On Tax Reform

From Leonard's Desk

People frequently observe that the United States tax code is a mess, and they are absolutely right.  The tax system is now the result of decades of parochial interests lobbying for various increases and reductions to benefit themselves.  So-called “tax reform” legislation has, rarely, if ever, constituted actual reform.  More often than not, including most recently at the end of 2017, Congress has simply enacted marginal changes of the same tired tax mechanisms – tax re-jiggering, not reform.

There are now, however, significant and serious proposals from Elizabeth Warren and Bernie Sanders to establish wealth taxes on “ultra-wealthy”, households with in excess, for example, of $50 million in wealth.  Such taxes would be in addition to existing taxes and would ratchet up in rates for yet higher wealth households.

Do wealth tax proposals represent true tax reform?  While wealth taxes assessed on the ultra-wealthy certainly hold the prospect of increasing current government revenues, they do not reform the taxes, tax incentives, and economic costs that most Americans pay.  Here, therefore, is what I believe true federal tax reform would look like:

  1. The individual income tax, which taxes an individual’s earned and unearned income, should be eliminated entirely.  Income is a highly arbitrary measure.  People in different parts of the country earn different incomes despite performing the same jobs.  As we know, women often earn less than men.  Dividend income, which is assessed as an income tax, is the result of capital allocation decisions made by a corporate board of directors and can be avoided using share buybacks.  Income is earned by younger working people but is often significantly reduced for older people, regardless of their stations in life.

  2. The corporate income tax, which taxes a portion of a company’s income, should be eliminated entirely.  Corporations are “pass-through” entities: their shares are all owned, ultimately, by individuals, and any activity related to those shares can and should be taxed at the individual shareholder level (as they are already in the case of S corporations).  Direct taxation of C corporations should be eliminated in favor of unified pass-through taxation.

  3. The capital gains tax, which taxes appreciation on investment gains, should be eliminated entirely. As a wealth advisor, I believe this tax causes enormous economic frictions in our society because it causes people to hold assets that they might otherwise prefer to sell in order to avoid taxes.  As a result, economic inefficiencies are caused by people (and companies) holding sub-optimal portfolios, and by causing skewed asset prices.  By eliminating the capital gains tax, assets will settle in the right hands at the right prices.

  4. The estate tax, which taxes the value of an estate over an established threshold, should be eliminated entirely.  The estate tax, currently, applies to a relatively small number of extremely wealthy households.  Many of those households evade much of the estate tax through the creation of trusts and the use of asset transfers.

With the elimination of such a broad array of taxes, how, then, will the federal government replace and raise lost revenues?  Answer: yes, wealth taxes.

Warren and Sanders are on the right track, but their version of wealth taxes is only as a supplemental tax on the ultra-wealthy, rather than the primary, even sole, vehicle for reform of the US tax code.  Wealth taxes were debated early in the country’s history, and through the Civil War years, but were ultimately not implemented in favor of income, capital gains, and estate taxes during the Progressive era.  Wealth, however, is the fairest basis for national taxation.  There are many valid objections and concerns about wealth taxes, including and especially capital flight and asset valuation impediments.  I’ll address these and other details in future pieces about wealth taxes.

The US tax system is ripe not for additional forms of wealth taxation on the wealthy, but a wholesale renovation of the entire tax system based on wealth taxes.

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