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Fighting to end destructive double taxation

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The Wall Street Journal’s Primer on Capital Gains Taxation

Posted by Dan Mitchell on September 24, 2012

One of the principles of good tax policy and fundamental tax reform is that there should be no double taxation of income that is saved and invested. Such a policy promotes current consumption at the expense of future consumption, which is simply an econo-geek way of saying that it penalizes capital formation.

This isn’t very prudent or wise since every economic theory agrees that capital formation is key to long-run growth and higher living standards. Even Marxist and socialist theory is based on this notion (they want government to be in charge of investing, so they want to do the right thing in a very wrong way – think Solyndra on steroids).

To help explain this issue, the Wall Street Journal published a very good primer on taxing capital gains.

The editors begin with an uncontroversial proposition.

The current Democratic obsession with raising the capital gains tax comes from a mistaken belief that the preferential rate applied to the sale of a family business, farm or financial asset is a “loophole” that mainly benefits the rich.

They offer three reasons why this view is wrong, starting with a basic inequity in the tax code.

Far from being a loophole, the low tax rate applied to capital gains is beneficial and fair for several reasons. First, under current tax rules, all gains from investments are fully taxed, but all losses are not fully deductible. This asymmetry is a disincentive to take risks. A lower tax rate helps to compensate for not being able to write-off capital losses.

Next, the editors highlight the unfairness of not letting investors take inflation into account when calculating capital gains. As explained in this video, this can lead to tax rates of more than 100 percent on real gains.

Second, capital gains aren’t adjusted for inflation, so the gains from a dollar invested in an enterprise over a long period of time are partly real and partly inflationary. It’s therefore possible for investors to pay a tax on “gains” that are illusory, which is another reason for the lower tax rate.

This may not seem like an important issue today, but just wait ’til Bernanke gets to QE24 and assets are rising in value solely because of inflation.

The final – and strongest argument – is that any capital gains tax is illegitimate because it is double taxation. I think this flowchart is very helpful for those who want to understand the issue, but the WSJ’s explanation is very good as well.

Third, since the U.S. also taxes businesses on profits when they are earned, the tax on the sale of a stock or a business is a double tax on the income of that business. When you buy a stock, its valuation is the discounted present value of the earnings. The main reason to tax capital investment at low rates is to encourage saving and investment. If someone buys a car or a yacht or a vacation, they don’t pay extra federal income tax. But if they save those dollars and invest them in the family business or in stock, wham, they are smacked with another round of tax.

There’s also good research to back up this theory – some produced by prominent leftists.

Many economists believe that the economically optimal tax on capital gains is zero. Mr. Obama’s first chief economic adviser, Larry Summers, wrote in the American Economic Review in 1981 that the elimination of capital income taxation “would have very substantial economic effects” and “might raise steady-state output by as much as 18 percent, and consumption by 16 percent.”

Summers is talking about more than just the capital gains tax, so his estimate is best viewed as the type of growth that might be possible with a flat tax that eliminated all double taxation.

Nobel laureate Robert Lucas also thinks that such a reform would have large beneficial effects.

Almost all economists agree—or at least used to agree—that keeping taxes low on investment is critical to economic growth, rising wages and job creation. A study by Nobel laureate Robert Lucas estimates that if the U.S. eliminated its capital gains and dividend taxes (which Mr. Obama also wants to increase), the capital stock of American plant and equipment would be twice as large. Over time this would grow the economy by trillions of dollars.

So why aren’t these reforms happening, either the medium-sized goal of getting rid of the capital gains tax, or the larger goal of junking the corrupt internal revenue code for a simple and fair flat tax?

A big obstacle is that too many politicians believe in class-warfare tax policy, even though lower-income people are among the biggest victims when the economy is weak.

For more information, here’s my video explaining that the right capital gains tax rate is zero.

P.S. Some of you may be wondering why I didn’t make a Laffer Curve argument for a lower capital gains tax. The main reason is because I have no interest in maximizing revenue for the government. I simply want good policy, which is why the rate should be zero.

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On Death Tax, the U.S. Is Worse than Greece, Worse than France, and Even Worse than Venezuela

Posted by Dan Mitchell on July 29, 2012

Considering that every economic theory agrees that living standards and worker compensation are closely correlated with the amount of capital in an economy (this picture is a compelling illustration of the relationship), one would think that politicians – particularly those who say they want to improve wages – would be very anxious not to create tax penalties on saving and investment.

Yet the United States imposes very harsh tax burdens on capital formation, largely thanks to multiple layers of tax on income that is saved and invested.

But we compound the damage with very high tax rates, including the highest corporate tax burden in the developed world.

And the double taxation of dividends and capital gains is nearly the worst in the world (and will get even worse if Obama’s class-warfare proposals are approved).

To make matters worse, the United States also has one of the most onerous death taxes in the world. As you can see from this chart prepared by the Joint Economic Committee, it is more punitive than places such as Greece, France, and Venezuela.

Who would have ever thought that Russia would have the correct death tax rate, while the United States would have one of the world’s worst systems?

Fortunately, not all U.S. tax policies are this bad. Our taxation of labor income is generally not as bad as other industrialized nations. And the burden of government spending in the United States tends to be lower than European nations (though both Bush and Obama have undermined that advantage).

And if you look at broad measures of economic freedom, America tends to be in – or near – the top 10 (though that’s more a reflection of how bad other nations are).

But these mitigating factors don’t change the fact that the U.S. needlessly punishes saving and investment, and workers are the biggest victims. So let’s junk the internal revenue code and adopt a simple and fair flat tax.

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The Right Capital Gains Tax Rate Is Zero

Posted by Dan Mitchell on April 14, 2012

The silly debate about the “Buffett Rule” is really an argument about the extent to which there should be more double taxation of income that is saved and invested.

Politicians conveniently forget that dividends and capital gains get hit by the corporate income tax. And since America now has the developed world’s highest corporate income tax rate, it’s adding insult to injury to tax the income again. Actually, it’s adding injury to injury!

No wonder Ernst and Young found that the United States has a very anti-competitive system for taxing dividends and capital gains. (perhaps it’s time to copy the clever British campaign against punitive double taxation)

If you believe in fairness, the right capital gains tax rate is zero. John Goodman of the National Center for Policy Analysis, has a good explanation.

Income tax time is an appropriate moment to go to the heart of President Obama’s complaint about the taxes Warren Buffett and other rich people pay, or don’t pay. What the president is really complaining about is that the tax rate on capital gains is too low. But there is a more basic question to be asked: why tax capital gains at all?

That’s a very good question, because a capital gain isn’t income. It’s an asset that has increased in value. But the tax only applies on the gain if you sell the asset.

But why does an asset, such as shares of stock, rise in value? According to finance research, asset prices rise in value when there’s an expectation that there will be a greater after-tax stream of future income. But that income will be taxed (at least once!) when it materializes, so why tax it before it even happens? John hits the nail on the head.

The companies will realize their actual income and they will pay taxes on it. If the firms return some of this income to investors (stockholders), the investors will pay a tax on their dividend income. If the firms pay interest to bondholders, they will be able to deduct the interest payments from their corporate taxable income, but the bondholders will pay taxes on their interest income. Here is the bottom line: There is no need for the IRS to tax the bets that people make along the way — as stock prices gyrate up and down. Eventually all the income that is actually earned will be taxed when it is realized and those taxes will be paid by the people who actually earned the income.

Amen. John is exactly right. He’s making the same arguments I put forward in my video on capital gains taxation.

By the way, the capital gains tax isn’t indexed for inflation. So if you bought an asset 30 years ago and it’s doubled in value, you’ve actually lost money after adjusting for inflation. Yet the IRS will tax you. Sort of adding injury to injury to injury.

Finally, I like how John closes his column.

…why not avoid all these problems by reforming the entire tax system along the lines of a flat tax? The idea behind a flat tax can be summarized in one sentence: In an ideal system, (a) all income is taxed, (b) only once, (c) when (and only when) it is realized, (d) at one low rate.

In this awful period leading up to tax day, isn’t it nice to at least dream of a tax system that is simple, fair, and non-corrupt?

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Romney: A Total Failure on Double Taxation

Posted by Dan Mitchell on January 24, 2012

Last night’s GOP debate did nothing to change my sour opinion of Mitt Romney.

During a discussion about tax reform, he attacked Newt Gingrich for the supposed crime of not wanting to double tax capital gains. Here’s how Politico reported the exchange.

Newt Gingrich joked about Romney’s 15 percent tax rate, saying: “I’m prepared to describe my flat tax as the Mitt Romney flat tax.” Romney jumped in to ask: Do you tax capital gains at 15 percent or zero percent? Gingrich’s answer: Zero. “Under that plan, I’d have paid no taxes in the last two years,” Romney said, alluding to the fact that all his income is from investments.

Romney’s remarks are amazingly misguided. Getting rid of the capital gains tax doesn’t result in a tax rate of zero. It simply means that there is no second layer of tax on top of the punitive 35 percent corporate income tax.

I’ve had to correct Warren Buffett when he makes this mistake. One would think, though, that GOP presidential candidates would have a better understanding of taxation.

In addition to being wrong on policy, Romney also is politically tone deaf. By demagoguing against Gingrich’s tax plan, he lends credibility to the dishonest claims that his personal tax rate is “too low.”

In a column for today’s Wall Street Journal, John Berlau and Trey Kovacs of the Competitive Enterprise Institute explain how the GOP candidates should deal with this issue.

The former Bain Capital CEO and Massachusetts governor caused a brouhaha last week when he estimated the tax rate on his investment income at 15%. “How unfair!” pundits exclaimed, noting that the top marginal rate for wage income is more than 30%. The tax rate on investors is unfair, but for the opposite reason. Our tax code layers taxation of dividends and capital gains on top of a top corporate tax rate of 35%—which even President Obama acknowledges is one of the highest in the world. …This double taxation brings the effective tax rate on investment income to as much as 44.75%. In other words, after the combined top tax rates hit $100 of corporate income, $55.25 remains for the investor. And this figure doesn’t even include various state and local taxes, or the death tax. Moreover, like the rest of us, Mr. Romney paid income taxes before investing… Mr. Romney and other presidential candidates should use the opportunity of releasing their tax returns to make an important policy statement. They should include not only their individual returns, but information about the taxes their corporations pay. …In this way the candidates can help explode the myth of the U.S. as a low-tax nation. As Cato Institute tax experts Chris Edwards and Daniel J. Mitchell write in their book, “Global Tax Revolution,” while the U.S.’s “overall tax burden . . . is lower than in many other nations,” the country “imposes more punishing taxes on savings and investment than many advanced economies.” The most popular tax reforms—from the “9-9-9 plan” of former candidate Herman Cain to flat tax proposals—all have in common the reduction or elimination of double taxation on investment. …If the traditional disclosure of tax returns is elevated into a “teachable moment” about the burdens of double taxation, all Americans could be winners.

The authors are very kind to reference the book Chris and I wrote, but I mostly like this article because it does such a good job of explaining double taxation.

I made many of the same points in my video on capital gains taxation.

And keep in mind that the capital gains tax isn’t indexed for inflation, so the rate of double taxation in many cases is far higher than these estimates suggest.

As illustrated by this chart, double taxation is a serious self-inflicted barrier to American growth and competitiveness. Too bad Republicans are too short-sighted to address this issue intelligently.

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Milton Friedman Talks Inheritance Tax

Posted by Brian Garst on November 5, 2011

Milton Friedman was never one to shy away from debate, but was a master at answering hostile questioning with persuasive economic reasoning. Here’s his take on the death tax:

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Explaining the Perverse Impact of Double Taxation with a Chart

Posted by Dan Mitchell on September 28, 2011

Whether I’m criticizing Warren Buffett’s innumeracy or explaining how to identify illegitimate loopholes, I frequently write about the perverse impact of double taxation.

By this, I mean the tendency of politicians to impose multiple layers of taxation on income that is saved and invested. Examples of this self-destructive practice include the death tax, the capital gains tax, and the second layer of tax of dividends.

Double taxation is particularly foolish since every economic theory – including socialism and Marxism – agrees that capital formation is necessary for long-run growth and higher living standards.

Yet even though this is a critically important issue, I’ve never been satisfied with the way I explain the topic. But perhaps this flowchart makes everything easier to understand (click it for better resolution).

There are a lot of boxes, so it’s not a simple flowchart, but the underlying message hopefully is very clear.

1. We earn income.

2. We then pay tax on that income.

3. We then either consume our after-tax income, or we save and invest it.

4. If we consume our after-tax income, the government largely leaves us alone.

5. If we save and invest our after-tax income, the government penalizes us with as many as four layers of taxation.

You don’t have to be a wild-eyed supply-side economist to conclude that this heavy bias against saving and investment is not a good idea for America’s long-run prosperity.

By the way, Hong Kong’s simple and fair flat tax eliminate all those extra layers of taxation.

That’s the benefit of real tax reform such as a flat tax. You get a low tax rate, but you also get rid of double taxation so that the IRS only gets one bit at the apple.

Posted in Capital Gains Tax, Death Tax, Dividends Tax | Comments Off

Huntsman Plan Targets Double Taxation

Posted by Brian Garst on August 31, 2011

Another proposed plan by a presidential candidate is tackling the issue of destructive double taxation. Former Utah Governor Jon Huntsman unveiled today his economic plan, titled “Time to Compete: An American Jobs Plan.” From the overview:

Eliminate The Taxes On Capital Gains And Dividends In Order To Eliminate The Double Taxation On Investment. Capital gains and dividend taxes amount to a double-taxation on individuals who choose to invest. Because dollars invested had to first be earned, they have already been subject to the income tax. Taxing these same dollars again when capital gains are realized serves to deter productive and much-needed investment in our economy.

Now if he just throws in the death tax, he can hit the double taxation trifecta.

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Warren Buffett’s Fiscal Innumeracy

Posted by Dan Mitchell on August 15, 2011

Warren Buffett’s at it again. He has a column in the New York Times complaining that he has been coddled by the tax code and that “rich” people should pay higher taxes.

My first instinct is to send Buffett the website where people can voluntarily pay extra money to the federal government. I’ve made this suggestion to guilt-ridden rich people in the past.

But I no longer give that advice. I’m worried he might actually do it. And even though Buffett is wildly misguided about fiscal policy, I know he will invest his money much more wisely than Barack Obama will spend it.

But Buffett goes beyond guilt-ridden rants in favor of higher taxes. He makes specific assertions that are inaccurate.

Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

His numbers are flawed in two important ways.

1. When Buffett receives dividends and capital gains, it is true that he pays “only” 15 percent of that money on his tax return. But dividends and capital gains are both forms of double taxation. So if he wants honest effective tax rate numbers, he needs to show the 35 percent corporate tax rate.

Moreover, as I noted in a previous post, Buffett completely ignores the impact of the death tax, which will result in the federal government seizing 45 percent of his assets. To be sure, Buffett may be engaging in clever tax planning, so it is hard to know the impact on his effective tax rate, but it will be signficant.

2. Buffett also mischaracterizes the impact of the Social Security payroll tax, which is dedicated for a specific purpose. The law only imposes that tax on income up to about $107,000 per year because the tax is designed so that people “earn” a corresponding retirement benefit (which actually is tilted in favor of low-income workers).

Imposing the tax on multi-millionaire income, however, would mean sending rich people giant checks from Social Security when they retire. But nobody thinks that’s a good idea. Or you could apply the payroll tax to all income and not pay any additional benefits. But this would turn Social Security from an “earned benefit” to a redistribution program, which also is widely rejected (though the left has been warming to the idea in recent years because their hunger for more tax revenue is greater than their support for Social Security).

If we consider these two factors, Buffett’s effective tax rate almost surely is much higher than the burden on any of the people who work for him.

But this entire discussion is a good example of why we should junk the corrupt, punitive, and unfair tax code and replace it with a simple flat tax. With no double taxation and a single, low tax rate, we would know that rich people were paying the right amount, neither too much based on class-warfare tax rates nor too little based on loopholes, deduction, preferences, exemptions, shelters, and credits.

So why doesn’t Buffett endorse this approach? Tim Carney offers a very plausible answer.

For more information about why class-warfare taxes are misguided, this video may be helpful.

Posted in Capital Gains Tax, Death Tax, Dividends Tax | Tagged: , , , , , , , | Comments Off

George Will: Eliminate Estate Tax for Economic Recovery

Posted by Brian Garst on August 12, 2011

In the midst of explaining how to fix the economy in an interview with PBS’ Charlie Rose, George Will had this to say about the death tax:

“I would eliminate the death tax. I don’t know why death is a taxable event in this country. No more estate taxes. Eliminate — go back to the classic — no taxation without respiration, that’s right. Go back to the classic Bill Bradley/Ronald Reagan tax reform of 1986. Lower the rates by eliminating loopholes and exceptions.”

Posted in Death Tax, Economic Growth | Comments Off

Gingrich Joins Chorus to Reduce Double Taxation

Posted by Brian Garst on June 18, 2011

Following in the footsteps of two other Republican presidential candidates, Newt Gingrich has promised to eliminate the capital gains tax if elected:

In a broad-ranging speech, Gingrich … promised to make current tax rates permanent, eliminate the capital gains tax and slash corporate taxes in an effort to lure capital back into the United States.

Ideally, we’d like to see every candidate in both parties looking to eliminate harmful double taxation. Unfortunately, President Obama wants to do the opposite. But while we continue to hope he has a change of heart, the more Republican candidates willing to strike a pro-growth position against double taxation, the better the odds of seeing a real change in tax policy become.

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