Tuesday, November 23, 2010

Tax Reform 201: The Optimal Tax Rate

Stuck on Static

Tax Rates, GDP, and Static Retrogression

- by: Larry Walker, Jr. -

Those immersed in the static conception of human behavior say that America will never grow its way out of debt. Well, that’s a self-fulfilling prophecy if we base our tax policy on the static view. So do they think we can tax our way out of debt? If that’s the case, we might as well extend unemployment benefits indefinitely, and break out the hot dogs and beans. But there is another conception, known as the dynamic view. Dynamic analysts know that lower tax rates have positive impacts on human behavior, investment, production, economic growth, and tax receipts. Those of us who are faithful to the dynamic conception of human behavior believe it is better to grow our way out, than to surrender.

Today’s top income tax rate of 35.0% is relatively low in terms of a top rate of 39.6% during the 1990’s, but relatively high compared to rates of 7.0% in 1913, 24.0% in the 1920’s, and 28.0% in the 1980’s. A careful analysis of gross domestic product (GDP), during the highest and lowest tax rates of the past 30 years, reveals that cumulative GDP growth was 45.7% (.26/.569) higher when the lowest tax rates were imposed. Based on economic data available from the Bureau of Economic Analysis, it appears that a top tax rate of 28.0% is optimal (and that’s including the tax expenditures available in the 80’s). So today, we’ll look at relative tax rates, then analyze the performance of GDP and government revenues at relatively low and high tax rates, and then try to figure out what Obama is talking about.

Relative Tax Rates

As Mark Perry points out, in Tax Cuts, Tax Hikes, It’s All Relative; tax cuts and tax hikes are indeed relative. “…Certainly, compared to the “Clinton tax hikes” that took effect in 1993 and raised the top marginal income rate to 39.6%, the reductions of the top tax rate to 38.6% in 2002 and 35% in 2003 were “tax cuts”. But if you go back further and compare the Bush tax rates to the highest marginal tax rates under Bush, Sr. (31%) and Reagan (28%), couldn’t the Bush II tax rates more accurately be referred to as the “Bush tax hikes”?

“Of course, the tax rates were much higher before 1988, here’s the full history back to 1913 in the chart below. Compared to most of the tax rates between the 1930s and the 1980s, couldn’t the Clinton tax rates also accurately be referred to as the “Clinton tax cuts”?”

Sure it's all relative, but what's the optimal rate? In order to find the answer, we need a measurement.

Cumulative GDP Growth and Tax Rates

An analysis of the cumulative growth of GDP for the periods of 1981 to 1988, and 1993 to 2000 reveals that with top tax rates capped at 28.0%, GDP grew at a cumulative rate of 82.9%; and that when top tax rates rose to 39.6%, GDP only grew by 56.9%. This refutes the myth that the economy performed better under Clinton’s burdensome tax rates. The economy performed better than when? In reality, the economy grew at a much higher rate under Reagan, in fact 45.7% greater (see the table and chart below).

GDP Growth 80's-90's

A top marginal tax rate of 28.0% is optimal.

Optimal Tax Rates - Click to Enlarge

Why did the economy perform so much better with lower tax rates? The answer may have something to do with behavioral psychology. Let’s face it, there’s a big difference between knowing that ones top tax rate will be under 30.0%, versus essentially 40.0%. Perhaps human behavior is both conditioned and determined by its own outcomes or consequences (rewards and punishments). As a commenter recently remarked, “My first customer, like my last, responded to stimuli that benefited him and his business, and at the best possible price.” And what are income taxes, if not a price?

The difference between top tax rates of 28.0% and 39.6% can be reasonably quantified as a cost, or benefit, of 45.7% in cumulative economic growth, over an eight-year period. The effect of tax policies on GDP is but one aspect of a dynamic tax policy. Lower tax rates lead to increased economic activity, and eventually to greater tax revenues.

Growth in Government Revenue and Tax Rates

In terms of government revenues, tax receipts grew at a cumulative rate of 75.8% during the 80’s, and at 85.6% during the 90’s. In other words, Clinton’s tax policies increased tax revenue by 12.9% more than Reagan’s (see table below). But when we bring GDP back into the picture, we see that Clinton's policies actually grew tax receipts by 50.4% more than GDP, while Reagan’s policies increased GDP by 9.4% more than revenue.

Government Revenues 80's and 90's

Under Clinton, government revenue grew at 85.6%, while GDP only managed 56.9%. Under Reagan GDP grew by 82.9%, while revenue increased by 75.8%. So which top tax rate is optimal? Although a top tax rate of 39.6% increased tax revenues by 12.9% more than a top rate of 28.0%, the cost to our economy was a loss of 45.7% in cumulative GDP growth. Again, a top tax rate of 28.0% is optimal. Think about it. What happens to you when your tax burden increases significantly faster than your personal income? Yeah, not a good thing; yet many idolize Clinton. And then there's Obama, who not only wants to raise top rates back to 39.6%, but also to reset the top tax bracket to where it was 17 years ago. What’s up with that?

Obama's Retrogression: Why $250,000?

Now that we know for sure that capping top tax rates at 28.0% leads to optimal economic and revenue growth, and that raising rates to 39.6% causes tax revenues to outpace the economy by 50.4%, the question is: What does $250,000 have to do with it? Well, a quick examination of the 1993 tax rate schedules reveals that the top tax bracket back then, seventeen years ago, was $250,000 (see table below).

1993 Tax Rates

Why is Obama regressing when it comes to the top tax bracket? He keeps saying he's moving ‘forward’, and 'making progress', yet when it comes to income tax brackets, he wants to put it in reverse. If that is indeed his intent, then the major flaw in Obama’s appraisal is that he has failed to adjust for inflation. In real terms, $250,000 of income today was equal to just $164,275 in 1993 (calculate it here). And, $250,000 earned in 1993 is the equivalent of $380,460 today. Annual inflation over the 17-year span has been 2.5%. In fact, the top tax bracket today would be $380,460 if properly adjusted for inflation, and yet in 2010 it is $373,650 (the same as in 2009).

So Obama’s proposal boils down to taxing those with current incomes of $250,000, in 1993 dollars, without the benefit of an inflation adjustment, while taxing everyone else in current dollars. And if approved, it will result in nothing more than ‘legalized theft’. In effect, taxpayers who made between $164,275 and $250,000 in 1993 would be pushed into the top tax bracket by 2011. If Obama was playing it straight, he would simply let the Bush tax cuts expire. But instead, we are being asked to tolerate the idea that some taxpayers deserve the benefit of an inflation adjustment, while others do not.

However, Obama’s static retrogression is implausible. If the imposition of a top tax rate of 39.6% were optimal for our economy, then Obama’s approach might be practical, however, in light of the facts, it is most unsuitable. History proves that our economy achieved maximum growth when top tax rates were limited to 28.0%. The difference amounted to a 45.7% increase in cumulative GDP growth over an eight-year period. Obama’s strategy of lowering the bar of the top income bracket, while raising the top tax rate will cost our economy more than 45.7% in cumulative growth over the ensuing eight years, as more taxpayers get bilked.

At a time when America really needs an across the board tax rate cut, Americans are being asked to accept higher taxes, and regressive income brackets. If we are dumb enough to accept Obama’s proposal, in time we will achieve what many long for, a flat-rate-tax. But unfortunately the rate will wind up being 39.6% for all who are fortunate enough to endure. We can do this, but we need to be dynamic. Don’t get stuck on static. Cut spending, lower taxes, step back, quit lecturing, and for God’s sake stop chanting.

In the beginning it was:

Yes we can!
Yes we can!
Yes we can!

Then those chants quickly evolved into:

Yes government can!
Yes government can!
Yes government can!

And just before fizzling into dead silence, it was:

More for government, less for us!
More for government, less for us!
More for government, less for us!

Now that this foolishness has been exposed, and a line has been drawn, the question is: Which side are you on? Do you side with the people, or with the government? You can’t be for both. Either you are in favor of keeping more of your hard earned pay, or you are for handing over more to the government. Either you are for individual freedom and personal responsibility, or more government control. You are either for you, or against yourself.

Prerequisites: Tax Reform 101: Stuck on Static; Obama’s Inverted Wealth Curve

Data Sources: Bureau of Economic Analysis; Office of Management and Budget

Thursday, November 18, 2010

Tax Reform 101: Stuck on Static

Lame Duck

Don't be lame. Be dynamic.

- By: Larry Walker, Jr. -

When it comes to tax policy, there are two schools of thought. Liberals and progressives cling to what’s known as static revenue analysis, while conservatives lean towards what’s known as dynamic revenue analysis. Today we will be comparing both concepts to gross domestic product, and government revenue between the years of 1993 and 2008. The objective is to open minds to the concept of dynamic analysis, and to prove once and for all that tax cuts lead to increased government revenues, and higher levels of economic activity. But first, lets look at a couple of examples:

Example 1: Static Revenue Policy – Joe the retailer owns a gift shop. One day Joe got sick and tired of lackluster sales and decided to raise prices by 100%. Joe believed that if he doubled prices, while maintaining the same volume of sales, that his revenues would double. Joe doubled prices but soon noticed that sales volume had dropped dramatically. Before the price increase, Joe averaged 1,000 customers per month, with average sales of $10 per customer, and total sales of $10,000 per month. After the price increase, the number of customers fell to 500 per month, with average sales of $20 per customer, and total sales of $10,000 per month. Joe soon realized that higher prices don’t necessarily lead to more revenue. Joe had applied a static revenue policy, and in the process learned that there’s more to business than meets the eye.

Example 2: Dynamic Revenue Policy – After taking a few businesses courses, Joe the retailer decided to give it another try. This time Joe decided to cut prices by 50%. Joe quickly noticed that sales traffic picked up dramatically. After the price cut, the average number of monthly customers rose to 2,000, with average sales of $10 per customer, and total sales of $20,000 per month. Why didn’t the average sale per customer fall from $10 to $5? Because, customers were already spending $10 per sale, and quickly figured out that they could now buy twice as much for the same amount; so consumption didn’t decrease. This time, Joe had applied a dynamic revenue policy, and in the process was able to double sales. Not only did sales double but, Joe was able to receive volume discounts from his suppliers for placing larger orders. Joe had finally arrived. Now, let's look at GDP.

Gross Domestic Product

A comparison of GDP between the periods of 1993-2000 and 2001-2008 can be looked at in two ways. Static minds will focus to the far right of the table below, and pontificate that GDP grew at a higher rate, an average of 5.79% under Clinton, than the lackluster 4.71% under Bush. What they miss is found in the third and fourth columns. Comparing the total amount of gross domestic product over each term, we see that total GDP under Clinton was only $65.4 trillion, while it was $98.4 trillion under Bush. We also see that average annual GDP under Bush was $12.3 trillion, while under Clinton it was a mere $8.2 trillion. In other words, total economic production grew by 50.4% during an era of lower tax rates.

Dynamic GDP Table - Click to Enlarge

So then why was the annual percentage growth rate higher under Clinton? That’s easy. If you make $10,000 per year and get a 10% raise, your pay will have increased by $1,000. Fair enough. But if you make $100,000 per year and get a 5% raise, your pay will have increased by $5,000. Which would you rather have, more money, or a larger percentage increase? I'll take the money.

Here’s what this looks like graphically:

Dynamic GDP Chart - Click to Enlarge

Government Revenues

Now let’s look at total government revenues over the same period. Static minds will focus to the far right of the table below, and lecture that government revenues grew at a higher rate, an average of 8.05% under Clinton, than the lackluster 3.04% under Bush. Again, what they miss is found in the third and fourth columns. Comparing the total amount of revenue raised over each term, we see that total revenues under Bush were $17.2 trillion, while under Clinton revenues were only $12.4 trillion. We also see that average annual revenue under Bush was $2.1 trillion, while under Clinton it was a mere $1.5 trillion. In other words, total government revenue grew by 38.7% during an era of lower tax rates.

Dynamic Revenue Table - Click to Enlarge

Lower tax rates lead to greater tax revenues, and a larger economy. That's the whole point. It’s the number of dollars that matters, not the rate of increase. The fact that revenue growth is achieved at lower annual growth rates is a bonus, especially when it comes to tax rates. The only problem we have is that the demands of government have grown faster than both revenues and GDP, but that’s another story. Remember: "Government is not a solution to our problem, government is the problem." ~ Ronald Reagan

If we want to grow the economy and spread wealth, tax cuts are the way to go. It all depends on ones philosophy. Liberals and progressives want to grow the size of government, at the expense of the economy. Conservatives want to grow the economy at the expense of government. So let us all think clearly now, and not be stuck on static. Have a Merry Lame Duck session.

Sources: Bureau of Economic Analysis and Office of Management and Budget

Tuesday, November 16, 2010

Real Tax Reform II : Taxing Corporations

Not Cash Cows

Ending Tyranny

- By: Larry Walker, Jr. -

In Part I, we focused on unfair tax policies surrounding S-Corporations and Partnerships. The prospect of increasing tax rates on business owners is a far cry from what most of us would consider meaningful fiscal reform. Part II examines how government, both federal and state, milks corporations, and specifically small Personal Service Corporations (PCs) out of billions of dollars every year. In terms of combined taxes, if we add together federal and state corporate taxes, payroll taxes, and taxes levied on the wages and dividends of its owners; when the smoke clears, government walks away with approximately 76.6% of a PC's pre-tax profits, and 45.4% of its gross income.

And just what is the end result of all the government’s efforts to hoard and redistribute our wealth? Well, as far as the federal government is concerned, with revenues of $2.2 trillion in fiscal year 2010, and a national debt of $13.6 trillion, it appears that Congress has already spent all of next year’s revenue times six. So when is enough, enough? Meaningful fiscal reform necessarily involves massive spending cuts, and major tax cuts. Our problem is government spending. Tax cuts have the effect of broadening the tax base, and are the only way to effectively increase government revenues.

“An unlimited power to tax involves, necessarily, a power to destroy; because there is a limit beyond which no institution and no property can bear taxation.” ~ John Marshall, McCullough v. Maryland, 1819

What is a Personal Service Corporation?

A personal service corporation (PC) is a corporation composed of employee-owners who perform substantially all of its services. Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts. Like other C-corporations, PCs are subject to income taxes; but unlike regular C-Corps, PCs are taxed at a flat rate of 35% of taxable income.

Corporate Income Tax Rates

The following table shows the 2010 federal income tax rates assessed on corporations. [In the examples which follow, the company is based in the state of Georgia and is subject to its corporate tax rate of 6% of taxable income.]

Corporate Tax Rates - Click to Enlarge

Sample Personal Service Corporation

In the following example, Taxed Enough Already, PC (TEA-PC) is a small personal service corporation with ten employees, and annual revenues of $800,000. In tax year 2010, TEA-PC paid salaries and wages of $300,000, payroll taxes of $25,805, and had pre-tax profits of $474,195. The total amount of corporate income tax paid was $194,420, after-tax profits were $279,775, and employee-owners were paid dividends of $150,000. TEA-PC’s sample income statement follows:

TEA Income Statement

The Issue: Combined Taxes

Examining its total contribution to federal and state taxes, we find that TEA-PC paid $220,225 in combined payroll taxes, and corporate income taxes. We also discover that its employee-owners paid an additional $112,950 in social security, Medicare, and federal and state income taxes. Finally we see that TEA-PC’s employee-owners got soaked for another $30,000 in taxes on dividends received out of the company’s after-tax profits. Overall, TEA-PC has been milked out of $363,175 in combined taxes. In other words, TEA-PC’s employee-owners have been assessed total taxes amounting to 76.6% of their pre-tax profits. That’s pathetic. How can American businesses grow, when they are being milked out of 76.6% of pre-tax profits every year?

Combined Taxes

Proving that TEA-PC was responsible for all of these taxes is easy. We know that the company directly pays payroll taxes on its employee’s pay, and corporate income taxes. What many non-business types don’t understand is that a corporation is also responsible for withholding and paying its employee’s share of taxes. Also, since in this case, the employees are owners, their after-tax dividend receipts are subject to double taxation. Dividends are first levied a 35% tax at the corporate level (plus 6% in state taxes), and then subject to another 15% on the owner’s personal income tax returns (plus 5% in state taxes).

Tax Ratios

An examination of TEA-PC's tax ratios reveals the following:

  1. Corporate payroll and income taxes paid were 27.5% of gross income.

  2. Corporate payroll and income taxes paid were 46.4% of pre-tax profit.

  3. The company was directly and indirectly responsible for paying combined taxes of 45.4% of gross income.

  4. The company was directly and indirectly responsible for paying combined taxes of 76.6% of pre-tax profit.

  5. The total taxes paid on dividends, which are taxed both at the corporate and individual level, amounted to 61% ((35% + 6%) + (15% +5%)).

Tax Ratios

The Proposal

In order to make the tax code more equitable, Personal Service Corporations, as well as regular C-Corporations, should be allowed to take a deduction for annual dividend distributions. This will lower corporate taxable income and the amount of corporate income taxes paid, put an end to double taxation; and enable more income to be distributed as dividends, and/or reinvested towards future growth. This is accomplished by adding a line to page one of Form 1120 for the dividend deduction.

In addition, the tax rate on PC’s should be cut dramatically. According to the tax rate schedule above, PC’s are taxed at the same rate as corporations with taxable income greater than $18,333,333. Why are PC’s with taxable income of $50,000, $100,000, or $400,000 taxed at the same rate as corporations making over $18,333,333? Does this sound like a pro-growth strategy? The government’s present fiscal commission is recommending cutting corporate rates to 26%, while others want them to be repealed entirely. Under the Revenue Act of 1926, the tax on corporations was 13.5% of net income (individual tax rates ranged from 1.4% to 25%). Today, we have a complex set of codes, rules, and regulations, which basically amount to nothing more than government lordship. It’s time to level the playing field so that no corporation has an unfair advantage over another, and so that government may no longer oppressively impose itself over private enterprises. I therefore propose a maximum corporate tax rate of 13.5% of net income.

The Effect

My proposal will effectively lower the amount of taxes paid by corporations, and personal service corporations by ending the double taxation of dividends. By allowing corporations a deduction for the amount of dividends paid, more income is distributed to the personal level for efficient consumption. Also lowering corporate tax rates to the level imposed during the Roaring 20’s will allow our economy to return to a policy of robust growth. Once enacted, my proposal will result in economic growth on steroids, massive jobs growth, skyrocketing levels of entrepreneurship, greater freedom, and less dependence on the federal government.

Related Posts:

Real Tax Reform I: Taxing Small Business

Tax Revolt of 2010 Authentic

Saturday, November 13, 2010

Real Tax Reform I : Taxing Small Business

Not Cash Cows

Stop Swindling Paper Profits

- By: Larry Walker, Jr. -

Much of the debate against raising tax rates on the upper bracket centers around how income taxes are computed on small business owners. The debate focuses on the way that pass-through income, which is earned by the shareholders of S-Corporations and Partnerships, gets taxed. What we need is a fundamental transformation in the way that businesses are taxed. A business should be treated as an investment, not a person. Once we have correctly defined the nature of a business, and how businesses ought to be taxed the rest of tax reform is easy.

“An unlimited power to tax involves, necessarily, a power to destroy; because there is a limit beyond which no institution and no property can bear taxation.” ~ John Marshall, McCullough v. Maryland, 1819

Defining Pass-Through Income

S-Corporations and Partnerships do not pay income taxes. Instead, income is passed through to its owners and taxed on their individual income tax returns. Owners of pass-through entities receive income from their businesses in primarily two ways. The first way is through salaries and wages, and the second is through K-1 distributions. Salaries and wages are reported on W-2 Forms and are subject to withholding, social security, Medicare, and federal and state unemployment taxes. K-1 distributions are reported to the shareholder on Schedule K-1, and are not taxable, nor subject to withholding or payroll taxes.

What are K-1 Distributions?

K-1 distributions represent distributions of profit paid to the owners of S-Corporations and Partnerships. K-1 distributions get their name from the tax schedule on which they are reported, Schedule K-1. In addition to reporting the amount of K-1 distributions, Schedule K-1 also reports the shareholders share (as a percentage of ownership) of net business income, non-deductible expenses, capital gains income, and any pass-through deductions and credits (i.e. accelerated depreciation).

K-1 distributions are similar to the dividends paid by C-Corporations, with one key exception. Taxable dividends are reported on Form 1099-Div, and taxed to the recipient as current year income. K-1 distributions are reported to the recipient on Schedule K-1, but are not taxed to the recipient as current year income. The recipient of Schedule K-1 is instead taxed on the entire net income of the business, which is usually far greater than the amount physically received as a distribution.

The Issue

The discrepancy lies in that S-Corporation and Partnership shareholders are taxed on their share (as a percentage of ownership interest) of the net income of the business, not on the amount of distributions they physically receive.

Example - A small business has net income of $400,000, only one shareholder, and paid the owner a salary of $100,000 plus a distribution of $50,000.

Under current tax law this shareholder has taxable income of $500,000, the entire net income from the business of $400,000, plus a salary of $100,000. But in reality, the owner has only physically received $150,000, a salary of $100,000, and a distribution of $50,000. The remainder of $350,000 was earned by the company, but has yet to be spent or distributed. Is it fair to tax the small business owner on $500,000 of income when she has only physically taken custody of $150,000? Foul! Anyone who thinks this is fair should make a voluntary tax-deductible charitable contribution to the federal government, and earmark it towards the national debt, which by the way is allowed under the tax code.

This is the issue at hand. On one side, you have those who want to treat the lowly small business owner as a millionaire, and to tax her on income she has yet to receive; and on the other side, you have those who think it hurts the economy to tax unrealized small business profits, which businesses need to retain for future expansion.

The Proposal

In order to make the tax code more equitable, shareholders of S-Corporations and Partnerships should only be taxed on the amount of income actually received. The amount of income received is comprised of salaries, wages, and K-1 distributions. Small business net profits should not be taxed until they have been physically paid out to shareholders. What is required is a simple change to Schedule K-1, instructing the shareholder to report the amount of distributions as taxable income, instead of the amount of net profit.

Other pass-through income, losses and deductions will be capitalized at the corporate or partnership level and kept up with on a cumulative basis. When the business is sold, or otherwise disposed of, the original investment, plus any capitalized earnings, losses and deductions will be taken into account in determining whether the sale or disposition is a long-term capital gain, or loss.

The Effect

What my proposal will do is simply return businesses to their original purpose. A business is an investment, not a cash cow for the government. Think about it. If you invest in $100 worth of corporation stock, and the value goes up to $10,000, you are not taxed on the unrealized gain each year, but rather on the realized gain which occurs when the stock is sold. Businesses are investments and should be allowed to grow as investments, and the only way this is going to happen is for the government to stop taxing unrealized business appreciation.

My proposal will effectively lower taxes on small businesses which are operating as S-Corporations and Partnerships. Once enacted, it will result in economic growth on steroids, massive jobs growth, skyrocketing levels of entrepreneurship, greater freedom, and less dependence on the federal government.

Q&A

[Q] What if the S-Corp never distributes all of its income?

[A] The income will eventually be distributed either in the form of K-1 distributions, salaries and wages to the owner, salaries to new employees; or it will be used to re-invest in new plant and equipment, or to make acquisitions. Any remaining accumulated profits will eventually be taxed upon the sale or disposition of the business. Among the reasons a business retains its income in the first place are to invest in the future, to repay debt, and to guard against future downturns.

[Q] What about the tax on distributions in excess of a shareholders basis?

[A] This problem is simplified by taxing pass-through shareholders on all distributions. There will therefore no longer be a need for tracking the shareholders basis for the purpose of taxing excess distributions. The shareholders basis will instead be tracked for the purpose of determining gain or loss upon the eventual sale, or other disposition of the business.

[Q] Is a business an investment or a person?

[A] Check the corporate resolutions. A business is an investment, which is owned by investors (i.e. shareholders).

[Q] What about the issue of double-taxation on C-Corporations?

[A] I believe it's wrong to subject a C-Corporation to income tax, and then to turn around and tax a recipient of dividends on the same income. This is double taxation. A simple solution is to give C-Corporations a deduction for the amount of dividends paid. It's just that simple.

Friday, November 12, 2010

Obama’s Tax Fallacy III

WH Rubbish

More White House Rubbish

- by: Larry Walker, Jr. -

Does keeping the current tax rates in place constitute a tax cut? No. Only a reduction in current tax rates could be considered a tax cut. Keeping the current tax rates on one group, while raising tax rates on another, constitutes a net tax hike (i.e. 0 + 1 = 1). That’s just common sense. Let’s face the facts; there are really only five logical possibilities:

  1. Lower Tax Rates on Everyone = Tax Cut

  2. Raise Tax Rates on Everyone = Tax Hike

  3. Maintain Current Tax Rates on Some + Raise Tax Rates on Others = Net Tax Hike

  4. Maintain Current Tax Rates on Everyone = No Change

  5. Raise Tax Rates on Some + Cut Tax Rates on Others = It Depends*

Net Tax Hike

Let’s focus on number three, which seems to be Obama’s solution. To raise tax rates on a few is to raise them on everyone. For example, let’s say that we have a two-person society, of limited resources, composed of Joe the employee, and Joe the employer. If tax rates are left alone on Joe the employee and raised on Joe the employer what will happen? Joe the employer will either have to cut back on expenses, one of which is Joe the employee’s wages, or raise prices in order to maintain the status quo. Either reaction will curtail economic growth. This drag on the overall economy will decrease the amount of income earned, and the amount of taxes paid by both Joe’s. Of course there are other possibilities, one of which would be for Joe the employer to fire Joe the employee, and move his operations to another country, one that has lower wage demands, which leaves Joe the ex-employee totally dependent on the State. The point is that the imposition of a net tax hike will have negative consequences.

One Economy

While Obama has neatly dissected the American economy into classes based on annual income, our economy is actually one. There is no lower class, middle class or upper class America; there is just one United States of America. It doesn’t matter whether you are a doctor, lawyer, accountant, CEO, manager, teacher, or wage earner; we are all interconnected. We all rely on the products and services of one another. To increase tax rates on one is to raise them on all, to cut tax rates on one is to lower them on all.

Defining the Problem

Now, since Obama has come up with a solution, the question we need to ask ourselves is, what is the problem? Are we looking for a way to grow the economy and to create jobs? Or, are we looking for a way to reduce the federal budget deficit? If the goal were to grow the economy and create jobs, then the logical solution would be to implement across the board tax cuts. Under number five* (above); a tax cut would imply cutting taxes by more than they are raised; otherwise only number one will suffice.

However, if the objective is to reduce the federal budget deficit, then tax policy alone will not suffice. The reason that tax policy will not solve our budget woes is that our budgetary problem is comprised of two variables: revenues and expenditures. The main reason for the present imbalance is expenditures. In fiscal year 2010, the federal government spent around $1.6 trillion more than its revenues. So can this problem be solved through implementing a $1.6 trillion tax increase? Not hardly. We already know that drastic spending cuts are required.

It has already been proven time and again that the act of lowering tax rates has the effect of broadening the tax base and increasing revenues. It has also been proven repeatedly that increasing tax rates has the opposite effect. A recent example would be the NY cigarette tax. As the NY Post reported, “Sales of taxed cigarettes have plummeted a staggering 27 percent statewide since the highest cigarette tax in the nation took hold in July.” So did over a quarter of NY smokers quit smoking? Not exactly, they simply started buying cigarettes outside of the state. So the plan to increase revenues by raising cigarette taxes actually wound up creating a budget shortfall.

We already know that a tax increase will not spark economic growth or aid in job creation; only a tax cut will suffice. It is also clear that a tax increase won't solve the budget dilemma. So why is Obama stuck on number three? What problem is he trying to solve? There is only one logical possibility: wealth redistribution (i.e. class warfare). Is this really where we should be focused at this moment in time? I say no. To me this is just a bunch of rubbish (i.e. partisan trash talk).

Certainty

Lowering tax rates would begin a new era of growth, like I personally experienced between the years 2003 through 2006, while a tax hike will only cause further cutbacks. Maintaining current tax rates would have one benefit, and one alone: certainty. Small business owners, such as myself, are just not able to function under the present cloud of unusual uncertainty. My experience this year has been that where I should have concrete answers, I have none. Most of my advice, and all of my decisions regarding asset acquisitions are on the shelf. It’s probably too late to change anything for 2010, but there’s always next year. However, there won’t be any definite decisions until there is certainty. And for me, certainty means stability. In other words, a temporary fix or patch won’t cut it. I’m holding out for a clearly defined long-term plan, such as W’s 10-year tax plan.

If I have to endure any more partisan rubbish from the White House, I will explode. I don’t think I can bear listening to another two years of partisan campaign trash. One and done son. One and done. For God’s sake, repeal the AMT, and either cut tax rates now, or extend the current rates, and then work on the out-of-control spending problem next year. These are the only logical options.

Related: Obama's Tax Fallacy II and Obama's Tax Fallacy

Wednesday, November 10, 2010

Fiscal Commission: Tax Reform I

Review of Tax Reform Proposals -

By: Larry Walker, Jr. -

I am in agreement with the Fiscal Commission's goals on tax reform. Although the details are a little vague, it's clear to me that Option 1 is probably out of the question, Option 2 is promising, and Option 3 is pretty much a joke. I think that those who have discounted this initial 'draft' report at face value are doing the commission a disservice. And as far as the Trash Talker In Chief, who has already started spouting off without even reading it, I have nothing but contempt for the comments I heard today out of South Korea.

I personally had a falling out with President Bush, when he put together a special commission on the War, and then proceeded to ignore everything they said. So I hope that someone in Washington takes this commission seriously and implements some of their more excellent ideas (the right ones). If not, there will probably be another major falling out.

Of course, the following tax reform proposals go along with proposed cuts in spending. I am just looking at the tax aspects today, but as long as spending is cut as proposed, there is hope of some kind of compromise on taxes. I think we do need to simplify our tax code and lower tax rates however, our main problem right now is spending. Thus, spending reform should occur prior to any type of tax reform, and of course the repeal of Obamacare is number one on that list. At the top of the tax reform list today is passing another patch for the AMT, and extending the 2010 tax rates for another couple of years. There's no time to waste on partisan trash talk.

My likes and dislikes are below in blue type, and a link to the original report is at the bottom.

Comprehensive Tax Reform

Goals:

  • Lower Rates
  • Simplify the Code
  • Broaden the Base
  • Cut Spending in the Tax Code (Tax Expenditures)
  • Improve Compliance (Tax Gap)
  • Make America the Best Place in the World to Start and Grow a Business
  • Reduce the Deficit

I have no problem at all with the commissions outline of goals for comprehensive tax reform. I think they are in agreement with what every fiscal conservative has been chiming for decades.

Option 1: The Zero Plan

  • Consolidate the tax code into three individual rates and one corporate rate
  • Eliminate the AMT, Pease, and PEP
  • Eliminate all $1.1 trillion of tax expenditures
  • Dedicate a portion of savings to deficit reduction and apply the rest to reduce all marginal tax rates
  • Add back in any desired tax expenditures, and pay for them by increasing one or all of the rates from their zero-expenditure low

Option 1: The Zero Plan

*Note: All options set aside $80 billion for deficit reduction and treat capital gains and dividends as ordinary income. Rates based on very rough static estimates. No behavioral effects are assumed. Magnitude of tax expenditures estimated broadly.

Although I like the idea of lowering the tax brackets and consolidating them down to the three, and having one lower rate for corporations, the elimination of all tax expenditures is problematic. Having survived through a household with four young children, I have empathy for parents of young children. Between day care, food, medical, and the extra running around that parents deal with, it would be right to extend the child tax credit. Although it wasn't there in my day, it would have given us some badly needed relief.

I am however not a fan of the EITC (earned income tax credit). I think the EITC discourages people from being all that they can be, and instead keeps them locked within a certain range of income. So the EITC can be dumped.

I agree with repealing the AMT (alternative minimum tax), in fact, we ought to just go ahead and do that right now. And I agree with repealing the limitations on itemized deductions (Pease), and personal exemptions (PEP).

I disagree with taxing dividends and capital gains at ordinary rates. I think we should encourage investment by extending more favorable tax rates to investment income.

I would like to see the continuation of deductions for mortgage interest, property taxes, state and local income taxes, and charitable contributions.

I am in favor of keeping deductions for retirement contributions such as IRAs and SEPs which are not addressed in this summary.

Thus, Option 1 falls short of the mark because by the time one adds back all the desirable tax expenditures, we're right back where we started. However, Option 2 is more appealing.

Option 2: Wyden-Gregg Style Reform

Individual Tax Reform

  • Repeal AMT, PEP, and Pease
  • Establish 3 rates –15%, 25% and 35%
  • Triple standard deduction to $30,000 ($15,000 for individuals)
  • Repeal state & local tax deduction, cafeteria plans, and miscellaneous itemized deductions
  • Limit mortgage deduction to exclude 2nd residences, home equity loans, and mortgages over $500,000
  • Limit charitable deduction with floor at 2% of AGI
  • Cap income tax exclusion for employer-provided health care at the amount of the actuarial value of FEHBP standard option
  • Modify and repeal several other tax expenditures
  • Dedicate portion of savings to deficit reduction

Again, the repeal of the AMT, PEP, and Pease are most desirable, fundamental to both options and should be done now, today.

I like the idea of having just the three tax brackets.

The tripling of the standard deduction is very appealing. It would take the place of the mortgage interest deduction for many, allow non homeowners a higher deduction, and not impair those with larger mortgages (under $500K). I think limiting the mortgage deduction on 2nd homes and mortgages over $500K is prudent. Why are we subsidizing 2nd homes anyway?

I'm OK with the limitations on charitable contributions, and the employer health care exclusion.

I don't know what is meant by 'repealing several other tax expenditures.' The commission needs to be more specific.

Corporate tax reform

  • Reduce corporate tax rate to 26%
  • Permanently extend the research credit
  • Eliminate and modify several business tax expenditures, including:
    • Domestic production deduction
    • LIFO method of accounting
    • Energy tax preferences for the oil and gas industry
    • Depreciation rules
  • International tax reform including a territorial system

The corporate tax reform ideas seem reasonable, but of course more detail is required.

Option 3: Tax Reform Trigger

  • Call on Finance and Ways & Means Committees and Treasury to develop and enact comprehensive tax reform by end of 2012
  • Put in place across-the-board “haircut” for itemized deductions, employer health exclusion, and general business credits that would take effect in 2013 if reform is not yet enacted
  • Haircut would limit proportion of deductions and exclusions individuals could take to around 85%* in 2015. Similarly, corporations would only take some proportion of their general business credits
  • Set haircut to increase over time until tax reform is enacted

*This is a very rough estimate of the haircut necessary to reduce the deficit by $80 billion in 2015

Option 3 is absolutely out of the question. Throwing tax reform back into the hands of politicians virtually assures that nothing will be accomplished for another 40 years. The use of the word 'trigger' pretty much sums it up. Who's going to pull it?

Source: http://www.fiscalcommission.gov/news/cochairs-proposal

Sunday, November 7, 2010

Obama on 'Getting Stuff Done'

Stuff?

Too Busy Talking Trash to Lead

By: Larry Walker, Jr.

What happens when you spend years trying to persuade people, yet they are not persuaded? What happens when you try to instill confidence, yet only raise doubt? What happens when you try to bring people together, yet they become more divided? What happens when you attempt to set a tone, yet the tone you set is one of deafness? And what happens when you attempt to make an argument that the people can understand, and they understand it, yet they reject it? You get fired.

Barack Obama on 60 Minutes said, "You know, I think that over the course of two years we were so busy and so focused on getting a bunch of stuff done that we stopped paying attention to the fact that leadership isn’t just legislation. That it's a matter of persuading people. And giving them confidence and bringing them together. And setting a tone. And making an argument that people can understand. And I think that we haven’t always been successful at that. And I take personal responsibility for that. And it's something that I've got to examine carefully as I go forward.”

You can bet that voters will be carefully examining Obama’s leadership skills as we go forward. As far as getting a ‘bunch of stuff done’, now the task at hand is figuring out how to undo all of it without further damage to the nation. The major tax is whether Obama will be able to admit his failures, and work with others to correct his misconceptions. And speaking of taxes, how long will it take Obama to make that decision? Has he learned any lessons? We are watching and waiting.

One lesson that Obama has yet to learn is that, whether he is speaking from the Oval Office, in India, or on the campaign trail, he speaks on behalf of all Americans. When Obama trashes ½ of America, he is trashing all Americans. As Obama moves forward with his attempts to divide employee against employer, brother against sister, and child against parent, he risks an even greater backlash: total and complete rejection. Grow up or depart.

Leadership Quotes

“Management is doing things right; leadership is doing the right things.” ~ Peter F. Drucker

“Delegating work works, provided the one delegating works, too.” ~ Robert Half

“The very essence of leadership is that you have to have vision. You can't blow an uncertain trumpet.” ~ Theodore M. Hesburgh

“The best executive is the one who has sense enough to pick good men to do what he wants done, and self-restraint to keep from meddling with them while they do it.” ~ Theodore Roosevelt

“Effective leadership is not about making speeches or being liked; leadership is defined by results not attributes.” ~ Peter Drucker

“You don't lead by hitting people over the head - that's assault, not leadership.” ~ Dwight D. Eisenhower

Definitions

Stuff: ideas of little value: trash

Trash: something worth little or nothing: as
a : junk, rubbish
b : (1) : empty talk : nonsense (2) : inferior or worthless writing or artistic matter (as a television show); especially : such matter intended purely for sensational entertainment (3) : trash talk

Translation

‘I was so busy talking trash that I forgot what I was supposed to be doing.’

Lesson

Leadership isn’t about talking trash.

References: President Obama on 60 Minutes: 'Leadership Isn't Just Legislation'