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A Call for Comprehensive Structural Tax Reform

November 11, 2012, 12:00 AM
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Forced compromise is not enough: in order to reinvigorate our economy and change the trajectory of our unsustainable budget, America needs to confront fundamental flaws in its investment tax policies and implement comprehensive structural tax reforms.    

It is broadly recognized that President Obama did not receive a mandate for action in the recent election, and that America remains bitterly divided.  What is less broadly recognized is that the choice we were confronted with at the polls was a false choice, a Devil’s Dilemma of mutually undesirable alternatives.  Both sides are correct about the flaws in their opponents’ platform.  

  • Doubling down on the failed strategy of tax cuts for the wealthy (the Romney/Ryan plan) would accelerate wealth and income inequality, increase budget deficits, undermine social welfare programs, and eventually lead to social unrest.
  • But unless we modify existing structural misincentives, higher tax rates (the Obama plan) will encourage more aggressive tax avoidance efforts and thereby exacerbate economic stagnation and instability.    

Obama’s administration may have survived the election, but they should understand they cannot simply Stay the Course.   Nor can we reasonably hope that forced compromise in response to the pending fiscal cliff will lead to some magical middle ground between the policy alternatives we have been battling over for the past two decades.  There is no magical middle ground between these flawed alternatives that will lead to economic growth and fiscal stability.  Compromising two bad ideas will not lead to a better one.  We need to broaden our perspective and look with fresh eyes at the challenges we face.  We need stop clinging to bad ideas, take the blinders off, and examine the unintended consequences of our current structural approach to taxing wealth and investments.  

Observation: Current tax and monetary policies are subsidizing unproductive asset allocations and a flight to safety for private capital; thereby obstructing economic recovery.

Let that sink in.  There will be no sustainable economic rebound until we recognize that our tax and monetary policies have created structural misincentives and destabilized our economy.  An economy over-weighted toward trading and speculation, where investors receive preferential tax treatment while actively seeking shelter from uncertainty and risk, will not generate robust job growth.  If the productive deployment of capital is the key driver of economic growth and prosperity (the central tenet of capitalist theory) then, “Our political and economic leadership need to examine and address the ways our tax and monetary policies subsidize unproductive private capital.”  We offer preferential tax treatment to investment income with the stated objective of encouraging productive investment.  But the structure of our policies is inadvertently subsidizing unproductive, illiquid, and speculative investments – and penalizing capital allocations most directly responsible for job growth.

How so?  Let’s say I have $2 million of capital available to invest.  If I invest it directly as equity in a productive enterprise, generating jobs and profits, I become subject to substantial equity risks as well as multiple layers of taxation; on profits, dividends and capital gains.  Alternatively, I can minimize my tax obligations and in most cases my principal risk, by seeking a multitude of alternative asset allocations.  I can park my money in cash or Treasury bonds.  I can receive favorable tax treatment for debt instruments.  I can speculate in gold, real estate, or other tangible assets.  I can speculate in valuation fluctuations of publicly traded equities or complex structured securities and derivatives (which is distinct from investing in productive operations).  In nearly all cases, the lower my risk, the lower my taxes.  The only real exception to the low risk/low tax relationship is where I have actual losses; yet even there government steps in and subsidizes them with tax loss offsets, thus rewarding failure while taxing my successful competitor more heavily.  If I don’t need income, I can minimize taxes by sheltering profits and deferring gains, often to near perpetuity.  Our tax policies are skewed to favor and subsidize low-profit, unprofitable, and illiquid capital allocations.

America’s tax and monetary policies have made tax avoidance and manipulation of asset values far more profitable than productive enterprise.  Those policies have stimulated dangerous and unstable financial engineering and created recurring asset bubbles and collapses – while simultaneously triggering the transfer of billions of dollars in investment capital and millions of productive jobs overseas.    Offering preferential tax treatment to our investment class is not just inequitable, applying disparate treatment to our citizenry, more importantly those preferences distort investment incentives; and imposing them converts capitalism to cronyism.  
If we desire to stimulate job growth, priority number one should be examining and correcting the structural flaws in our tax policies that distort investment decisions.  We have to stop trying to re-inflate the bubble and turn our attention to the underlying fundamental misincentives of tax policy.  The FED may be able to boost asset values and stock market indexes temporarily, but doing so will not produce a broad, sustainable, productive economy.

By favoring unproductive capital we have abandoned Adam Smith’s Invisible Hand – to our great detriment.  The key to robust job growth is comprehensive structural reform of investment tax policies and a return to the principle of equal treatment which lies at the core of both democracy and capitalism.

We tend to think of economic stimulus as requiring governmental disbursements.  I posit that if Governments would simply level the playing field and stop subsidizing unproductive capital with ill-conceived preferential tax and monetary policies the natural response would be an aggressive reallocation of private capital that would provide far greater economic stimulus than anything government can afford to offer directly.  How big might the potential impact be of such a policy shift?  The Fed reports aggregate Household and Nonprofit asset holdings total approximately $72 Trillion.  Reallocate 3% of that toward more productive activities and you will unleash $2.1 trillion of private stimulus investment.  

If we eliminate misplaced biases and subsidies in existing tax policy private capital will flow naturally toward more productive investments, stimulating job growth and sustainable economic expansion.  If we simultaneously flatten and reduce earned income tax rates, that will stimulate real growth in wages for the working middle class and thus boost consumer demand.  I believe that structural reform of our investment tax policies would allow us to 1) equalize effective tax rates between labor and capital, while simultaneously 2) stimulating more productive capital investment and thereby job creation.    

There is not space here to argue all the merits (or potential pitfalls) of the comprehensive structural tax reforms I envision.  Indeed, more important than arguing the merits of any particular proposal, my point is that fresh ideas and new solutions are urgently required.  The first step to finding them is weeding out the bad ideas.  Effective, equitable, growth-oriented tax reform will not come from cobbling together compromise over bad ideas.  But if we expand our view and debate outside the boundaries of those bad ideas this year might be different.  

If we reevaluate the facts and acknowledge the flaws of our current policies and proposals, if we listen more carefully to criticism and open our minds to fresh ideas and alternative perspectives, then cooperation might be a path to a fresh and more promising approach to reform. The overlap of the pending fiscal cliff with a post-election lull in political bickering may offer us the best opportunity and incentive to do so, but our immediate challenge is more than just crafting political compromise.  We need to re-acknowledge the concept of a “loyal opposition,” and embrace our shared societal goals, set aside the hyper-partisan rancor that blinds us to weaknesses in our own ideas, and productively cooperate in assessing fresh alternatives.  
We need to find a better path.  In order to achieve renewed growth and vitality, and preserve the American Dream, America needs to address fundamental structural flaws in tax policy and instability in our economy that neither party has yet even acknowledged.  

I urge and invite you to read more about the questions and perspective I offer in the short post Want Job Growth? – Reinvigorate Capitalism or a longer Tax Notes’ article Factual Distortions Derail Productive Debate on Tax Reform.  A brief description of the specifics of the proposed structural reforms I envision and its perceived beneficial incentives is viewable at Premise.
Reactions and rebuttals will be gratefully received, either publicly as comment to this post, or privately via the contact form on my home website.

 

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