Misunderstanding the Tax Debate (II)

I’m going to do something different to start this post.  I’m going to highlight those that disagreed with the last post.  Thanks for disagreeing, because it makes this post better.

Response 1:

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.

Response 2:

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 isn’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?

Response 3:

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.

I like my readers.  Why do I like my readers? One, they are bright people, even if I might disagree with them.  Second, they are relatively polite.  I was walking through Times Square with another prominent blogger, and he said to me, “When I see the comments at your blog, David, you have nice commenters, whereas those at my blog are not.”  I said to him that there were three factors in play:

  • He has more readers than I do.
  • His format did not allow for filtering.  I filter, but rarely.    Also, it’s harder to comment on my site, and that’s a feature, not a bug, because I want people who are determined to comment, not something that is off the top of the head.
  • I pointed out to him that his rhetoric had bomb-thrower tendencies, and what kind of crowd would that attract?

So, I like my readers, and commenters.  In general, if you comment here, and I don’t delete it, I respect you.  (Deletion rate is less than 0.1%.)

But now to my main point.  Much as I like Buffett, I disagree with him on tax policy, because he is a hypocrite.  Let him argue that stock holdings should be taxed annually on the unrealized increase, and I would agree with him.  He doesn’t pay as much taxes as he should because:

  • Berkshire Hathaway doesn’t pay a dividend.
  • He never sells shares of his company.
  • He engages inside his company to avoid taxes in every legal way.  He is not interested in paying taxes in the slightest.

My tax proposals would make Buffett and those like him pay, and others who game the system as well.  The critiques above miss the point in a major sense.  Much avoidance of taxation comes from having companies that are heavily indebted.  I don’t believe that having heavily indebted companies is a good thing.  If they faced taxation on the presumed increase in their value annually they would be forced to have more liquidity, and that is a good thing.

My proposal would lead to companies not being so heavily indebted.  That’s a feature, not a bug.  We need to discourage debt in the financial sector, because it tends to create booms and busts.  If you want to do a big capital investment, save for it, or borrow on a very short term basis.

My proposal on taxation should be phased in gradually.  Mr Buffett should not be presented with a bill for $12 billion, but rather a request for $1.2  billion for 10 years, reflecting the value he has obtained untaxed.  With respect to taxation, he is the ultimate hypocrite.  If he did not speak on such matters, I would respect him, because he is generally such a wise man, but he has prostituted his position to the current political scene.  Thus I don’t respect him here.

(As an aside, we could drop the estate tax after instituting this, because appreciation would be taxed annually.  As such, the cost basis at death would be very near market.  One thing that was little noted in the one year elimination of estate taxes in 2010 was that if you inherited something in that year, your tax basis did not step up to market, but remained at the cost basis of the decedent.  The taxes may be delayed, but they weren’t eliminated.  That’s still quite an advantage.)

I believe that a less levered system is better for the economy as a whole.  It is far better to disallow interest as a deduction for corporations. and allow corporations to dividend to shareholders without taxation.  Or, eliminate corporate taxation, and tax dividend receivers directly, combined with a tax that taxed profitable companies that did not pay dividends.

The economy is better off when it is less levered.  Debt obligations make the economy less flexible, demanding fixed payments, regardless of how likely they are.  For modeling, it is best to think of the unlevered economy. What is the native demand, leaving aside the  speculative demand?  Borrowing to create speculative demand should not be encouraged by the tax code.  After a phase-in, interest should not be tax-deductible, but would add to the cost basis of assets.

My views are relatively simple:

  • Taxes should be moderate, and levied on the approximate increase in value annually.
  • Corporations and individuals should avoid borrowing to finance investment/consumption, at least, it should not be tax-favored to borrow in the short run.
  • Everyone should be taxed; there is no way to avoid it.  This ensures fairness.
  • All classes of income should be taxed at the same flat rate.
  • There are no non-income deductions/credits, and no use of the tax code for social engineering.
  • This should be phased in over ten years to avoid a shock.
  • For illiquid situations, businessmen would have to plan in advance for taxation, which would impose a cost on illiquidity in the economy.
  • We would not favor savings over consumption — goodbye to the complexities of IRAs, life insurance, pensions, and all other deferral vehicles.

The overarching idea is to create a flat taxation system, where the increase in value is taxed annually, and where there is little incentive to engage in any sort of action to convert one sort of income into another.  This would level out many of the advantages that the wealthy have, while leaving in place a relatively transparent taxation system with few preferences which would be stable, and create predictability in taxation.

Those are my views.  I am trying to create something more stable, fair, and transparent (can’t hide income).  Those are desirable goals.  Why shouldn’t everyone love this, aside from the rich that use the overly generous tax code?  Feel free to comment below…

PS — this would have implications for US entities owning foreign assets, but I haven’t figured out how to make this work globally without making people/firms flee the US.  Ideas are welcome.  Thanks to all readers/commenters, I appreciate all of you.

18 Comments

  • cig says:

    Thank you for engaging in dialogue, it’s a great pleasure!

    I’d like first to suggest that you should consider unbundling your propositions. It’s a general point: when policy recommendations are self contained, you will never benefit from trying to push them as a basket, as lots of people will find something they don’t like in the basket and reject the whole because of the items they dislike.

    In this instance, I totally agree with the idea of removing tax deductibility for interest payments, for corporates, and individuals too. It would be an unmitigated good if lot of things currently financed through fixed income instruments moved to equity. This idea is self contained, and can be promoted on its own, and it should be easy to find broad support for it.

    On taxing unrealized capital gains, I still think it’s impractical, whatever the merits in principle. You have not addressed my objection on whether you do cash tax refunds for years where there are net unrealized losses, with the attendant problems either way. And there’s another major operational objection: taxing unrealized capital gains implies complication of the tax system. By taxing capital gains on realisation, the tax system currently just needs to observe and note down cash flows, which is simple enough, while to tax unrealised the tax system has a new, herculean, task: coming up with yearly valuations of all assets. It’s easy for liquid ones, but requires a huge new bureaucracy and private counter bureaucracy (people arguing with the tax office that the valuation they came up with should be different) for all the rest. Surely we can all agree that we don’t want more of the workforce moving into the business of administering taxation.

    On substance on illiquidity, I think that to “impose a cost on illiquidity” is going the wrong way. The real world is illiquid. Useful things, buildings, equipment, even teams who make the value of service businesses, are all illiquid and generally desirable, so if anything tax should facilitate that, not hinder it. Unfortunately, given that liquidity is a continuum it’s hard to find a way to tax capital gains differently as a function of liquidity, hence ending up where we are and taxing everything on realization. But would going full whack to the other end of the spectrum really help?

  • albertlea says:

    There is a lot of nonsense floating around these days about Warren Buffett and his effective tax rate.

    As the Chairman, CEO and largest shareholder of Berkshire Hathaway, Buffett’s choices are Berkshire’s choices. Berkshire’s choices include maintaining its domicile in the United States (unlike nearly all its insurance competitors) and refusing to engage in complicated tax avoidance schemes (unlike nearly all sizable American companies).

    As a result, Berkshire with its huge profits and 32% corporate tax rate pays roughly 2.5% of all the corporate income tax paid in the USA each year. Since Buffett, as the largest shareholder, effectively pays 30% of that, he undoubtedly pays more tax each year than any other American and probably more than any other person on earth.

    Given all that, it’s hugely ironic that neither the left nor the right seems to have any idea how much tax Buffett actually pays each year.

    • BRK also has a large deferred tax liability, which means it hasn’t paid. Granted there are provisions in the tax code that encourage that but those should be deleted.

      Buffett has shielded most of his increase in net worth from tax by never paying dividends, and never selling his stock. What a miser. We should all be taxed like we tax traders, on unrealized capital gains. Note that this would cushion the economy in years like 2008 when there are losses — taxes would go down.

  • accessd says:

    Thanks for all the posts over the years. Definitely one of the most thoughtful and interesting blogs.

    I’d like your thoughts on some form of tax based on a person’s assets and property, rather than on income or appreciation. Since the value of one’s entire net worth would be subject to tax, the rate would necessarily be very low. Some fraction of 1%. This form of taxation has existed before. Some years ago my local taxes were in the form of a Personal Property Tax. That tax was replaced by a more typical income tax, after some local zillionaire challenged it in court. I don’t remember the details, but I believe it was due to some little technicality of not taxing local assets the same. A so called “wealth tax” is also referenced in the book, The Millionaire Next Door.
    Please express your thouths, as I feel such a tax offers several advantages, including simplicity and fairness.

    • Do you live in Pennsylvania?

      • accessd says:

        Yes, at the time I was a resident of Montgomery County, PA.
        I was told, at the time Montgomery County was one of the wealthiest municipalities due largely to the revenues from that Personal Property Tax. I don’t have any numbers to back that up. I suppose I could dig up some old tax records to see what I paid. Anyway, I was just trying to get some thoughts from those with greater knowledge and access to real numbers to comment. Thanks to cig for his reply. Agree that getting the people with the most assets, and influence, to go along is unlikely, as evidenced by the replacement of that local Personal Property Tax with an income tax all those years ago.

    • cig says:

      US GDP = 15 trillions. US private wealth = 55 trillions. A “fraction of 1%” of that is peanuts, too small to replace income tax or become an essential contributor to the tax system.

      It’s a likeable idea, but good luck getting people who will pay it to accept it at a realistic rate.

      • accessd says:

        What rate do you think would be needed to produce revenues similar to todays federal income taxes?
        Obviously, such a tax would hit those with the most, the hardest. But, it would be a true flat tax that all would be subject to.

      • But the proposal does not do it at a fraction of 1% — it would be taxing the whole productive capacity of the US economy annually, which does not happen under the current tax code. Much income escapes taxation, and this remedies the problem. It is not the tax rates, but the definition of income.

  • Underground Bakery says:

    1) Buffett could have saved literally billions of dollars by converting Berkshire to a private equity company at any point over the past several decades.

    2) Berkshire already pays a fortune in taxes every year, dividends or not.

    3) It would be irresponsible to Berkshire shareholders not seek tax efficiency. For moral/societal purposes Warren’s best tools are free speech and his vote, and those are exactly the tools he’s using to say his tax rate should be higher.

    4) Even without dividends, you still pay taxes on gains when you benefit from them–unless you give it all away to charity, which coincidentally is exactly what Warren is doing.

    5) I’ve heard good things about your blog, but the concept of taxing unrealized gains has no merit from an economic or political point of view. It’s just insane, and I think your quoting reasonable people pointing out why is close enough to a mea culpa. We also come to crazy conclusions sometimes, but it’s important to admit when we were wrong.

    • 1) Right, and this proposal takes direct aim at private equity.

      2) BRK has a large deferred tax liability.

      3) I want a tax code that does not allow for tax efficiency.

      4) Buffett is a miser. Misers should be taxed because they don’t care about benefit — they/we should be taxed on our increase. I don’t care that Buffett will give it away, he has paid less personally to the government than he should have. He is a hypocrite.

      5) Taxing unrealized gains is a very reasonable concept. It is done in Canada, and many other countries. I am hardly insane, but your comments do not impress me.

      • cig says:

        The Canada section of the “Capital gains tax” Wikipedia article says: “Unrealized capital gains are not taxed.”

        Maybe it is an error in Wikipedia, but if so do you have a reference handy that explains how it works, in Canada or any other country that has a system that is close to what you advocate?

        • Then that’s changed since I took the actuarial exams 20 years ago, because I had to learn a summary of Canadian tax law at that point — then again, maybe I am confusing it with taxing the inside build-up of life insurance policies.

          I’ll look and check to see if anyone else taxes URCGs.

          • FrankM says:

            As a Canadian, I can answer the Capital Gains question regarding Canada. Unrealized capital gains are not taxed, except, that every individual is deemed to have disposed of all assets the day of his or her death, so a taxpayer often has a really big capital gain for the year of his death. There are no really effective ways to avoid this, so most capital gains will eventually be taxed. The quid pro quo is that we have no estate taxes (although Ontario has pretty high probate fees)

  • equityval says:

    David, I will echo the thoughts about your thoughtful posting.

    That said, I think there are some real practical problems with your proposal.

    I agree with the notion of removing the incentive for debt in the tax code. That can be dealt with in a very straightforward manner of removing the deductibility of interest.

    Trying to value and tax illiquid assets on an annual basis has two major problems (and probably more on further reflection). The first is that putting values on illiquid assets would become a bureaucratic nightmare and ultimately a game that would favor the wealthy. Just think about a house, which as illiquid assets go, generally has a least a few salient benchmarks that one might use to come up with an approximation of value, yet hundreds of millions of dollars each year are spent litigating assessed valuations.

    When you get into private companies, you are really opening a can of worms. What would the IRS say Instragram was worth at the end of last year? Would they have been within a $100 million of being right? Valuing private companies is a challenging enough art for those that dedicate their careers to it. Imagining that a bunch of IRS bureaucrats would not make a hash of it is beyond the pale for me.

    Moreover, and this gets into my second point, where would the founders of an Instagram realistically come up with the funds to pay the capital gains on that gain in value? This is a major flaw in the proposal. The entrepreneurial process is one that, I believe, is key to the dynamism and adaptability of US economy. The process of company building often goes on for years with a very uncertain and often difficult to discern value creation progression. Moreover, the cost of equity is usually onerous at this stage and entrepreneurs often forego cash income in an effort to sustain the business in its early days, leaving them with little means to meet the IRS annual dunning in your proposal. The only realistic options for entrepreneurs under this plan would be to sell a portion of the company each year to pay the tax bill, a process for many private companies that is expensive, prolonged and often unsuccessful. Remember, most private businesses are not social media darlings with private investors lining up to shower them with money. Most are often funded with savings, credit cards and small sums from friends and family. Raising equity once or twice in the start up process is hard enough. Doing it every year to pay the tax man will drive a lot of people either out of business, force them to surrender control of the business, or deter them from attempting it in the first place.

    There are other scenarios along this line, such as retired people living in areas with rapid real estate appreciation. Do you want them to sell their houses to pay the annual capital gains taxes? Paying galloping real estate taxes is enough of a challenge for retired people. Does adding this make sense given how disruptive a change of venue is to the elderly generally speaking?

    Matching the obligation to pay with a (realistic) ability to pay ought to be a core consideration in a tax code.

    Finally, there is the matter of the effect of inflation on capital assets and your proposal would both become an annual tax on inflation as well as an enormous incentive for the government to further debase the currency by creating nominal capital gains that could be turned into revenue.

    I appreciate the effort to think outside the box, but practically, I don’t see this working.

  • Keith H says:

    It’s not clear to me how unrealized losses would be treated under your proposal if a taxpayer is going to be “taxed as a trader,” as you put it.

    Is the plan to basically treat the taxpayer as if he/she has made a Section 475 mark-to-market election?

    If that’s the case, (and if my understanding of the tax law is correct), the taxpayer would enjoy full deductibility of unrealized losses, without regard to the annual $3,000 capital loss limitation.

    Full deductibility of losses sounds good to me as a taxpayer, especially in down years for the market such as 2009. But I suspect the US Treasury would see it a different way.

  • accessd says:

    I searched up some numbers. As cig noted US personal wealth is in the ballpark of 55 trillion dollars. Federal Income taxes collected were 1.4 trillion dollars. Therefore, 2.55% of personal wealth was paid to the IRS as income tax. Of course not everybody paid 2.55% of their own personal wealth in taxes. Some paid more, some paid less. Whether the taxes were based on income or not doesn’t change the fact that 2.55% of our collective wealth was paid.
    Now 2.55% does seem unsustainable, if your living off your savings. In trying to think up alternatives it does soon become obvious why tax systems get complicated.
    How about something much more conservative. How about replacing the AMT with a “wealth” tax. AMT tax revenue was “only” 102 billion dollars, which gives a tax rate of only .185% of net wealth. No more AMT patches.

  • Keith H says:

    I agree with those who have said that having to put a value on a closely-held business each year for income tax purposes would place a severe burden upon the owner.

    One possible solution? As a first step, you might set up a national database of closely-held business sales. Require those involved in the sale to report sales price, number of years in business, and other relevant numbers.

    Then have a neutral party take all of the database information and synthesize it into a table of current values. It would have to be presented in an easy-to-use format, such as the actuarial tables that the IRS publishes for a retirees calculating their IRA required minimum distributions. But not overly simplistic. The business owner would need to have complete confidence that the methods used to develop the estimates were determined in a rigorous manner

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