The Problem with Income Tax, and a Solution for Prosperity

Do you ever wonder why it is that the wealthiest people behind the biggest new businesses always seem to favor more progressive political views, such as increased social program spending and higher income taxes? Aren’t those taxes bad for them and their business? Pro-tax is anti-business, right? Surely they must be selflessly sacrificing their tax dollars for the betterment of society because they all truly care about us.

Well, not exactly.

I’ve really tried to stay away from politics, and I don’t actually consider this piece political. In fact, my only intent here is to convince you of one thing: it’s complicated! Way more than I can do justice to, unfortunately, but I’ll try here to at least suggest that a more informed debate is in order. Why? Because I’m frankly appalled by the way that the political media infantilizes American voters by focusing on touchpoint emotional issues rather than the considerable economic forces that we’re up against. For the record, I wrote this about 6 months ago, and this emotional pandering and avoidance of real issues has only gotten worse.

Wealth and Income
First, let me introduce you to America. We have roughly 320 million people in 120 million households with a total income of about $15 Trillion yearly, and about 20% going to the top 1%[1]. This much is fairly well-known. Much less is known about wealth. The best publicly-available information tells us that there is roughly $100 Trillion in wealth divided roughly equally among stocks[2], bonds[3], and real estate[4]. Private and OTC markets are another matter entirely, and I don’t have a very good guess, but I’d give it at least at another $50 Trillion. Of that wealth, the same 20% goes to only 0.1%, now holding more than the bottom 90% [5]. And that’s just what we know based on what they are forced to disclose.

That’s an unfathomable amount of wealth, even to those that hold it. In that 0.1%, the average wealth is about $250–300 Million. Compare that to an income of $1.6 Million that will put you in that category, and you’ll start to see what I’m getting at. Let me make it clear: these people DO NOT care about TAXES!

There is actually a lot more to just how much they don’t care about tax rates. Firstly, no matter what your desire for cash, if you have a growth asset like a business or real estate, you take loans rather than realize income, as Mark Zuckerberg famously got a nearly-free mortgage when buying a house[6]. Secondly, there are plenty of ways around paying taxes anyway. Tax rates may be irrelevant, but tax law is crucial. Google, Amazon, Apple, Facebook [7,8], and basically every big company with a founder that cheers on progressive policy at the expense of higher taxation, actually pays pretty much zero tax on their income by use of offshore tax havens. Want to change that? Watch out; international taxes are massively complex, there is huge competition for tax avoiders, and ultimately they can move.

So what do they care about?
In a word: Growth. Firstly, it’s obvious that a 1% increase in the value of their wealth is much more important to them than any marginal reduction in income from taxes. But once again, the real numbers massively overshadow the obvious. The total value of the derivatives market is somewhere near $1 Quadrillion, which could basically wipe them out if something goes wrong (again). So not only are they hoping for growth, the super-wealthy DEPEND on it.

So follow me for a second, and it will all make sense. The super wealthy have an insane amount of wealth, but it’s all being risked on economic growth. Growth depends upon social stability, and an expanding consumer base. Social program spending is designed to create stability and increase the consumer base. In real terms, government spending on transfer payments like social security, pension guaranty, and income assistance to lower income households, is all but certain to be spent right away. In more conceptual scenarios, we already have experienced many episodes of civil unrest to suggest that we’re a powderkeg for a larger event that would be a significant economic disruption. Frankly, the ultra-rich are scared [9] for all their billions that society will collapse and the economy will tank unless we can keep poor people happy and spending. That’s the kind of fear that turns a Scrooge into a very kindly progressive.

So the truth is that they really do care about you, Mr and Mrs Consumer. It may not be for the reasons you’d like to believe, but it’s really just as well. They want you to be taken care of with free healthcare, free education, housing, food, “safe spaces”, whatever you need to be happy and spending instead of rioting.

But… who is going to pay for it? 
Currently, when the government pays for it, it is income-earners, and therefore mostly middle-class working people that foot the bill for economic growth that primarily benefits the top 1% of wealth-owners[10]. I keep hearing suggestions of increasing tax on the wealthy, but this is foolish in our current system: these people do not and will never pay income tax.

If the government does not pay for these social structures, it will probably be well worth their while to massively step up philanthropy. There is a clear historical precedent of this happening in the wake of the last great economic boom, which was the postwar industrialization of America. By contrast, the European model of progressive government spending after their industrialization didn’t work out so well for them (you know, world wars and stuff…). Maybe I’m taking this too far, but I really would have a lot more hope for big problems like education, healthcare, drugs, social stability, police accountability, and the like if they were in the hands of Sergey and Elon rather than the political class. I’m also crazy enough to believe that the tech elite could find solutions that would actually be better for them too, without needing the powers of government.

But ultimately they still don’t want to pay for it, and this is why they get involved in government, mostly by political campaign donations. Frankly, their money dwarfs any grassroots fundraising capability, and we are going to have to accept that no politician stands a chance without being in the pocket of ultra-wealthy donors. So you have a situation where the ultra-wealthy donors control the politicians, who legislate by forcing the middle class income earners to pay for their ideas. Does this sound good to you?

And if you still think the government is the way to go, I suppose there is the possibility of a wealth tax. It’s been done elsewhere, and I’m not the expert, but it’s definitely complicated, and the lack of it is frankly why a lot of very wealthy people come here.

Another idea
Yet another possibility exists: taxing incomes based on paper gains. What this means is that you would pay for the appreciating value of assets before realizing cash income. In theory, this is really no different than the current system because, as the theory goes, all gains are eventually realized as income. In practice, however, due to the many labyrinthine tax laws, it’s a lot different.

For one thing, it would basically end most of the corporate tax haven tricks. The shell game works by having a domestic entity own an offshore entity that takes all the profit out of every sale. The value of the equity in that entity increases their assets, but they never take cash flows as US income. If the gain in equity by GAAP is taxed instead of the realized income, the loophole is closed.

Of course there is a problem with volatility. If I gain huge one year and lose huge another, I could end up paying a lot more than I would otherwise. This is easily fixable if the IRS would apply not a yearly, but a lifetime tax policy for both corporate and personal entities. What that means is that they always correct your taxes to reflect the rate on average lifetime earnings. So if you already paid on gains, they pay you back on losses.

The system could be remarkably simple. Just report what you have, which you already have to do, and they will take care of computation. Itemizing deductions and losses is not really necessary because the only thing that matters is the number at the end. Purchases are taxed separately through sales tax, so they would reduce the bottom line.

The only place it gets complicated is foreign transfers and purchases, as you could just transfer money out and claim it as a loss, or as in the current situation, be prevented from transferring capital in. The easy solution is simply to exclude all foreign transfers from the gain/loss calculation, including foreign purchases and sales. This would have the obvious appearance of an import tariff and export subsidy, but it’s actually not so; it’s just a correction to put trade on equal footing in terms of tax policy, whereas currently domestic industry is massively disadvantaged in trade.

Let’s look at the numbers to see what this would mean. Equity wealth growth is roughly 7–11%[11] long-term, which means that we can expect about $10 Trillion in valuation gains, 95% of which goes to 1% of the population[12]. So the mean gain in this category is somewhere around $10 Million dollars per household, which includes a lot of personal net losses, so the real top 1% gain is much larger considering the large variance. Regardless, this absolutely dwarfs the $700k [12] for the top 1% in income, which already pays about half of all taxes [13], so the rates would be a lot lower, getting us closer to competitive with the Asian Tigers.

Misguided rage
So back to the point… There are a lot of very intelligent people that I otherwise greatly respect who staunchly espouse that “we must” have government pay for this and that, all in the name of social justice. Their antipathy may be misguided. This could not be sweeter to the ears of the top 0.1%, because the money is going into their pocket, and the debt falls back on us. There is, of course, another long-term effect of hollowing out the middle class, which gives them more stability in their perch. That’s just a bonus.

Note that I don’t have anything against the rich. In fact, my first point here is that even massive income inequality can be a catalysts of social progress that is good for everybody, simply because they are so invested in the economy that it is in their best interest to take care of it. This is pro-economic-mobility. On the other hand, I think I’ve made my point that income taxation to achieve the same through government programs has the opposite effect. It’s also entirely possible that this is just the price we have to pay to keep America competitive for their companies and dollars.

It’s complicated. Regardless, it’s our responsibility to this republic to understand policy well enough to seek informed rational debate about facts and reject coverage designed to polarize with emotions.

Sources
[1]https://en.wikipedia.org/wiki/Household_income_in_the_United_States
[2]http://data.worldbank.org/indicator/CM.MKT.LCAP.CD 
[3]https://en.wikipedia.org/wiki/Bond_market#U.S._bond_market_size 
[4]http://metrocosm.com/new-york-city-property-values-in-perspective/
[5]http://www.slate.com/blogs/moneybox/2014/12/31/best_graph_of_2014_the_rise_and_rise_of_top_0_1.html
[6]http://www.sfgate.com/technology/businessinsider/article/Mark-Zuckerberg-Is-So-Rich-His-6-Million-Home-3710185.php
[7]http://www.theguardian.com/business/2015/jun/19/tax-havens-money-cayman-islands-jersey-offshore-accounts
[8]http://www.forbes.com/sites/timworstall/2013/10/09/facebook-is-not-avoiding-tax-no-really-it-isnt/#55aaf02b32a1 
[9]http://www.amazon.com/Emergency-This-Book-Will-Save/dp/0060898771
[10]http://blogs.wsj.com/economics/2013/09/10/some-95-of-2009-2012-income-gains-went-to-wealthiest-1/
[11]http://www.simplestockinvesting.com/SP500-historical-real-total-returns.htm
[12]http://www.denverpost.com/business/ci_24889586/robert-reich-income-inequality-defining-issue-u-s#ixzz2rcLtMrAF
[13]http://www.cnbc.com/2015/04/13/top-1-pay-nearly-half-of-federal-income-taxes.html