Monday, February 6, 2012

Sense About Cents

There is currently a great deal of debate about the "fairness" of providing a preferential rate for capital gain and dividend income in the Internal Revenue Code.  I have written previously about the tax policy rationale and implications for the lower rate in "A Tax Policy Primer".

I also suggested a few common sense thoughts on dealing with the preferential rates if President Obama and the Democrats were really serious about dealing with the issue rather than demagoguing it.
  • If the ordinary income tax rate is reduced there is less need for a preferential capital gains rate.  History has shown that as the top ordinary rate goes up it becomes necessary to establish a lower capital gains rate.  In fact, when the top tax rate was 28% under President Reagan the capital gains rate was eliminated.  It was re-established when ordinary rates went up under President Bush (41) and President Clinton.
  • President Obama is going in the wrong direction on both counts.  He wants to raise both the ordinary income and capital gains rates at the same time.
  • Allow an inflation deduction for capital assets and you have a stronger argument for treating capital gains the same as ordinary income.
  • If the corporate income tax rate is reduced there is not as strong an argument for the preferential dividend rate.  It is the total tax of the combined total that should be considered.  If the corporate income tax was eliminated there would be no argument at all for a lower dividend rate.
Let's put aside the tax policy discussion and look at just the revenue side of the equation.   To hear the Democrats talk about the issue, you would assume that doing something in this area could really make an impact on the deficit.  I have already pointed in an earlier post that the 30% minimum tax on millionaires (the so-called Buffett Rule) that President Obama wants to impose would only generate enough revenue to reduce the budget deficit by less than 4% annually.

What if the preferential rate on both capital gains and dividends was eliminated for all taxpayers? The recent CBO report provides needed context.  Taxing all investment income at ordinary rates would increase revenues by about .5% of GDP.  This is equal to an estimated $77 billion in 2012.  This would reduce the deficit by only 7%.  It hardly would make a dent in the deficit.  At the same time, what adverse effect would this have on investing and job creation? This is the real issue that needs to be carefully considered.

Compare this to other tax preferences in the Internal Revenue Code.  The deduction for home mortgage interest reduces tax revenues by $125 billion-almost 60% more than the preferences for all investment income. The big daddy of tax preferences is the exclusion of employer contributions for employee health care premiums.  This reduces revenues by $280 billion!  This is almost 4 times more costly than the investment income preferences.

The reality is that big revenue gains are generally only achievable by taxing those things that most people are taking advantage of.  Many more are taking advantage of mortgage interest and health care than capital gains and dividend income.  This is where the big revenue increases are.

If we really need more tax revenue so badly why are we dealing with pennies on the dollar?  Tom Hutchinson in Money News does a pretty good job of making sense out of the cents that are on the table in the "Buffett Rule".
But why is this tax such a big deal when it does so little? Given the severity of the nation's fiscal problems, the solution of simply sending the government a little bit more money is weak to say the least.

Obviously this is politics. It feels good to tax the rich. Also, many people are unaware that the new tax will do so little to help the deficit. The administration understands the pervasiveness of the false perception and intends to exploit it.

But, I believe there is something else — what I call the "beachhead" theory.

President Obama ultimately wants to raise taxes much higher, expand government much more, and redistribute wealth to an extent never before seen in this country. But, he won't dare lay his vision out for the American people. That would be political suicide. He might speak in platitudes like "fairness" or a "balanced" approach. But, he wouldn't dare tip his hand on the specific policy measures he will propose in support of these lofty platitudes.

His intention is to incrementally transform the country, one falsely disguised step at a time.

Politically, he can't just raise taxes across the board. He needs to start with something much more sellable.

It's analogous to America's World War II strategy in the Pacific. Right after Pearl Harbor, we couldn't just go barreling into Tokyo. It was too well defended. We would have gotten ripped apart. Instead, we started by invading the most far flung, poorly defended territories the Japanese empire controlled. Once we seized the farthest outlying territory, we used it as a launch pad to go after the next weakest held territory, and so on.

In this case, the farthest outlier and most poorly defended in terms of tax policy is taxes on millionaires and billionaires. After all, these people only account for a tiny portion of the electorate. And, who cares if they pay more? They're rich already. But, make no mistake about it. A higher tax on millionaires won't be the end of anything, it will be just the beginning. It Congress passes this tax it will serve as a political base from which to launch more taxes.

After most people see a tax hike implemented with no detrimental effect to their finances, they will be more willing to accept new taxes. The next target will likely be the $200,000 and higher earners. Then, within a short period of time, the administration will be perfectly comfortable suggesting new taxes that it wouldn't dare suggest at this point. Eventually, all tax payers will pay more, either by a higher rate or some other backdoor method.

This new millionaires' tax may be just people who can easily afford it paying more taxes. But, it is also something much more ominous. It is the crucial first step, or launch pad, for much higher taxes for all taxpayers and wealth redistribution on a scale most have not imagined.
Those that read BeeLine regularly know that I am a strong fiscal conservative.  At the same time, I am also a pragmatist.  I have stated that I am not adverse to some tax increases if it would truly result in balancing our budget.  However, I was not born yesterday.  Any tax increases need to come only after spending cuts come first and are in the bank (not on some list for future adoption).  Taxpayers in this country (all 53% of us) need to stick together and insist that there will not be one red cent ( and almost all the cents are now red) more of taxes until we see spending cuts first.

It is much too easy to think that a tax increase is ok if it is not on you or me.  Someday soon after they get their first few cents out of the millionaires they will be coming after more...from you and me.  The nature of government is that it is never enough.  You need air to breathe and food to live.  Government needs taxes to live and to feed itself.  It is time to cut off the oxygen until government goes on a diet.  

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