How to Fix Our Tax Problem
The former chief economist for the Fed told me I’m a lunatic. But here's what we do: Tax the rich. And the poor.
“If at first the idea is not absurd, then there’s no hope for it.”
It was killed in 1895. its corpse was reanimated in 1913, grafted together with mismatched body parts like Frankenstein’s monster—and, like Frankenstein’s monster, it was given a diseased brain. It takes 17,000 pages of the Federal Register to describe its horrifying features and another million pages of case law to interpret its malevolent intent. It takes 6 billion hours of time and $400 billion in costs each year to appease it—or to sneak around it. We sent a Super Committee of the brightest minds of Congress to tame it, and it threw them in the river like Boris Karloff’s monster did to the little girl. And now we’re trying to see if giving it a new haircut (a surtax on millionaires and billionaires) or a fingernail trim will make it behave.
It’s the United States income tax code, and we need to put a stake in its heart and bury it for good.
Question: if a group of relatively smart people with no political axe to grind and no pet constituency to protect were given a blank canvas and the mandate of devising a scheme to finance their collective government with minimal impact on economic activity, would they pick an income tax? (Emphasis on smart and nonpolitical.) Answer: not in a million years.
I was a corporate tax attorney at a major downtown law firm for seven years, seven years of my life I can never have back. I struggled through many of those 17,000 incomprehensibly arabesque pages of code sections and regulations. I read countless tax cases. I know a thing or two about taxes. Here are the problems with an income tax:
* First and foremost, it’s all about definitions. What is income, by the way? Sounds simple, but it’s not. Revenue is not income. Gifts are not income. Inheritances are not income. Gains from the sale of some assets are income but some are not, and they’re taxed at different rates. Dividends on stocks are sometimes income and sometimes not, and they’re taxed at different rates. Some expenses reduce income and some do not—and some are amortized or depreciated over extended periods. The income of individuals is taxed differently than that of corporations or trusts. In short, there’s a lot of room to play games.
* There are timing issues. When is income realized, such that the person who earns it should be taxed? One guy gets millions of dollars of cash flow, but it’s not taxed because it’s not deemed “realized”—or he’s figured out a way to accelerate expenses he hasn’t actually paid to shelter it. A different guy gets a K-1 on phantom income and is crushed by a tax bill with no cash to pay it.
* There are collection issues. For everyone other than W-2 wage-earners, the income tax is essentially an honor (or dishonor) system. The guy who mows your lawn and whom you pay in cash may or may not report his earnings. We can only speculate. But that’s a penny ante problem, you say. A lawn guy? Well, it’s not. The untaxed underground economy is estimated to be $2 trillion, meaning $400 billion to $500 billion in tax goes uncollected each year. And that doesn’t take into account the guy who sells stock in his private company in a nonbrokered sale. He can make hundreds of thousands, if not millions, on the sale. But we’ll have to count on him to remember that gain when April 15 comes around, because there’s no entity that records the sale and lets the IRS know.
* Finally, there are earmark/pork-barrel problems. The tax code is one of Congress’ favorite ways to reward its biggest donors with credits, deductions, and exemptions. It perverts the tax code beyond recognition.
And here’s what this mess has produced: almost half of our citizens pay no federal income tax at all (far more than half, if you count the kids who, by Newt’s way of thinking, should be working). By contrast, the top 5 percent of income-earners paid almost 60 percent of the nation’s taxes—but they earned almost a third of the entire country’s income, which is why you have class warfare and plenty of justification for animosity on both sides. (As an aside, in 2009, 1,400 millionaires didn’t pay any federal income tax. The real class warfare should be between the millionaires who bore a disproportionate share of the nation’s tax burden and the 1,400 millionaires who skated owing nothing. I need to find out what accounting firm they’re using.)
Think of this: when you have people who made a gargantuan amount of money (I’m looking at you, Andy Beal) paying white-shoe law firms more than $1 million for a tax opinion (I’m looking at you, Jenkens & Gilchrist—or I was, until you were sued out of existence) to devise complex tax shelters named after a serial killer to shield hundreds of millions in capital gains that the bounty of this country allowed you to earn, there is something wrong with our tax system. And when GE can file a 57,000-page tax return and pay no tax on $14 billion in profit, it’s game over.
So, if we gave Congress a mulligan on its tee shot off the Sixteenth Amendment, what tax system would smart/nonpolitical people choose?
Perry’s 20 percent flat tax? To its credit, it has the appeal of fitting on a notecard that you can tug out of your front breast pocket when giving a drunken speech in New Hampshire, but that’s about it. You still have each issue previously identified—it’s still an income tax—but you’re guaranteed to reduce revenue. Perry’s plan allows the taxpayer to choose between a 20 percent flat tax and what he or she would owe under the old system. Ergo, everyone would choose whatever’s cheaper, and tax receipts would go down. And worse, you would spend even more time and money figuring out two different tax returns. (And not to get bleeding heart here, but a 20 percent flat tax might be harder for lower income people to bear than someone like me or the readers of this magazine.)
By the time this article appears on the stands, Perry might already be out of the race. But never fear, Newt Gingrich has done him one better—a 15 percent flat tax!—with the same choice to do your taxes under the old system. And Gingrich is supposed to be the smart one.
Herman Cain’s already gone but still flogging his 9-9-9 plan. As a dial-around long distance telephone plan, it works great. As a comprehensive tax system, not so much. Whereas it does eliminate the distinction between corporate and individual earnings, all the definitional, timing, and collection issues remain. Plus, a 9 percent sales tax is regressive on lower income people—unless you exempt food, clothing, etc., in which case you reduce tax receipts.
Donald Trump’s net worth tax? Remember him? In 1999, he proposed a 14.25 percent net worth tax. Okay, not something you would want to be hit with every year, but what about it? The total net worth of U.S. households in 2009 was $54.2 trillion. The president’s budget for fiscal 2012 is $3.7 trillion. Therefore, we would need a 6.8 percent net worth tax for a balanced budget. Every year. Obama would love it, but there are just not enough detestable millionaires and billionaires to get the job done. The total net worth of the richest 400 individuals in our country is $1.53 trillion according to Forbes magazine. If we imposed a 100 percent tax on all of their wealth, wiping them totally out, it wouldn’t pay even half of the annual budget. And then what would we do next year?
Besides, a net worth tax is unworkable. You have valuation issues (What’s my private company worth?), liquidity problems (I’ll have to sell my farm to come up with the money to pay the tax on the value of my farm), and tax dodging (Er, let’s not talk about my overseas assets and cash held in foreign accounts). We would be stuck taxing people’s bank and brokerage accounts—causing every sentient person to withdraw all of his or her money from banks and brokers. And that would be the end of the country as we know it.
What about the Americans for Fair Taxation’s 23 percent solution? A national sales tax is a neat idea—except that (i) at almost a quarter of the price of the goods themselves, it would be horribly regressive; (ii) not enough transactions actually constitute “sales”; and (iii) like the net worth tax, the impact on economic activity would be dramatically adverse.
A property tax? Sorry, but the Constitution prohibits it (unless it’s apportioned among the states by numbers). And even if it didn’t, you would have the same valuation, liquidity, and tax-dodging problems you have with a net worth tax.
Really what we need is a tax system that doesn’t focus on who is taxed and at what rate, but what is taxed and when. Preferably, it would get at income, net worth, property, inheritances, sales, loans—the whole schmear. It would have the broadest reach possible, which would allow for a low rate of tax.
Here’s a bit of heresy for the Democrats: everyone, even the poor, needs to pay federal tax. Everyone enjoys the stability of our government and the security of our military, benefits from our monetary system, and gets around on our roads. Everyone needs to pay something for it, to be invested in the decisions our government makes.
That said, the ideal taxing system would follow the money.
So here’s a bit of heresy for my fellow Republicans: the middle class needs to pay disproportionately more than the poor, the rich need to pay disproportionately more than the middle class, and the über rich need to pay yet more. Why? Either we’re going to have a shared community where the ones who have more contribute more, or we’re going to have a society like Sao Paulo in Brazil, where millions live in squalor in favelas, and the rich hundreds live in walled communities under armed security and drive around in armored Mercedes.
And while you’re reeling from that bit of apostasy, here’s another: no organization should be exempt from federal taxes. I belong to a rich church. It does wonderful things for the community. It also benefits from the stability of our government, etc. It needs to pay federal taxes. My old law school has a $32 billion endowment, up a whopping $4.4 billion from just a year ago. Its endowment is larger than the GPD of more than half of the world’s countries. It’s obscene. It needs to pay federal taxes. (And it needs to stop asking me for money.)
The ideal taxing system would be immune from definitional hanky-panky. It would match the collection of the tax to when the money is there.
In short, the ideal taxing system would be a small tax on every single monetary transaction.
That’s right: a miniscule tax, say 1 percent (or less—depending on what the annual dollar total of every single transaction in the country adds up to), on every single monetary transaction, including wages, gifts, inheritances, property sales, rent payments, retail sales, legal services, company acquisitions, loans, and sales of stocks and securities.
Would this hurt the working poor? Let’s assume that someone earns $19,000 and that his employer passes the entire tax on to the employee. A 1 percent tax on $19,000 is $190. The employee would pay a 1 percent tax on all his spending and savings (if he’s able to put anything away, that is). So another $190 of tax, for a total of $380 on his entire earnings, spending, and savings. That’s hardly regressive.
But, you say, what about the millionaire? She would pay a 1 percent tax on her $1 million earnings and a 1 percent tax on her savings and spending, for a total of $20,000. That’s a long way from the $350,000 in taxes she would pay on her earnings under the current system. To which I say, that’s assuming she’s not one of the 1,400 millionaires who paid no tax at all.But, you’re right. The bulk of the tax would not come from income. Instead, it would come from a tax on the following type of transaction, which is not currently taxed. My firm just negotiated a $45 million loan for a client. Under a 1 percent transaction tax, the lender would pay a tax of $450,000 on the loan (which, of course, it would pass on to the borrower). The borrower would pay a 1 percent tax on all the loan repayments, meaning a total tax (with the transaction tax also being charged on the interest paid) of almost $1 million.
Now we’re talking. But would that kill the economy? I don’t think so. The tax would be only half of the “facility fee” that the bank charged for the trouble of making the loan to my client. With all the broker, attorney, and accounting fees my client paid, the extra $450,000 would be barely a blip. And with the interest rate as high as it was, the extra one point on the repayment wouldn’t have fazed him. (And let’s not forget that he’s no longer paying an income tax on his business profits, so he has that extra money.)
But wouldn’t a 1 percent tax on stock trades kill the stock market? I’m involved in a small hedge fund, so I’m not entirely ignorant of how the stock market works, and I certainly have an interest in the outcome if the stock market were to tank (that is, tank worse than it did in the internet bubble of 2001 and the subprime debacle of 2008 and the European debt crisis of 2011, etc.).
I called a friend who works at a large investment bank.
“It would kill the stock market,” he said.
“If you tax something, you get less of it.”
“Well, we have to tax something,” I said, “and if we’re taxing income, then by your thesis we’re getting less income.”
“The stock market is bigger than that. It would destroy the efficient allocation of capital.”
By “efficient allocation of capital,” he means high-frequency trading where stock traders make thousands of trades per hour in the same stock, exploiting minute spreads in the bid and ask price. In other words, he meant it would kill his business.
But fluctuations in a company’s stock price do not necessarily affect the company’s business. It’s not like the company is getting the money being made by the persons buying and selling its stock. Does Apple make fewer iPhones when its stock drops $8 per share? Does it really need its stock price to be “efficiently allocated” down to the penny on a second-by-second basis?
I called a portfolio manager I know who runs a hedge fund. He has about $75 million of capital under management.
“It would kill performance across the industry,” he said. “Most funds turn over their portfolios between four and five times per year. A point to sell and a point to buy equates to a 10 percent tax on the value of the portfolio, assuming five turns. That’s a $7.5 million tax for us.” (He
can do math pretty quickly in his head.)
“So if that’s the kind of tax that came down the pike, would you have to fold the tent?”
“No, the market would adjust. It would kill high-frequency trading, of course, but there would still be trades. A lot of stocks fluctuate by more than 1 percent per day anyway. Plus, reported performances would be normed for taxes.
“Trading as much as I do means that most of our gains are short-term taxed at 35 percent. Assuming five turns of the portfolio every year, I would have to produce a 28 percent return to equate to a 1 percent transaction tax. Pretty tough to do on a consistent basis, but I would just trade less, which would reduce the tax hurdle. We would be fine.”
A pretty quick retreat.
What about the broader economy? Would people stop buying? Of course not. No one cares about the little extra that comes on a bill. I thought about the custom floor mats for my car that I bought online for $149. The “shipping and handling” charge was $12.99—8.7 percent!—but I didn’t think twice. Think about all the extraneous charges on your phone bill. Think about any bill. No one cares about small transaction costs.
So it was time to test my idea on some smart people, people with more august titles than just “stock trader.” I called Michael Cox, a fellow professor at SMU. He’s the director of the O’Neil Center for Global Markets and Freedom, and he holds the distinction of having been the only man ever to hold the title of chief economist for the Federal Reserve System.
“It’s the height of lunacy!” he said. “It would be horrible for the economy.”
“It’s the equivalent in the surgical world to operating on someone with a butter knife.”
“But why? What part specifically?”
“The general principal of taxation is to administer taxes in such a way that they are the least discouraging of good behaviors—things we
want people and businesses to do. A bad tax is one which discourages things that lead to the production of GDP. Education, saving, investment, productivity, making something, starting a business, hiring people, inventing, innovating, and so on—these are things you don’t want to tax. A ‘good’ tax is one that falls on consumption, especially if that consumption behavior is undesirable. Like cigarettes. A transactions tax would tax all things equally, which in no way would be optimal.”
“There’s research that assessed the optimization of taxes?” I said. “Can I see it?”
“I’ve done economic research for 40 years,” he said. “I know a crazy idea when I see one. There are thousands of crazy ideas that I don’t spend time taking seriously.”
“So there’s been no research?”
“Has anyone done any serious research on space aliens traveling to Earth to create crop circles?”
To be fair, he mentioned early in the call that he had just returned from Disney World with his small child. That will put even the sturdiest horse off its feed, so I decided not to mention that I totally disagreed with his thesis about using the tax system to encourage good behavior and discourage bad. In my view, the ideal tax system would not be in the business of deciding what’s good economic activity and what’s bad. Who is to decide? Moreover, you’ll immediately fall into the conundrum of using the tax code to encourage the construction of cigarette factories—and then taxing the heck out of them to discourage their consumption. It was clear that the good professor would not be in the mood for such an argument.
But I knew I was on to something.
The editor of this magazine sent my idea to someone he knew at the Federal Reserve Bank of Dallas. The Fed staffer emailed back to state that a limited version of the transaction tax had been proposed by Pennsylvania Representative Chaka Fattah (also noted by professor Cox), but it didn’t include stock sales. He said that the idea had been debunked by Snopes.
Snopes? Really? (To be fair, the staffer may have just dashed off the email without giving the topic a lot of thought, and he explicitly stated that his observations were not the position of the Fed. But still.)
His other objections were (i) a transaction tax is less efficient than a VAT because it can tax the same productive activity more than once; (ii) it’s more regressive than a sales tax; and (iii) some currently public transactions would be driven underground.
We’ve already shown that a 1 percent transaction, even assuming a tax on 100 percent of wages and 100 percent of spending/savings is hardly regressive—but that just shows the innumeracy of human thinking (although surprising to witness in a Fed staffer). One percent is simply very small. Otherwise, no one would withdraw money from an ATM and pay a $2 transaction fee (which, for any withdrawal under $200, is far more than 1 percent).
Some public transactions being driven underground? You mean, more than the $2 trillion that’s operating down there already? Also, right now under-the-table income is not ever caught in the federal tax web. However, all transactions eventually appear at the cash register or at the leasing office or in the stock market, in which case the federal government would get its sliver.
Finally, taxing the same productive activity more than once? The income tax is the worst on that score. Consider $100 of earnings at ExxonMobil. It pays $35 in corporate income tax. Let’s say it distributes a dividend of the remaining $65 to its shareholders. They pay a 15 percent income tax, leaving $54.4. Let’s say they spend all $54.4 at an ExxonMobil gas pump. ExxonMobil’s wages are approximately 20 percent of gross revenue, meaning $10.88 of that $54.4 is subject to 35 percent income tax at the employee level, or another $3.81 in tax. Finally, ExxonMobil’s income is approximately 8 percent of gross revenue, meaning an additional $4.35 of that $54.4 is subject to 35 percent corporate income tax, or another $1.52 in tax. Bottom line, $100 in ExxonMobil earnings is stripped down to less than half remaining after the repeated bites at the tax apple. No way can a transaction tax even approach that level of tax drag.
So unless you’ve got something better than Snopes and space aliens, I believe the transaction tax works—as long as the dollar amount of all transactions is at least $370 trillion annually (to fully balance the $3.7 trillion budget). Sounds kind of steep, though, given our economy is only $14 trillion. Is the money there? Let’s look again to our favorite whipping horse, the stock market. Average daily dollar amount of trades in stocks and bonds is about $900 billion, or $329 trillion annually. Add total wages, total consumer spending, total business spending, total property sales, total inheritances, and total credit (to name a few)—and I think we more than get there. Even assuming a drop-off in securities trades, I think the transaction tax is less than 1 percent.
Put that on your butter knife and spread it.
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