What do you think of the President's tax proposals? During his State Of The Union Address, President Obama laid out his ideas for using the tax code to partially address yawning income inequality, calling for increased taxes for ultra high earners to pay for tax cuts for the middle class and credits for low income families. Of course, his proposals have zero chance of making it through a republican controlled congress. Rich people are their primary constituent group, far more important than the middle and low income people who happen to reside in their congressional districts. There is no way a republican caucus is going to tolerate anything other than the trickle-down policies that have been proven failures. The President's proposals are politically useful as a statement of his commitment to middle class Americans and as an opening bid to negotiations over much needed tax reforms. To that latter end, I wish that the President had gone further. President Obama has proposed a package of changes including:
- Raising capital gains tax rates on the wealthiest taxpayers from 25% to 28% - the capital gains rate in place under President Reagan
- Closing the loophole that allows the massive accumulation of tax deferred and tax free wealth in retirement accounts. The American taxpayers support and encourage working class people saving for retirement through tax deferred products like Individual Retirement Accounts. Rich people have used IRAs to defer massive investment gains. The President proposes to cap the amount that can grow tax deferred to $3.0 million.
- Closing the loophole that enables the intergenerational transfer of assets at a stepped-up basis. Today, someone who bought an asset for $1,000 (the basis) that grows to a $1.0 million current value can pass that on to their children at the new basis of $1.0 million. The children can then sell the asset and pay taxes on the stepped up basis. Requiring taxes to be paid on gains in 529 college savings plans upon withdrawal. They currently grow tax free and have benefited primarily upper income families.
As reforms, these measures do little to address the fundamental structural inequities in our tax code that favor capital over labor, particularly that capital that does nothing to create employment. Personally, I would like to have seen some additional proposals:
- Eliminate capital gains tax treatment for secondary securities transactions. What happens when an entrepreneur uses $100,000 of her personal savings, or money she has raised from friends, family and investors to open a beauty shop? She buys some inventory, she buys some equipment, she pays some rent, she hires a couple of people, she pays a contractor to make the place look nice and she might make other expenditures to assure that she has a terrific grand opening. In short, incremental economic activity ensues including the creation of jobs. What happens, however, if a securities broker convinces a well to do client to buy $100,000 of a particular stock? How many jobs does that create? What incremental economic activity is driven by such "investment"? The answer is little or nothing. The hairdresser's investment is PRIMARY because it went directly into the business and created incremental economic activity in the inventory and equipment subsequently bought. She might have hired a couple of hairdressers. She paid a contractor to do some decorating. Conversely, the purchase of stock through a broker is not a primary investment because the money didn't go into the company to be used in building the business. It was used instead to pay the person who previously owned the securities. This is a SECONDARY transaction that creates no incremental economic activity - thus, no jobs. For this reason alone, the primary investment - made directly into the business - is the only type of investment that should have a lower capital gains tax rate. The secondary transaction should not because it does not have the same positive impact. There is no economic benefit to secondary securities purchases and the rich people who make such investments are NOT job creators.
- Eliminate lower tax rates on dividends funded with leverage. When a private equity firm decides that they want some cash out of one of their portfolio company investments, they will cause that company to borrow a bunch of money and distribute that money to them in the form of a dividend. As with the secondary market securities transaction, little incremental economic activity is created. In the meantime, the added debt leaves the company less able to withstand an economic downturn, making it more likely to terminate employees should such an event occur. Historically, dividend tax rates have been low to mitigate the supposed "double-taxation" effect of corporate profits (taxes paid at the corporate level and then on distributed dividends). But as we well know, many corporations have taken advantage of enough loopholes to pay no taxes whatsoever. As well, the increased interest expense created by the debt used to fund the dividend lowers profit and thus minimizes taxes.
- Eliminate lower tax rates on carried interest. Private equity firms - like Mitt Romney's Bain Capital - are investment managers, placing capital on behalf of investors into privately held (their stocks don't trade on a public exchange) companies. Those private equity firms are compensated with annual management fees plus a percentage of any gains from those investments called "carried interest". Because investment gains are taxed at lower capital gains tax rates, some believe that carried interest should be taxed at those same lower rates. But carried interest is a form of compensation for labor, just like w-2 wages for other labor activities. This is yet another loophole that should be closed.
These are some of the areas of the tax code that perpetuate income inequality and the wealth gap. To meet the demands of their investors, companies engage in capital markets activities to with taxpayer assistance, maximize returns. Instead of putting profits and cash flow back into productive use through job-creating capital investment, they use the cash to buyback their publicly traded stock, which drives up the price of the stock, which drives up the value of the shareholders' positions, which the shareholder unwinds by selling the higher priced stock, in a transaction for which they pay that low capital gains tax rate. Few investors use the proceeds to provide start-up and growth capital to the small and emerging business that create jobs. They simply buy more securities in secondary capital markets. I believe there to be other areas of tax reform that would foster a fairer, simpler, less cumbersome code . To be sure, we should be pursuing policies that at the very least don't perpetuate the continued concentration of capital into an ever smaller number of hands.