Misunderstanding the Tax Debate

This should be a short post, because my comprehensive view on tax reform is found here.  The summary is that the problem is not tax rates.  The problem is the definition of income.  Just as in ancient times, people would make themselves look poor when the taxman came, so do the wealthy do today.  “Income? I hardly earn any income.”

And that is because of loopholes in the tax code for social engineering purposes, but even more for the ability to defer taxation of what should be income.  My view is that we should all be taxed like traders, with no opportunity to defer taxation.  No tax deferral for IRAs, HSAs, 401(k)s, DB pensions, insurance, annuities, endowments, stock (even private stock will have to report transactions).   As asset prices rise, you would get taxed.  No deferral.

You might think this is an ugly system, and it is, though Zillow would have one amazing business when the government uses it to tax increases in housing values, with a true-up at the eventual sale.  They might even find new business by creating pricing grids for other sets of illiquid assets.

The idea is that taxation should follow value creation, which is income, even if it is not cash income.  Gone would be the days where one has an appreciating asset, and borrows against it, and pays no tax.  All increases in value would be taxed, and assets where the increase can’t be measured would assume a 15% annual return for taxation purposes, with a true-up at the sale of the asset.

Deferred tax liabilities would be made payable in a few years, and deferred tax assets would receive payment in the same period.  Deferred gains in stock would be immediately taxable.  Hello, Mr. Buffett, you want the rich to pay taxes, here is your bill.

This would include an elimination of all deductions, corporate and individual.  And, I would beef up the IRS to enforce this.  Once the concept of income gets simple and immediate, enforcement gets easier.  The IRS could focus on one question: how much are they prospering?  Tax in proportion to that.

A proposal like this could rapidly balance the budget without raising tax rates.  Now none of the midgets running for President would adopt such an idea — it offends both the left and the right.  But it would raise taxes on the rich, unlike what an otherwise bright guy like Buffett proposes.  Rates aren’t the question, the question is the definition of income.

And until we focus on the definition of income, we will continue to drift as a nation, at least until a crisis hits that reveals our weakness.

3 Comments

  • cig says:

    It’s all well meaning but it’s likely to fail in practice, with unintended consequences and nasty corner cases where you have to reintroduce complexity.

    For example imagine a taxpayer with one, liquid but volatile asset, which is essentially long term flat. It goes up +X in one year, -X the next, etc. So the taxpayer has essentially zero income (amortised) but must pay on the +X on the positive years. The no deferral rule prevents creating an offsetting tax credit on -X years, so he’s either paying tax on non-existing income, no good (>100% tax rate), or requires a refund on the down years, which creates a new class of enforcement problems that didn’t exist before (people creating fake losses to get actual cash, when they could only get tax credits before).

    Another example is a taxpayer with a single illiquid asset, say a small business owner who owns nothing else, and the business is with tight cash flow, or a disabled/elderly person who owns their house outright but nothing else and who lives on welfare. If the business/house valuation goes up, these guys have a tax bill. So now they must raise money out of an illiquid asset just to pay tax, and as it’s illiquid and they don’t have cash flow they might have to either pay distressed credit rates on their tax borrowing, or just sell the business/house which is a bit of a harsh punishment for a tax-cashflow issue.

    Income is intrinsically a tricky problem. You can clean up the crud from time to time, indeed you must as some nonsensical rules will inevitably accumulate, but a simple tax idyll is unfortunately not realistic I believe.

  • rrebold says:

    I respectfully don’t think so. The example of the taxpayer with the volatile asset could also be compared with a person who pays income taxes on a salary. If they lose their job next year (volatility) they would have paid too much this year by your model. The issue is that it seems less fair to tax work (salaries) at a higher rate than wealth (dividend income). Perhaps it could be separated from capital gains – which is’t real income until it is sold at a profit. It could also be argued that salaried people contribute more to the economy than dividend income does. I’m not a job creator if I go sell a $100K of stock on the NY Stock Exchange – what have I added to the economy?

  • mwilbert says:

    This does not strike me as a good idea. It isn’t practical to tax appreciation of illiquid untraded assets, and the overhead and intrusion involved in doing something like this fairly would be tremendous.

    I don’t see why we should be so reliant on taxing income anyway. Pigovian taxes would be better for the economy, and consumption taxes would be easier to levy. Even a Henry George style single-tax would seem preferable to trying to impute income to people as a result of asset fluctuations.

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