesses. Doing so would further suppress economic growth, job creation, and wage increases. Instead, Congress should end the double taxation of income earned through equity financing in tax reform by eliminating taxes on saving and investment, including capital gains and dividends.

Incidentally, what Curtis wrote isn’t some sort of controversial right-wing theory. It’s well understood by every public finance economist.

The International Monetary Fund, for instance, is generally on the left on fiscal issues (and that’s an understatement). Yet in a study published by the IMF, Ruud A. de Mooij outlines the dangers of tax-induced debt.

Most tax systems today contain a “debt bias,” offering a tax advantage for corporations to finance their investments by debt. …One cannot compellingly argue for giving tax preferences to debt based on legal, administrative, or economic considerations. The evidence shows, rather, that debt bias creates significant inequities, complexities, and economic distortions. For instance, it has led to inefficiently high debt-to-equity ratios in corporations. It discriminates against innovative growth firms, impeding stronger economic growth. … recent developments suggest that its costs to public welfare are larger—possibly much larger—than previously thought. …The economic crisis has also made clear the harmful economic effects of excessive levels of debt… These insights make it more urgent to tackle debt bias by means of tax policy reform.

What’s the solution?

Well, just as Curtis Dubay explained, there are two options.

What can be done to mitigate debt bias in the tax code? In a nutshell, it will require either reducing the tax deductibility of interest or introducing similar deductions for equity returns.

And the author of the IMF study agree with Curtis that the way to create neutrality between equity and debt is by using the latter approach.

Abolishing interest deductibility would indeed eliminate debt bias, but it would also introduce new distortions into investment, and implementing it would be very difficult. …The second option, introducing a deduction for corporate equity, has better prospects. …such an allowance would bring other important economic benefits, such as increased investment, higher wages, and higher economic growth.

And Mooij even acknowledges that there’s a Laffer Curve argument for getting rid of the double tax on dividends.

The main obstacle is probably its cost to public revenues, estimated at around 0.5 percent of GDP for an average developed country. …In the long term, the budgetary cost is expected to be significantly smaller, since the favorable economic effects of the policy change would broaden the overall tax base. And in fact, a number of countries have successfully introduced variants of the allowance for corporate equity, suggesting that it is not only conceptually desirable but also practically feasible.

Another study from the International Monetary Fund, authored by Mooij and  Shafik Hebous, highlights the damage caused by luring companies into taking on excessive debt.

Excessive corporate debt levels are a serious macroeconomic stability concern. For instance, high debt can increase the probability of a firm’s bankruptcy in case of an adverse shock… Given this concern about excessive corporate debt, it is hard to understand why almost all tax systems around the world encourage the use of corporate debt over equity. Indeed, most corporate income tax (CIT) systems allow interest expenses, but not returns to equity, to be deducted in calculating corporate tax liability. This asymmetry stimulates corporations to use debt over equity to finance investment.

We get the same explanation of how to address the inequity in the tax treatment of debt and equity.

Effectively, there are two ways in which debt bias can be neutralized: either by treating equity more similar as debt by adding an allowance for corporate equity (ACE); or by treating debt more similar for taxation as equity by denying interest deductibility for corporations.

And we get the same solution. Stop double taxing dividends.

ACE systems have been quite widely advocated by economists and implemented in some countries, such as Belgium, Cyprus, Italy, Switzerland, and Turkey. Evaluations generally suggest that these systems have been effective in reducing debt bias… Yet, many countries are still reluctant to introduce an ACE due to the expected revenue loss.

By the way, the distortionary damage becomes greater when tax rates are onerous.

A recent academic study addresses the added damage of extra debt that occurs when tax rates are high.

For a country like the United States with a relatively high corporate income tax rate (a statutory federal rate of 35%), theory argues that firms in this country should have significant leverage. …The objective of our study is to estimate how much such variation in tax structure arising from global operations explains the variation in capital structure that we observe among US publicly traded multinational firms. …We employ the BEA’s multinational firm data and augment it with international tax data… Using our calculated weighted average tax rate, we include otherwise identified explanatory variables for capital structure and estimate in a multivariate regression setting how much our blended tax rate measure improves our understanding of why capital structure varies across firms and, to a lesser extent, across time. …Economically, this coefficient corresponds to a 7.1% higher book leverage ratio for a firm with a 35% average tax rate over the sample period compared to an otherwise identical firm with a 25% average tax rate. These results demonstrate that, contrary to some of the earlier literature finding that tax effects were negligible, firms that persistently confront high tax rates have significantly more debt, both economically and statistically, than otherwise equivalent firms who persistently face lower corporate income tax rates. …Irrespective of whether we examine leverage ratios based on book values or market values, whether we include cash or not, or if we alternatively examine interest coverage, we find that multinational firms confronting lower tax rates use less debt. The results are not only statistically significant, but the coefficient magnitudes suggest that these effects are first order

There’s some academic jargon in the above excerpt, so I’ll also include this summary of the paper from the Tax Foundation.

A new paper published in the Journal of Financial Economics finds that countries with high tax rates on corporate income also have higher corporate leverage ratios. …Using survey data of multinational corporations from the Bureau of Economic Analysis (BEA), the authors…find that businesses that report their income in high tax jurisdictions have corporate leverage ratios that are substantially higher than those in low tax jurisdictions. More precisely, they find that a business facing an average tax rate of 35% has a leverage ratio that is 7.1% higher than a similar firm facing an average tax rate of 25%.

By the way, here are the results from another IMF study by Mooij about how the debt bias is connected to high tax rates.

We find that, typically, a one percentage point higher tax rate increases the debt-asset ratio by between 0.17 and 0.28. Responses are increasing over time, which suggests that debt bias distortions have become more important.

The bottom line is that the U.S. corporate tax rate is far too high. And when you combine that punitive rate with a distortionary preference for debt over equity, the net result is that we have companies burdened by too much debt, which puts them (and the overall economy) in danger when there’s a downturn.

So the obvious solution (beyond simply lowering the corporate rate, which should be a given) is to get rid of the double tax on dividends.

The good news is that Republicans want to move in that direction.

The not-so-good news is that they are not using the ideal approach. As I noted last year, the “Better Way Plan” proposed by House Republicans is sub-optimal on this issue.

Under current law, companies can deduct the interest they pay and recipients of interest income must pay tax on those funds. This actually is correct treatment, particularly when compared to dividends, which are not deductible to companies (meaning they pay tax on those funds) while also being taxable for recipients. The House GOP plan gets rid of the deduction for interest paid. Combined with the 50 percent exclusion for individual capital income, that basically means the income is getting taxed 1-1/2 times. But that rule would apply equally for shareholders and bondholders, so that pro-debt bias in the tax code would be eliminated.

For what it’s worth, I suggest this approach was acceptable, not only because the debt bias was eliminated, but also because of the other reforms in the plan.

…the revenue generated by disallowing any deduction for interest would be used for pro-growth reforms such as a lower corporate tax rate.

Though I can’t say the same thing about the border-adjustability provision, which is a poison pill for tax reform.

P.S. While the preference for debt is quite harmful, I nonetheless still think the worst distortion in the tax code is the healthcare exclusion.

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I wrote yesterday about how the Organization for Economic Cooperation and Development (OECD) is pushing for bigger government in China. That’s a remarkable bit of economic malpractice by the Paris-based international bureaucracy, especially since China is only ranked #113 in the latest scorecard from Economic Freedom of the World. The country very much needs smaller government to become rich, yet the OECD is preaching more statism.

But nobody should be surprised. The OECD, perhaps because its membership is dominated by European welfare states, has a dismal track record of reflexive support for bigger government.

It supports higher taxes and bigger government in Asia, in Latin America, and…yes, you guessed correctly…the United States.

And here’s the latest example. In a new publication, OECD bureaucrats recommend policy changes that ostensibly will produce more growth for the United States. Basically, America should become more like France.

Income inequality has continued to widen… Public infrastructure is not keeping pace… Promote mass transit… Implement usage fees based on distance travelled…to help fund transportation… Expand federal programmes designed to improve access to fixed broadband. …Expand funding for reskilling… Require paid parental leave… Expand the Earned Income Tax Credit and raise the minimum wage.

To be fair, not every recommendation involves bigger government.

Adopt legislation that cuts the statutory marginal corporate income tax rate…

But even that single concession to good policy is matched by proposals to squeeze more money from the private sector.

…and broaden the tax base. …Continue with measures to prevent base erosion and profit shifting.

By the way, even though European nations dominate the OECD’s membership, American taxpayers provide the largest share of funding for the OECD.

In other words, we’re paying more taxes to have a bunch of international bureaucrats urge that we get hit with even higher taxes. And to add insult to injury, OECD bureaucrats are exempt from paying taxes!

Maybe that’s why they’re so blind to the harmful impact of bad tax policy.

It’s especially discouraging that the bureaucrats are even advocating greater levels of discriminatory taxation of saving and investment. Here are some blurbs from a report in the Wall Street Journal.

The Paris-based think tank has just junked the conventional economic wisdom on tax it had been promoting for years. …“For the past 30 years we’ve been saying don’t try to tax capital more because you’ll lose it, you’ll lose investment. Well this argument is dead…,” Pascal Saint-Amans, the OECD’s tax chief, said in an interview. …Since the 1970s economists had argued capital income should be taxed relatively lightly because it was more mobile across countries and attracting investment would boost economic growth, ultimately benefiting everyone.

Actually, the argument on not over-taxing capital income is based on the merits of a neutral tax system that doesn’t undermine growth by punishing saving and investment.

The fact that capital is “mobile across countries” was something that constrained politicians from imposing bad tax policy. In other words, tax competition promoted better (or less worse) policy.

But now that tax havens and tax competition have been weakened, politicians are pushing tax rates higher. And the OECD is cheering this destructive development.

Here are some passages from the OECD report on this topic.

…there have been calls to move away from a narrow focus on economic growth towards a greater emphasis on inclusiveness. …Inclusive economic growth…implies that the benefits of increased prosperity and productivity are shared more evenly between people… More specifically with regard to tax policy, inclusive economic growth is related to managing tradeoffs between equity and efficiency. Growth-enhancing tax reforms might come at certain costs in terms of meeting equity goals so tax design for inclusive growth requires taking into account the distributional implications of tax policies.

In other words, the OECD wants to shift away from policies that lead to a growing economic pie and instead fixate on how to re-slice and redistribute a stagnant pie.

And here’s a flowchart from the OECD report. Keep in mind that “inclusive growth” actually means less growth. I’ve helpfully put red stars next to the items that involve more transfers of money from the productive sector of the economy to the government.

That flowchart shows what the OECD wants.

But if you want a real-world example, just look at Greece, France, and Italy.

Which brings me to my final point. To be blunt, it’s crazy that American taxpayers are subsidizing a left-wing overseas bureaucracy like the OECD.

If Republicans have any brains and integrity (I realize that’s asking a lot), they should immediately pull the plug on subsidies for the Paris-based bureaucracy. Sure, it’s only about $100 million per year, but – on a per-dollar spent basis – it’s probably the most destructive spending in the entire budget.

P.S. The OECD even wants a type of World Tax Organization.

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Why would the economy grow faster if we got fundamental reform such as the flat tax?

In part, because there would be one low tax rate instead of the discriminatory and punitive “progressive” system that exists today. As such, the penalty on productive behavior would be reduced.

In part, because there would be no distorting tax breaks that lure people into making decisions based on tax considerations rather than economic merit.

But we’d also enjoy more growth because there would be no more double taxation. Under a flat tax, the death tax is abolished, the capital gains tax is abolished, there’s no double taxation on savings, the second layer of tax on dividends is eliminated, and depreciation is replaced by expensing.

In the wonky jargon of public finance economists, this means we would have a “consumption-based” system, which is just another way of saying that income  would be taxed only one time. No longer would the internal revenue code discourage capital formation by imposing a higher effective tax rate on income that is saved and invested (compared to the tax rate on income that is consumed).

Indeed, this is the feature of tax reform that probably generates the most growth. As I explain in this video on capital gains taxation, all economic theories – even Marxism and socialism – agree that capital formation is a key to long-run prosperity.

The good news is that reducing double taxation is a goal of most major tax plans in Washington. Trump’s campaign plan reduced double taxation, and the House Better Way Plan reduces double taxation.

But that doesn’t mean there’s an easy path for reform. The Hill reports on some of the conflicts that may sabotage legislation this year.

The fight over a border-adjustment tax isn’t the only challenge for Republicans in their push for tax reform. …Notably, some business groups have criticized the proposal to do away with the deduction for businesses’ net interest expenses. …the blueprint does not specifically discuss how the carried interest that fund managers receive would be taxed. Under current law, carried interest is taxed as capital gains, rather than at the higher rates for ordinary income. During the presidential race, Trump repeatedly said he wanted to eliminate the carried interest tax break, and Office of Management and Budget Director Mick Mulvaney told CNN on Sunday that Trump still plans to do this. Many Democrats also want carried interest to be taxed as ordinary income.

The border-adjustment tax is probably the biggest threat to tax reform, but the debate over “carried interest” also could be a problem since Trump endorsed a higher tax burden on this type of capital gain during the campaign.

Here are some excerpts from a recent news report.

Donald Trump vowed to stick up for Main Street over Wall Street — that line helped get him elected. But the new president has already hit a roadblock, with fellow Republicans who control Congress balking at Trump’s pledge to close a loophole that allows hedge fund and private equity managers to pay lower taxes on investment management fees. …The White House declined to comment on the status of negotiations between Trump and congressional Republicans over the carried-interest provision. …U.S. Rep. Jim Himes, D-Conn., a House Financial Services Committee member and former Goldman Sachs executive, said there is chaos on the tax reform front. “That’s on the list of dozens of things where there is disagreement between the president and the Republican majority in Congress,” Himes said.

Regarding the specific debate over carried interest, I’ve already explained why I prefer current law over Trump’s proposal.

Today I want to focus on the “story behind the story.” One of my main concerns is that the fight over the tax treatment of carried interest is merely a proxy for a larger campaign to increase the tax burden on all capital gains.

For instance, the ranking Democrat on the Senate Finance Committee openly uses the issue of carried interest as a wedge to advocate a huge increase in the overall tax rate on capital gains.

Of course, when you talk about the carried interest loophole, you’re talking about capital gains. And when you talk about capital gains, you’re talking about the biggest tax shelter of all – the one hiding in plain sight. Today the capital gains tax rate is 23.8 percent. …treat[ing] income from wages and wealth the same way. In my view, that’s a formula that ought to be repeated.

The statists at the Organization for Economic Cooperation and Development also advocate higher taxes on carried interest as part of a broader campaign for higher capital gains taxes.

Taxing as ordinary income all remuneration, including fringe benefits, carried interest arrangements, and stock options… Examining ways to tax capital income at the personal level at slightly progressive rates, and align top capital and labour income tax rates.

It would be an overstatement to say that everyone who wants higher taxes on carried interest wants higher taxes on all forms of capital gains. But it is accurate to assert that every advocate of higher taxes on capital gains wants higher taxes on carried interest.

If they succeed, that would be a very bad result for American workers and for American competitiveness.

For those wanting more information, here’s the Center for Freedom and Prosperity’s video on carried interest.

Last but not least, wonky readers may be interested in learning that carried interest partnerships can be traced all the way back to medieval Venice.

Start-up merchants needed investors, and investors needed some incentive to finance the merchants. For the investor, there was the risk of their investment literally sailing out of the harbor never to be seen again. The Venetian government solved this problem by creating one of the first examples of a joint stock company, the “colleganza.” The colleganza was a contract between the investor and the merchant willing to do the travel. The investor put up the money to buy the goods and hire the ship, and the merchant made the trip to sell the goods and then buy new foreign goods that could then be brought back and sold to Venetians. Profits were then split between the merchant and investor according to the agreements in the contract.

Fortunately for the merchants and investors of that era, neither income taxes nor capital gains taxes existed.

P.S. Italy didn’t have any sort of permanent income tax until 1864. Indeed, most modern nations didn’t impose these punitive levies until the late 1800s and early 1900s. The United States managed to hold out until that awful dreary day in 1913. It’s worth noting that the U.S. and other nations managed to become rich and prosperous prior to the adoption of those income taxes. And it’s also worth noting that the rapid growth of the 18th century occurred when the burden of government spending was very modest and there was almost no redistribution spending.

P.P.S. Now that we have income taxes (and the bigger governments enabled by those levies), the only silver lining is that governments have compensated for bad fiscal policy with better policy in other areas.

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Time for a boring and wonky discussion about taxes, capital formation, and growth.

We’ll start with the uncontroversial proposition that saving and investment is a key driver of long-run growth. Simply stated, employees can produce more (and therefore earn more) when they work with better machines, equipment, and technology (i.e., the stock of capital).

But if we want to enjoy the higher incomes that are made possible by a larger and more productive capital stock, somebody has to save and invest. And that means they have to sacrifice current consumption. The good news is that some people are willing to forego current consumption if they think that saving and investment will enable them to have higher levels of future consumption. In other words, if they make wise investments, it’s a win-win situation since society is better off and they are better off.

And these investment decisions help drive financial markets.

Now let’s focus specifically on long-run investments. If you have some serious money to invest, one of your main goals is to find professionals who hopefully can identify profitable opportunities. You want these people, sometimes called “fund managers,” to wisely allocate your money so that it will grow in value. And in some cases, you try to encourage good long-run investments by telling fund managers that if your investments increase in value (i.e., earn a capital gain), they get to keep a share of that added wealth.

In the world of “private equity” and “venture capital,” that share of the added wealth that goes to fund managers is known as “carried interest.” And as a Bloomberg article notes, it has played a big role in some of America’s great business success stories.

Venture capitalists…helped transform novel business ideas into some of the world’s most valuable companies, including Apple, Alphabet Inc., Amazon.com Inc., Facebook Inc., and Microsoft Corp. According to a 2015 study by Stanford University, 43 percent of public U.S. companies founded since 1979 had raised venture cash.

An article from the National Center for Policy Analysis has some additional data on the key role of investors who are willing to take long-run risks.

…up to 25 percent of pre-initial public offering (preIPO) startup funding comes from private equity or venture capital backers. Increasing the tax burden on these entities would damage a valuable access-to-capital pipeline for some startups — particularly in the energy, technology and biotech sectors where large up-front investments could be required.

The obvious conclusion is that we should be happy that there are people willing to put their money in long-run investments and that we should not be envious if they make good choices and therefore earn capital gains. And most people (other than the hard-core left) presumably will agree that people who take big risks should be able to earn big rewards.

That consensus breaks down, however, when you add taxes to the equation.

There’s the big-picture debate about whether there should be “double taxation” of income that is saved and invested. There are two schools of thought.

  • On one side, you have proponents of “consumption-base” taxation, and they favor reforms such as the flat tax that eliminate the tax code’s bias against saving and investment. These people want to eliminate double taxation because a bigger capital stock will mean a more prosperous economy. Advocates of this approach generally believe in equality of opportunity.
  • On the other side, you have advocates of the “Haig-Simons” or “comprehensive income tax” approach, which is based on the notion that extra layers of tax should be imposed on income that is saved an invested. These people want double taxation because it is consistent with their views of fairness. Advocates of this approach generally believe in equality of outcomes.

In the United States, we’ve historically dealt with that debate by cutting the baby in half. We have double taxation of capital gains and dividends, but usually at modest rates. We have double taxation of interest, but we allow some protection of savings if people put money in IRAs and 401(k)s.

But the debate never ends. And one manifestation of that ongoing fight is the battle over how to tax carried interest.

Folks on the left want to treat carried interest as “ordinary income,” which simply means that they want regular tax rates to apply so that there’s full double taxation rather than partial double taxation.

So who supports such an idea? To quote Claude Rains in Casablanca, it’s the usual suspects. Strident leftists in Congress and their ideological allies are pushing this version of a capital gains tax hike.

Rep. Sander Levin (D-Mich.), Sen. Tammy Baldwin (D-Wis.) and a group of millionaires made a push on Wednesday for consideration of legislation to close the carried-interest tax “loophole.” “We have to eliminate this loophole to make that sure everyone is paying their fair share and especially so that we can invest in an economy that creates jobs and lifts working American wages,” Baldwin said during a news conference on Capitol Hill. …The carried interest tax break is “the most egregious example of tax unfairness,” said Morris Pearl, chair of the Patriotic Millionaires — a group of 200 Americans with annual incomes of at least $1 million and/or assets of at least $5 million.

Folks on the right, by contrast, don’t think there should be any double taxation. And that means they obviously don’t favor an increase in the double taxation on certain types of capital gains. And that included carried interest, which they point out is not some sort of “loophole.” As Cliff Asness has explained, the treatment of carried interest is “consistent with the way employee-incentive stock options and professional partnerships are taxed.

But this isn’t just a left-right issue. Some so-called populists want higher capital gains taxes on carried interest, including the President-Elect of the United States. Kevin Williamson of National Review is not impressed.

Trump doesn’t understand how our economy works. …The big, ugly, stupid tax hike he’s planning is on Silicon Valley and its imitators around the country, the economic ecosystem of startup companies and the venture capitalists who put up the cash to turn their big ideas into viable products, dopey computer games, social-media annoyances, and companies that employ hundreds of thousands of people at very high wages. Which is to say, he wants to punish the part of the U.S. economy that works, for the crime of working. The so-called carried-interest loophole, which isn’t a loophole, drives progressives batty.

Kevin points out how carried interest works in the real world.

If you’re the cash-strapped startup, you go to venture capitalists; if you’re the established business, you go to a private-equity group. In both cases, the deal looks pretty similar: You get cash to do what you need to do, and the investor, rather than lending you money at a high interest rate, takes a piece of your company as recompense (for distressed companies being reorganized by private-equity firms, that’s usually 100 percent of the firm) on the theory that this will be worth more — preferably much more – than the money they put into your business. Eventually, the investor sells its stake in the company and pays the capital-gains tax on its capital gain.

And he doesn’t hold Trump in high regard.

Donald Trump does not understand this, because he isn’t a real businessman — he’s a Potemkin businessman, a New York City real-estate heir with his name on a lot of buildings he doesn’t own and didn’t build and whose real business is peddling celebrity and its by-products. He’s a lot more like Paris Hilton than he is like Henry Ford or Steve Jobs. Miss Hilton sells perfumes and the promise of glamour, Trump sells ugly neckties and the promise of glamour.

In her syndicated column, Veronique de Rugy explains why Republicans shouldn’t make common cause with the class-warfare crowd.

Trump…has seemingly swallowed a key assumption of the left. During the campaign, Trump and Hillary Clinton both pledged to raise taxes on carried interest. …sensing an opening, Senate Minority Leader Chuck Schumer recently indicated that he’d be willing to work with Trump on the issue. Of course he would. Democrats have been trying for years to raise taxes on capital. In fact, they see the reduced rate on all capital gains as a loophole. Their goal is to treat all capital gains as ordinary income because they want higher tax burdens overall. …Republicans need to remember that the left’s goal is not fairness but higher taxes. Treating carried interest as ordinary income for tax purposes would simply be the first step toward higher taxes on capital in general. That would be bad for economic growth and for our wallets.

Chuck Devore of the Texas Public Policy Foundation also has a sensible take on the economics of this issue.

…If the investment professional sees his marginal tax rate on capital gains from carried interest almost double, from 23.8 percent to 43.4 percent, he’ll change his behavior and charge more for his services. Pension funds and colleges will get less… Increasing taxes on investment success would mean less investment and consequently, fewer jobs, less innovation, and less prosperity. According to the Tax Foundation, the U.S. already levies the 6th-highest capital gains taxes among the 34 developed nations of the Organization for Economic Co-operation and Development… Generating capital gains means that money was used efficiently, benefiting not just the professional investment manager, but savers and the world. Losing money, on the other hand, is nothing to celebrate.

I agree.

The carried interest right is really a proxy for the bigger issue of whether there should be increased double taxation of capital gains. Which would be the exact opposite of what should happen if we want America to be more competitive and prosperous.

For more background on the issue of carried interest, this video from the Center for Freedom and Prosperity is very succinct and informative.

And if you want more info on the overall issue of capital gains taxation, I’m quite partial to my video on the topic.

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