A Major Reason for the left-right disconnect: The Worse Kind of Tax – And a much better Alternative

It probably comes with little surprise, that the “worse kind of tax” being referred to is the dreaded Income Tax; and with good reason, it is true.

However, other than vast amounts of criticism of the tax usually based either on criticism of taxes in general, or on the validity and constitutionality of the US Income Tax, there is precious little available on the specific ills of the income tax compared to other types of taxes, and an alternative which could support today’s massive governments.

This article is the first in a series in which we will tackle ever more complex economics related and financial subjects to point out the increasingly inadequate systems most of the world is functioning under.  They encourage boom-bust cycles, constant devaluation of a nation’s currency, corporatism, debt, a constant unquenchable need for economic growth, government dependency, and the erosion of personal freedoms. At the same time they discourage that very same economic growth, true capital investment, work, savings, stability, individual risk taking, and self-reliance. Taxation is a good place to start. It is very interesting to note that large part of the disagreement between the right and the left on this matter (on the rate of income tax, not its existence), comes from a skewed perspective on the issue that I have never seen discussed. It will be herein.

Economics is complex, so this series of articles will be a bit long, but give yourself some time, share them, bookmark them, they are definitely worth a read.

At the Lighthouse, it is no secret we favor the lowest taxation possible, and by no means do we discount the position that the US Income Tax is unconstitutional (or was inappropriately ratified); this very well may be so but that is a legal argument only. Certainly in many countries, it is not unconstitutional and the legality of it in the US has become purely an academic matter since it is a fact of life. Nearly 60% of the tax revenue comes from Income Tax (Individual and Corporate). Large part of the remaining 40% really should not even be counted in this total as it is intended to fund future liabilities, and not to fund the day-to-day operations of the government.

Foremost in this category for example, is the 36% of the tax revenue which comes from Social Security (and related Social Insurance) taxes. These have for years ran on a surplus and so the government has appropriated the funds for current expenses, though as it is now infamously known, they will run in ever increasing deficits as the baby boomer generation retires and proportion of younger workers that can be taxed decreases. People paying Social Security taxes on a monthly and yearly basis are comforted by the fact that they believe this money is their retirement account which is being invested, taken care of and guaranteed by the Federal Government; most do not know it is being immediately spent to cover part of the US’s vast deficits.

Thus, approximately 60% of total Federal US tax revenue comes from Income Tax, and if taxes earmarked for future liabilities are discarded, the figure approaches 100%.

Clearly, an examination of such an important tax (it is similarly crucial in many developed nations) would be very prudent. What are its benefits and detriments? Are there any better alternatives? Amazingly, that discussion is largely absent. There is a significant discussion about the LEVEL of Income Tax, or whether it should be a progressive or Flat Tax, there is much discussion about deductions and loop holes, and even discussion about double taxation and the issue of Corporate Income Tax vs Individual Income Tax. But All these arguments begin at and accept the premise that the government should run primarily on an income tax.

This is basic human nature, and is reminiscent of many episodes which in hindsight now look absurd. Peasants in Medieval Europe often rebelled and even viciously murdered their local Feudal nobility (sometimes along with unspeakable acts inflicted on the noble family). When stating their goals, and reasons for uprising, it never occurred to them that they should not be serfs at all, but rather as free as the Feudal lord himself, as we would imagine it today. Things are the way they are, and their complaints were virtually always within the existing framework. Under Feudalism, through law or custom, Lords also had certain obligations towards serfs under their dominion along with certain limitations on their power over them. Serfs also had certain guaranteed rights and privileges, however minimal.

Uprisings and revolts usually claimed that these had been broken by an excessively oppressive feudal lord, and not that they themselves wished to challenge or change these customs or laws. Drastic changes such as these are much more rare and require charismatic individuals (usually but not always from the top rather than the bottom classes) to convince large segments of the population of the legitimacy of radical new ideas. We also should not be boxed into thinking Income Tax must always exist simply because it does.

Income Tax Basics (Skip if you know this)

Firstly, a brief and simplified account of what is usually stated on these matters is in order before we alleviate the flawed imagery that usually separates well-meaning conservatives and liberals on the issue.

Empirical evidence, some common sense, and long history of experience tells us that raising Income tax (and taxes in general) discourages economic growth and lowering taxes encourages it. That today, is not in itself argued (much). Lowering taxes helps business and the economy as a whole. Raising taxes can cause business to flee the jurisdiction to another with lower taxes. This happens constantly whether it be businesses fleeing the high tax, high regulation California environment to the low tax, low regulation Texas one, or American corporations moving to China altogether.

The other side of the argument is basically ideological and usually rests on some idea of  “fairness”. Even though raising Income Tax may hurt the economy somewhat they argue, it is necessary to take from those who have a lot in order to guarantee a safety net for those who do not. They would argue that a blazing wonderful economy is of little use if some people are left behind; homeless, hungry or worse. The government they believe, has many responsibilities in many aspects of life, and it requires a lot of money to fund these activities. They believe taxes, and especially taxing the rich, is the preferred way of funding them. The left also would argue that at least some of the negative economic impact high corporate and individual taxes would have, can be counter balanced by the fact that a larger government with higher spending, is in fact ultimately spending the money and so this in itself would stimulate the economy.

Though I summarized the left’s position in as convincing way as is possible, reality of course points to the contrary. Government spending does not create wealth the way the private sector does (note the virtually invisible effect of the recent gigantic Obama stimulus packages). This is because it takes away the cornerstones of trade: mutual benefit, free will and freedom of contract. Government spending does not produce the goods and services that people actually want (at a profitable level through low prices, productivity  or innovation), but rather those that the government dictates. In fact, it tends to fund goods and services people actually do not want, otherwise public spending would not be needed. Government seldom purchases PlayStations. Furthermore, government spending, free of market dynamics of pursuit of profit, innovation and competition, is always wasteful and often corrupt. We all know plenty of examples of this truism, be it the $200 dollar hammers the government purchases, or the difference in the level of customer service  between your favorite fast food restaurant serving hundreds of people per hour courteously and efficiently, and that experienced when going to a government agency servicing one person per hour rudely and condescendingly for tasks that require little more than stamping a couple of documents.

In addition, large government spending tends to never be funded by high taxation alone since politicians do not dare tax the people at such high levels, and so is eventually funded by the government “printing money”, a hidden tax on all (not just the rich) that causes runaway inflation. Inflation is the surest way to destroy a nation’s economy and vaporize its wealth.

However, these arguments are where the issue seems to stop. Since the leftists’ point is mostly ideological, whether higher taxes hurts an economy overall or doesn’t is of little importance to them, though this is not often admitted. This is a fair point, and reasonable. I for example, believe a powerful army is necessary for the defense of a nation. The taxes required to fund this army hurt the economy, despite the fact that they are spent (soldier’s salaries, defense industry, etc). To put it bluntly, “I don’t care”. A booming economy is of little use to me if the enemy can waltz into the nation and conquer it at will. So though that is a bit of a simplification, the leftist is stuck in that ethical argument in which purely economic argument does not interest him, as he focuses on a what he believes is a moral imperative.

Now, more complex and in-depth analysis of the economic argument will indeed show him that in reality, ALL are better off with a smaller less intrusive government, including those he wishes to protect. To describe briefly, the story of much of the democratic third world post WWII is an example. The situation is bad, and then the candidate who blames the capitalist, the industrialist and the rich as exploiters of the poor people, and who promises higher wages, more free government entitlements, less working hours and higher benefits, wins the election (or dictatorship, junta etc). The candidate who espouses what I do here, loses. Then the situation goes from bad to worse, as the “exploiters” flee in fear of nationalization of their assets and impossible business environment. During the next election, the industrialists are blamed again, and the next candidate who promises even more of all the formerly mentioned goodies wins and the situation goes from worse to terrible. This periodically resets after hyperinflation runs wild, large portions of the country’s wealth is lost, the country defaults on its debt, GDP contracts drastically, and a new currency is issued by a new government that starts the cycle over again. In some cases, the consequences can be far worse (starvation, civil war, foreign invasion etc).

On the other hand, the capitalist free market nations tend to be much better off in general, and the “poor” there live with a standard of living the great majority of people in the third world would classify as very wealthy. Since everything is relative, the poor there often still envy the larger house, bigger flat screen TV, more frequent vacations and the like of their wealthier neighbor and do not realize that their standard of living is quite high despite the fact that not everyone can live in a mansion and have 50 servants (since then the 50 servants would not exist as they too would need 50 of their own).  Rather than “leave people behind”, the booming free market tends to raise people along with it, by providing many job opportunities, freedom to innovate and pursue ones goals, full employment and higher real wages, etc. Since the economy as a whole is better off, charity also increases and man takes care of his fellow man. The difference is that those in need may accept the help of their fellow man who wishes to grant it, rather than demand it as a “right” by simply existing. The welfare state converts “beggars” into creditors (they are “owed”), and philanthropists into slaves of the state who MUST produce in order to sustain all because they CAN. They can never be taxed enough as the more people they can support, the more people that do not produce are created. We see the result of this behavior worldwide with young people lounging about in tents, smoking pot and demanding that all sorts of things be given to them.

This of course, encourages dependency and discourages work, self reliance, savings (why save for a rainy day when the state provides for my rainy day)  and risk taking.  Eventually, the would-be philanthropist, investor and creator of jobs turned slave, tires of the ever growing burden on his shoulders and gives up or gets out of Dodge (to where he is welcomed and valued for the jobs he comes to create). The state then can no longer sustain the growing number of people who deserve much and earn little (today’s Greece, and tomorrow’s US if the present course is followed), and it collapses under the strain.

How does the socialist leaning third world in the example then continue to excuse what keeps happening? Well, easy, it continues to blame the industrialists, and when there are not any left domestically then simply blames them abroad….

the imperialistic colonialist, capitalist bourgeoise 1st world nations “exploit” the third world into poverty.

… or so it goes. How is that they do this? Simply by engaging in mutually agreed upon trade (the ingredient that is missing from government spending). The 1st world invests in the third world since it tends to have a scarcity of jobs and thus low wages, and creates jobs there (much to the dismay of the “deserving” people back home in the 1st world country who are infuriated at the outsourcing of jobs that they do not wish to actually perform, at least not under any conditions that the employer can actually afford). The developed nation also buys and sells technology, goods and raw materials from and to the underdeveloped nation. This relationship, though conducted freely by parties who are happy to do so, is labeled by complex babble as exploitation. Easy to do since the goods the developed nation sells to the underdeveloped nation tend to be more expensive finished products than the raw materials it tends to buy from it. Furthermore, the discrepancy in wage levels between the two nations lends itself to this false description as well.

What is ignored, is that “evil foreign corporation” employing the locals for wages that look very meager to people in the developed country, is the single entity on the entire planet that is willing to offer those people the MOST money and benefit. If the state’s welfare was greater than their salary, they would prefer not to work. If another factory or company was offering them a higher wage to work for them, then they would also happily do so. Rather than unemployment and starvation like many of their countrymen face, the workers are happily employed. As long as the employment is optional (meaning not slavery or coerced through force), the workers obviously prefer to be there than not be there. The fact is, that the “evil” company is the best bidder on earth for their current labor. The people with good intentions who go around closing these factories (by labeling them “sweat shops”) offer the workers nothing better, simply unemployment and poverty. In exchange they purchase for themselves a good night’s sleep back in their 1st world king-size bed where they tell themselves they have done good. They would do better to set up a competing enterprise next door who offers higher wages, but that would be difficult, expensive and risky.

Finally the most ironic proof against the myth of exploitation is that when these socialist countries are not subject to the dreaded “exploitation” (ie trade and investment), they blame their poverty on THAT. Case in point would be Castro’s Cuba who endlessly blames the countries’ abject poverty on the US embargo of the island nation. If countries open to trade and investment from the US are exploited into poverty, then the decades long embargo on Cuba should have made it wealthy!

As we see today, a great part of the third world has finally learned these lessons and created an environment where the investor, the industrialist, and the risk taking innovator are welcome as opposed to enslaved. This part of the third world (China and other parts of Southeast Asia for example) continue to surge upwards and improve their citizens’ standard of living just as the developed world does exactly the opposite, and embraces ever more socialist policies that are bringing it to its knees.

What is the Confusion then?

With all the aforementioned being so.. why do so many educated well meaning people continue to favor “taxing the rich” in order to fund all sorts of niceties. The reason in large part is simple and illuminating; the concepts I described above are the reality concerning income tax, while what the well meaning leftist or centrist person has in his mind is quite different. People tend to imagine the vast wealth of the rich, millions of dollars in bank accounts, in financial instruments, property and other assets… a life of extreme luxury and often leisure that they see the rich enjoy (in their own experience and on the world’s media), and it is hard to just not believe they could give up a little more of their vast wealth to do so much good for society.

The point that is hard to evade is that regardless of the millions more that may be taken from a billionaire, and the hundreds of thousands more taken from a millionaire, common sense says that their lifestyle won’t even change as they spend such a small percent of their vast wealth anyways. On the other hand, any amount of money given to the poor, the lower middle class, and even the middle class creates a very large real difference in their daily life.   One imagines the wealthy still in their mansion, but with a few less digits on their bank account statement or with one private jet instead of two. How could it not be Ok to take from them in order to help struggling people?

Complex economics and financial arguments, however true, have a difficult time shaking these understandable thoughts from people. Therein lies the schism in the issue, and as usual, people are comparing apples and oranges.

If that was indeed the reality, the left would have a much more compelling argument. On principle, it would still bother me since the fact that one may have so much does not legitimize stealing it simply because others have less. However, it would at least make more financial if not moral sense. That is apples, so what is Oranges?

The rich can be infinitely rich, with their giant bank accounts, private jets, mansions and life of leisure and comfort and not pay one cent of Income Tax!!

The scenario in people’s heads of just taking a little bit more of this vast wealth is completely erroneous, no one gets taxed for just HAVING money. You can put 50 billion dollars in the bank in a non-interest bearing account, live off it, and never be charged one dime of income tax. If you instead deposit it in a regular interest account, you would be taxed a relatively small amount on the INCOME (the interest) you earned, but nothing on the principal (the 50 billion dollars). Interest on average US savings accounts today is not even .5% a year. Even if the income tax rate was a whopping 70%, the wealthy depositor would pay a whole 70% of the .5% interest he earns, meaning .035% of his 50 billion dollars. If you raised Income tax to 100%, that paltry sum would increase to a whole .5% of his 50 billion. To make matters worse, obviously as the tax rate increases to 100%, then no wealthy person would deposit his money in an interest bearing account since he cannot receive ANY of the interest (due to the 100% tax rate).

Obviously, as the income tax rate increases, and it becomes less and less worthwhile to have money in an interest bearing account where it is safe and guaranteed, it goes without saying that it would not be worthwhile to actually invest it and risk it in a business or venture that would create jobs and stimulate the economy. The higher the income tax rate goes, the less worthwhile it is to take on the effort, stress, headaches, and risk of investing your money in productive ways.

Furthermore, something that people typically forget, is that making money is quite difficult. The markets are extremely competitive, and making money is not as simple as just investing money. As is widely known, the great majority of new businesses fail. The majority of active investors in the stock market lose money. Though it may sound cliché to remind that these investors risk their capital,  they really do risk it and often lose it. In order to provide a good or service of the quality the market demands, at a price the market will pay while still earning a profit is in itself very difficult. It requires a combination of  luck, hard work and intelligence. One can hire these talents (except luck who refuses to be employed) and then diminish the possible margin of profitability. Doing this is difficult enough as anyone who has ran a business knows, but doing it on top of government red tape, endless regulations, taxes (payroll, local, etc)  and fees (when others elsewhere may not have as much of these) is extremely difficult, and if one is still able to achieve all of that somehow, if the small margin that is left as profit is heavily taxed, then the final risk/reward equation is shifted sharply against even attempting this venture.

Note that income tax is not negative, only positive. Whereas if one earns money after all the hurdles mentioned, a large part of it will be taxed, on the other hand if one loses money the government will not share in the losses. A loss is 100% loss, while a profit is a fraction of the total since it will be taxed. A great type of partner is the government, shares in profits, but never in losses. Many will now interject that losses are indeed “write-offs” but that is true of a net position only. You must have positive income in order to write anything off. The government will not send a an individual or a company a check for losing money overall. Amusingly they will do this only if you did not even try to make money at all, it’s called welfare.

So the idea constantly pushed that the rich in their endless greed, in order to have just a little bit more, constantly chase efficiency and savings, forsake their country in order to hire cheaper labor elsewhere is highly skewed. First of all the term “greed” when used by people complaining that others have too much money or that they do not have enough has always troubled me. A greedy person is one who refuses to share a cookie with you. A person who wishes to earn more money for his family and children, or a person who wishes to achieve and excel is not greedy, but a worthy member of society. Leave greed out of economic discussions, most people of all classes wish to have more money, but wishing does not create money, earning it does. Nothing is more absurd than blaming greed for economic woes. It is hard to even understand what that means. Secondly, if the super rich were worried about squabbling for scraps and saving every little penny possible, then they themselves would move to third world countries where their millions would buy them much more. There they could get a meal for $.50 instead of for $5. On the contrary, the rich tend to move to expensive nations and cities (Moscow, New York, Tokyo, London, Los Angeles, etc) and are actually quite splurgy… wasn’t the endless luxury and spending that made people angry to begin with?

The rich spend, and in doing so stimulate important parts of the economy, but that is personal spending. In fact, the top 10% of households in the US make up 50% of all consumer spending, which drives the US economy.  When speaking in business terms, there are no wealthy businesses and poor businesses the way individuals are wealthy or poor. A wealthy business cannot afford (at least not for long) to waste money “eating” at 5 star restaurants when the competition eats at Subway. So the reality is not that the wealthy move their companies abroad, downsize or otherwise take other unpopular actions in order to save a few more pennies for themselves, but rather to shave off a few more pennies in the extremely tight margins of modern business in order to survive because the competition is willing to do the same. Ironically, it is the rich owners that probably have the least to lose in terms of real life changes if their companies go bankrupt. They will continue to own all the wealth they personally owned outside of the company (and continue to not be taxed on it), and it is the company’s creditors, suppliers  small investors, managers, workers and customers who have the most to lose; often their livelihood. When this happens in a large scale, it is the entire country that has the most to lose.

Many times if not most often, these medium to large businesses that require a lower tax rate to survive are not even owned by this imaginary super wealthy person everyone wants to tax more. Corporations are taxed an income tax just like individuals (more on that in a bit), and this makes it difficult for them to operate profitably, especially when competing corporations of other nations may enjoy lower or no income tax. No matter how wealthy or large a business is, its owners could be (and very often are) all regular middle class and even lower class folks. Publicly traded corporations are owned by thousands and millions of small investors. In fact, pension funds and mutual funds are owners of a massive share of the market so that lower class people are often part owners of companies without even knowing it. These investors, just like large ones, risk their capital in the hope of profit, and while bankruptcy may mean the complete loss of their capital (which again could be their life savings or retirement account), the corporation enjoying a lower tax rate and regulatory burden could mean the difference between these individual owners earning $1,000 per month and $4,000 per month as an example. The difference between being able to retire decently and not.

This money would not come from the state, it would not be money that they demand they are “entitled” to and should be stolen from someone else who earned it, but instead was earned through hard work and prudent investment.  While the leftist imagines billionaires in swimming pools when he talks about raising taxes on the big corporations, it is actually most often this type of individual that he wishes to harm.

 

And if all this wasn’t bad enough, Income Tax is often taxed Twice!

This phenomenon is often termed “Double Taxation”. Like many complicated financial concepts, it is usually skewed to support political agendas. Currently, presidential candidate and wealthy investor  Mitt Romney has to constantly defend the fact that his effective tax rate has usually been so low (as low as 13%), while many if not most Americans have to pay a much higher rate (especially if one considers payroll taxes). The truth is that Romney, though apparently not doing a good job in explaining it well, in fact does pay this relatively smaller income tax IN ADDITION to regular high corporate income taxes. They simply do not figure in his tax returns and this is what is known as double taxation. It works in the following way:

Let us imagine a company that manages to conduct business, pay wages and expenses, collect sales revenues, and after paying all sorts of local taxes, fees, permits, licences, state sales tax on goods and services it consumes and all sorts of other nanny state horrors, it manages to still have a net profit. After all these expenses, the net profit is one million dollars. The next step is of course to give the net profit to the company’s owner. If this company is owned by one individual, this individual would now pay Income Tax on the $1,000,000 and supposing the rate was 50% would be left with $500,000 dollars free and clear.

Fairly straightforward. However, when the company is a corporation and is owned by several or even thousands of owners as are most publicly traded corporations, the story is different. The corporation is first taxed Income Tax as an entity itself in what is known as corporate tax. Fair enough, so the corporation itself pays the income tax on the $1,000,000 and is now left with a net profit (after tax) of $500,000. These $500,000 should be disbursed to the owners, just like they were when the owner was only one individual. In this case the owners are simply the shareholders. That is exactly what happens, but in addition the government now takes advantage of the disconnect between the small shareholder and the corporation. Assuming there was 500,000 owners of the corporation who each owned one share, then each owner would receive $1 of profit. The shareholder, who may or may not be aware that his company actually earned $2 per share in profit and has already paid $1 per share in federal income taxes, is now required to report the $1 as income in HIS individual tax return. He now owes the government an additional 50 cents on his profit, and ends up with a free and clear net profit of only 50 cents per share.

In other words, the $500,000 that were left over as profit after paying taxes, are now taxed a second time and reduced to $250,000 that are distributed to the respective owners. The same money paid Income Tax twice (often without anyone realizing it). This raised the effective tax rate from 50% to 75% without ever having to declare it so. It should be noted, that in the Bush tax cuts which are about to expire, there was included provisions to effectively end double taxation for certain types of dividends.

So US companies, unlike most in the western world, have their income taxed twice. Anyone following along will realize that this does not answer why Romney’s effective tax rate would be lower than the normal income tax.  The reason for the lower tax rate has to do with the effect that the unjust practice of double taxation tends to have. Because companies know their profits will be taxed a second time if they distribute their income to their respective owners in what is known as dividends, they tend to try to refrain from doing so. The $500,000 in our example remains intact while in the corporation’s bank account, and only gets reduced by a second half when distributed to the owners. Therefore, corporations come up with all sorts of reasons and ways to keep these assets on their books, be it in cash or investing them in some way. It is rather absurd since the entire point of the corporation to begin with was to create profit for its owners/shareholders.

As long as the company does not distribute the profits, there is no double taxation, so what effects do these accumulated profits have? They simply tend to increase the valuation of the company as a whole and therefore raise the value of the stock shares. Simply, rather than have each shareholder end up with an additional $0.50 per share owned, the company can keep the money in its bank account and increase the share price by $1. This is called a capital gain as opposed to income. When hard assets like property, long term securities, a painting by Picasso, etc appreciate in price, the government refers to this as a capital gain as opposed to income. When people’s homes go up in value, these gains are also considered capital gains and not income such as wages. The government of course ALSO taxes capital gains but at a lower tax rate than income. Clinton era capital gains tax was 28% while George W lowered them to 15%.

Therefore, Romney as a shareholder, received part of his income as dividends after the Bush tax cuts which were tax exempt, and most of his income as capital gains by simply selling his share in the companies he invested in. On average, his published tax rate would be quite low when compared to regular Income Tax. What should be understood is that all of this tax is additional tax paid AFTER the respective companies already paid full income tax on their profits. Without double taxation, Romney’s tax rate should be effectively “0”. This would not truly mean zero at all, but the rather the full income tax rate that was applied to the company’s income to begin with. But trying to explain this to the voters in 10 second sound bites is quite difficult. This is the same reason why Warren Buffet famously “complained” (while keeping his money) that he paid less taxes than his secretary. While this is untrue for several reasons (he pays many millions more than his secretary, AND his tax RATE may be lower than the secretary’s because the companies he owns have already been taxed to begin with).  Many wealthy people’s income consists of dividend and capital gains tax only, and so appear to be under-taxed. Again, this shows the inadequacy of our system where the hard working business is highly taxed, but where passive investors or owners of wealth are not.

The tendency to forcefully keep profits within a company in essence “trapped” and not distribute them to the respective owners also has very negative consequences. Money and resources are not efficiently allocated. The owners could use these funds to invest in industries with better growth prospects or that are in need of capital, or in new innovative ideas. They could also simply spend it for their personal use or whatever else they desire to do; this would result in a better allocation of resources, bringing capital to where its most needed rewarded rather than maintain it trapped in companies that do not need it (or are poor investments) for fear of being slashed in half by government double taxation.

Many right leaning people therefore support the elimination of capital gains tax and taxes on dividends since they are an unfair form of double taxation. Though they are correct on principle, the issue should actually be in reverse. This is the subject matter for another occasion, but in essence, individual human beings are/should be taxed. Business owners should be no exception. Corporations are not people or citizens and should not be taxed. To the leftist, corporations are entities endowed with rights and privileges by the state and so should pay for their charters. For the believer in freedom, corporations are nothing more than an agreement between people… typically the agreement of several partners to share in the risk and profits of an enterprise. For us, it is not a state charter or endowment of magical powers and special privilege by the state that creates a corporation, but simply the contract between individuals that does so. So rather than eliminating individual taxes AFTER corporate tax has been paid, the better position is that Corporate taxes should be completely eliminated, and individual owners of companies pay their respective taxes just like everyone else. Owner’s income from their shares should be automatically considered income, since it is,  and so there would be no need to keep money locked up in the corporation. The corporation is not a citizen of the federal government and should not have some sort of magical power where owners income and wealth therein stay exempt from taxes.

In short, the vast excesses that one imagines the rich having has nothing to do with Income tax as income tax taxes income and not wealth. Such vast excesses do not exist in income, be it of individuals, small businesses, or large corporations. The only time they may exist is when the business is created or protected by a government granted monopoly (like banking cartels, ports, old land-line telecommunication companies, utilities etc).

Progressive or Graduated Income Tax

In a progressive Income Tax scheme such as most countries now have, matters are even worse since the more Income you attempt to make, the more you are punished for your efforts. Few realize that the fact that taxes are charged as a RATE means they are already extremely progressive. The rich man does not get more votes, nor any more rights then the poor man in today’s state. On the contrary, it is most often the poor that is the beneficiary of the state’s largess and the rich man that is the provider of it. Both are equal citizens under the law, and have equal rights. It would be perfectly reasonably to form a system, as the earliest democracies were, where each citizen owes a certain amount to the state each year. Since both are equal citizens, both may be drafted to defend their nation in time of war, and both owe an equal amount to the government and tax. That a certain individual may earn more or less than another is their private business, why would that in itself alter the amount of tax he owed?

So the fact is that the so called “Flat Tax” is not flat at all. A true Flat Tax would be where each citizen for example owes a $3,000 per year to the federal government, regardless of their income or wealth. People will immediately jump and say that this is impossible, that enough funds could never be taxed this way since they again imagine the many millions taxed from very wealthy people. Ironically, if each citizen in the US  was taxed $3,000 per year, (a sum which can even be easily afforded on a minimum wage salary), that would roughly equal the 1 trillion dollars of income tax currently collected each year in the highly progressive and complex US tax system. The resulting Juggernaut of economic expansion that would follow such a system is hard to imagine. Of course, the numbers are there just as an example, of course my citizen count includes minors and the unemployed, etc. It is simply meant to show that even this arrangement is possible, especially when one considers the waste in government spending which could be drastically reduced in any event.

Therefore, the fact that the tax is charged as a percentage, flat or otherwise, already is incredibly progressive! The citizen who earns $1 (over the minimum income that isn’t taxed at all, and after all deductions) can pay 50 cents of income tax, and the man who earns $1 million, pays $500 thousand. They both still get one vote, the same free public school to send their children to, the same army’s protection, so on and so forth. On top of that, to actually increase the RATE of tax which people pay on income above the fact that it is already a rate, is beyond progressive, it is exponential.

The result is a system where the majority votes to take and spend the money of the minority. They believe it is to their benefit, though in reality ultimately it is to everyone’s detriment. In 2009, individual Income taxes revenues were collected in the following proportions (by income group):

 

 

• The top 1%  paid over a third of all Income Tax at 36.7% (and only earn 19% of the income)
• The top 5% paid 60%
• The top 50% paid 97.7%

The bottom 50% of earners, half the entire nation, paid virtually no federal income tax.

This is why in more skewed language, the media often portrays tax cuts as going to the wealthy. Of course if only the wealthy are paying taxes, any tax cut would by definition go to them. The intention however, is simply a tax cut. This excludes taxes on small business, and corporations we discussed. Exactly how much does the left think that can be squeezed from the top before the entire house of cards collapses?

The Solution – A Wealth Tax

So a large part of the disagreement between the left and right comes from the illusion of taxing wealth that in fact is not taxed at all. In fact, it is quite absurd that most nations tax (and hence punish) the activity that is most essential for its survival, the pursuit of income. It isn’t idle wealth that is taxed by the federal government, or property, or having money, or even spending money, but actually MAKING money that is taxed. When speaking about businesses and the wealthy, it makes it less and less possible to invest capital in the nation, but when speaking about the middle class and the working class it is far worse! The very act of making money (income) is taxed so a family living paycheck to paycheck and with two hard working parents is taxed on those profits just as much as the rich are (understandably perhaps at a different rate).

On principal, and pragmatically, there can be nothing worse for a nation when it comes to taxes than taxing Income. All taxes discourage some activity (and often encourage an other) by their very definition. Raising Sales Tax discourages spending but increases spending, tariffs discourage imports and exports, property tax discourages home ownership, income tax discourages business and investing. We begin by the premise that no tax is GOOD, but rather an evil necessity. Nothing can be worse than taxing Income.

Whether hard working people and risk taking entrepreneurs wish to spend their income recklessly, save it frugally for the future, or invest it for future profits, it always gets taxed. The nation in essence is punishing production as its main source of income. What then is the solution?

One answer is a truly Flat Tax where all citizens owe a fixed amount of tax each year. The benefit this would have on democracy could not be overstated. People could no longer vote on how to spend other people’s money (hence 50% of American earners pay no income tax whatsoever), but rather how to spend their own. Though it may seem that under such a system the lower earners would be unduly burdened, the economic output that would be released with be so great that it would ultimately benefit all. Productivity, output, efficiency and real earnings all would increase greatly. Of course, this truly Flat Tax could be combined with some minimal marginal rate,  so that the very low end earners still not pay any taxes, and only then gradually increase to the maximum amount (in our previous example, the $3,000 annually).

However, another less radical solution would be to actually implement what everyone actually imagines Income Tax is. A Wealth Tax.

While it is irrational, detrimental and arbitrary to tax earnings and discourage production, a wealth tax does the very opposite. People should not be punished for their attempt at benefiting the economy, risking their capital in an effort to provide better and cheaper goods and services for consumers, and for creating jobs in the process. They also should not be rewarded for sitting idly. Likewise the worker should not be taxed on his labor. Payroll taxes are hidden on both sides of the equation in order to get away with higher rates. Whereas the worker believes the company is paying him let us suppose $10 per hour for his work, and he gets to keep $8 (after taxes), in reality the company is paying $12 per hour for his work and believing the worker is receiving $10 (after their taxes). So the $2 spread is in reality a $4 spread, where the employer pays more and the worker receives less. The government is always a silent partner.

A Wealth Tax on the other hand has some ideological legitimacy and is far less harmful to an economy. Unlike the Income Tax, a proportional Wealth Tax has some logic at its core. A state at its very essence is a jurisdiction over certain territory where the rule of law is enforced by arms. Hopefully this rule of law guarantees freedom for its citizens also defended by force of arms and courts of justice. The police protect the citizen from his neighbor, and the army from hostile enemies. The greater share of the nation that an individual OWNS (and not EARNS), the greater part of the state resources are being spent in protecting the individual assets. Money in bank vaults, land, factories, intellectual property, natural resources etc, the state must protect them all. So in exaggeration, if a man owns half the land in the USA, it could be argued that half the army’s budget is directed to his benefit as it protects that same land.  Though not precise, this legitimacy and raison d’être is something the income tax completely lacks.

Furthermore, and of more interest to economists, the wealth tax does not reward the idle rich and punish the entrepreneur but rather the opposite. Our original rich man with the $50 billion in the Bank would now still pay taxes on his entire $50 billion rather than be rewarded with doing nothing with it by a 0% tax rate.  Under this system, he is better off trying to invest it and earn more money than simply watch it be reduced by taxation every year.

Now it should be clear that a Wealth Tax would be nowhere near what an Income Tax is in terms of percentage. Whereas Income Tax tends to range between 30% on the low side and up to 80% on the high side, a wealth tax would be tiny in comparison.

Just roughly speaking (without getting into ins and outs of accounting), in 2009, the NET wealth of the US was estimated at 63 trillion dollars (the UN gives an even higher estimate at 188 trillion dollars). This means that a Wealth Tax of 1.58% would have brought in as revenue the same 1 trillion dollars the current Income Tax scheme provided. For simplicity, we will raise it further to 2%.

One can easily see how incredibly less painful such a tax would be on EVERYONE. The average (mean) household in the US has a net worth of $100,000 US.  The middle quintile household has a median net worth of $186,000. The total federal wealth tax under our 2% example would $3,720 for the entire household for the whole year. Instead, currently, the middle quintile of US households has a income of $65,000 and pays an effective tax rate of about 15.5% which is $9,750 nearly triple the amount. On the other hand, idle wealthy with proportionately little income compared to wealth would pay much more in taxes compared to the current system. And perhaps most importantly, people living pretty much paycheck to paycheck would, unlike in the present time, pay no income as they have no net worth. The rat race to pay taxes would end, and only when one has amassed wealth are any taxes due. Furthermore, these taxes remain a very small percentage of the wealth.

Now, detractors may point out that if Income Tax discourages earning Income, then a Wealth Tax would discourage amassing wealth (or likewise earning Income in-order to amass wealth). Firstly, it is important to note all taxes will have a negative effect, which is why they must be kept to a minimum, and they will all discourage something if not another. However, an analogy with income tax here is incorrect completely.

Paying high rates of income tax on profit can and does discourage people from trying to earn more. This is because once again, earning money is difficult, hard often stressful work. Most importantly, money must often be risked in order to earn profit. So it is reasonable that people may decide against risking 100% of their capital invested in order to have the potential to earn a 10% return on it that will be taxed at 50%! However, wealth is wealth, and taxes or no taxes, it is always better to have more than less. It is hard to imagine anyone will decide to not earn more money because they will only keep 98% of it instead of 100%. The calculations shift drastically in the favor of investing and earning. The greatest part of this arrangement, is that whether you invest it and risk it or not, it will still be taxed, wealth is wealth. And so though in the current Income Tax system a citizen can decide NOT to invest money in order to keep it from being taxed, the same does not hold true under a Wealth Tax as it will be taxed either way. In order to not be taxed on certain wealth, a citizen would have to not refrain from investing it, but rather give it away or lose it. Once again, few indeed would lose 100% of their money in order to not lose 2% of it in taxes.

In such a system, where the effective Income Tax rate would drop to zero for all, it is difficult to explain the yoke that would be lifted from the economy and businesses. Consumers, workers and businessmen alike would find their standard of living drastically improved, competing against foreign nations much easier, and the cost of living being reduced. Finally, whereas the current system is very inflationary, taxing Wealth would have a deflationary effect, as a small percent of the actual total dollars in circulation would be removed from the economy yearly. This deflationary effect would actually ease the tax burden itself.

In the current system, a constant Wealth Tax exists anyways in the form of yearly inflation which usually tops 3%. It is a hidden tax, never approved by legislation, to fuel the government’s wild spending that it can never fund with enough Income Tax without completely crushing the economy. 

Criticisms

I will address three valid criticisms of such a system.

Firstly, deflation. Some economists are inexplicably afraid of deflation where it is inflation that is the death of nations. Some deflation is usually good, and if it ceases to be, or becomes excessive deflation, the cure could not be simpler. Unlike inflation which spirals out of controls of even the best meaning governments, the death of deflation is but a few clicks away of any government. As Milton Friedman famously said, simply “drop cash out of helicopters”. Meaning if prices keep falling as the dollar becomes too dear, the government can simply make more dollars and quickly make them less dear. If it prefers not to use up fuel on helicopters, it  can mail (or electronic direct deposit in this day and age) a $10,000 check to every citizen in the country and watch how quickly those dollars lose their value.

Secondly, some people may find uncomfortable the idea that your assets can continuously disappear, that something can never be owned outright because it will be lost eventually through yearly taxation. In essence, one must continue to earn (to cover the wealth tax) or become poorer every year. The answer lies in that very sentence; well of course. One must earn or become poorer, for we are no longer in Eden. Ironically, becoming 2% poorer every year is much better than the current disastrous loss of wealth that occurs by inflation. Any American looking back at the last 10 years, quickly realizes how $10,000 or $100,000 are simply not a fraction of what they used to be in real purchasing power. Even the “cooked” government figures on inflation places them well above 3% nearly every year. The reason the figures are artificially low, is because cheap goods from China have kept the basket of goods used to measure inflation inexpensive whereas the cost of US goods and services have skyrocketed. Citizens cannot pay their rent, insurance, litigation fees, car loans, mortgages, taxes, fees, etc etc in China. If the real cost of living allowed them to have any money left over after basic bills, then all the government’s low inflation figures indicate is that they then could buy a cheap calculator from China.

Additionally, property taxes which are a form of Wealth Tax already exist. A person can not own property outright and own it forever without earning more income because of the yearly property taxes. If he cannot pay them, the property will be taken by the government. Conceptually, I find no fault in this reality since it is, simply a reality. Nothing can ever be owned “free and clear” completely since existing requires work. The property requires constant protection from the state so that Iranians do not  invade it and take it. Just like the nation cannot simply live on without any income, neither can her citizens. Existing, living, and protecting ones assets and country do require constant work. In Israel, it means (besides massive taxes life-long), 3 years of every young man’s life in arms and uniform. Two percent a year of amassed wealth so that we may keep 98% is not too much to ask.

The final criticism I will preemptively address is the most valid and the one, in the interest of “brevity” that cannot here be answered thoroughly. While a Wealth Tax we showed will not discourage earning income, it would encourage flight of wealth or hiding of wealth if it is not administered correctly. Some nations briefly experimented with a Wealth Tax and some (like France) abandoned it while some like Scandinavian countries still have it. France did experience large flight of wealth. However, all of these Wealth Taxes were simply an additional tax in hyper taxed socialist countries. They did not replace Income tax, but only added another tax on top of the many already in place. The flight of capital is a normal phenomena of all such socialist countries where every conceivable tax the authorities can come up with are put in place. It would also stand to reason that something not doing well in France, is probably a good indication that it can go well elsewhere.

The main issue is a complex accounting one. Property tax gets around it by charging a tax on the gross value of the land in question, as opposed to net worth. The state or county are not interested in whether you own the 50 million dollar private island free and clear, or you actually have a 49.9999 million dollar mortgage from the bank on it; the title holder is still charged the full property tax. This solution is the simplest one, and will stop citizens from attempting to on paper have less wealth than they really do. This could be done in a myriad of ways, mostly by declaring liabilities against assets, so that the “net” value is smaller.

For example, if 3 friends are facing the newly installed wealth tax, and two are quite wealthy in net worth terms, and the third is massively in debt, the two could sign over contracts and liabilities to the unfortunate friend matching their assets to cancel out the net value. Meanwhile, as long as the third friend’s indebtedness was big enough to cover his friends’ assets they signed over to him in essence, then he also still would be in a negative net worth position and owe no wealth tax.

Without entering into further details, it is sufficed to say that these issues confront the concept with a regulatory obstacle but not a principle one. Liquid assets (ie cash, stocks, bonds etc) cannot really be hidden legally and not hidden easily at all (except cash under your mattress). Property likewise cannot be hidden, so these two factors are enough to build an intelligent enforcement strategy whose details are beyond the scope of the current paper. For example, Wealth Tax can be levied on real property (land, buildings, factories etc) and liquid assets only, and much like current property tax rules, net worth can be ignored and the full gross value taxed. This way, no one worries about playing funny games with Net values and the tax authorities don’t have to worry about it. Amazingly, in this case, our sample Wealth Tax Rate drops from 2% to much lower since our total wealth figures were based on Net Value. If you tax the gross value, the taxable value rises drastically and so your tax rate can drop drastically, probably about half.

This concludes the first article on how a nation can unlock vast economic potentials and drastically raise the quality of life for its citizens while expanding their individual freedoms. This would be a nice change from the endless spiral of inflation, devaluation, stagnation, recession, deficits, debt and expanding government control the last years continue to shower us with. Lowering government spending, lowering the tax burden in general, eradicating the Income Tax and switching to a Wealth Tax system would be a great start.