|
Commentaries
Tax Reform
Savings,
Retirement and Social Security Reform
Contributing
Members Commentaries
|
Key To Reforming The Tax Code: Properly Defining
Capital, Income
Investor's Business Daily
June 21, 2005
By Ernest S. Christian
Congress has before it the opportunity to take
a major step toward tax reform, while also achieving several
of its most pressing real-time legislative priorities in the
tax area.
It can repeal the pernicious alternative minimum tax (AMT)
that is devastating the middle class. Instead of scrambling
to keep the temporary 15% tax rates on dividends and capital
gains from going back up to their previous high levels in
the near future, it can permanently reduce the rate to zero
for most financial assets. It can provide permanent first-year
expensing for capital equipment.
And it can enact a Universal Savings and Investment Account
(USIA) that will allow all Americans the freedom to save in
a way that dovetails with the idea of allowing private accounts
to supplement Social Security.
Moreover, it can do all of this without raising taxes or increasing
the deficit.
The key to accomplishing these results is found in the basic
tenet of tax reform - which is to define income correctly.
The present definition is overly broad. It taxes both the
income used to purchase a share of stock and the dividends
received.
But, in real terms, the purchase price of the stock today
and the amount of dividends received in the future are the
same thing.
When we buy a share of stock, what we are really purchasing
and paying for in advance is the stream of dividends the market
predicts the stock will produce. The price of the stock is
the discounted present value of the dividends.
Since we paid for the dividends with after-tax income (i.e.,
capital) when we bought the stock, the dividends should not
again be taxed when actually received in the future. Nor should
there be any tax if the stock is sold in the meantime at a
gain in anticipation of the dividends.
The Supreme Court and others have sought to illustrate the
distinction between taxing income and capital by analogy to
a tree (stock) and the fruit (dividends) it will produce.
Taxing the fruit is the same as taxing the tree - and if the
tree has already been taxed once, based on the value of the
fruit the market anticipates it will produce next season,
the fruit should not again be taxed when it arrives in the
spring.
A practical way of distinguishing between capital and income
- and avoiding double taxation - is exemplified by the Universal
Savings and Investment Account that was recently put before
the Tax Reform Advisory Panel for consideration.
Taxpayers who desire to save a portion of current-year income
would first pay tax on that income, thereby converting it
to "capital." They would then put the after-tax
capital in a USIA, which would function like a brokerage account.
When they use this capital to purchase a stock, the dividends
and gains received in the future would be correctly identified
as returns of capital and would not be taxed again as additional
income.
Similarly, the interest received on bonds purchased in a USIA
account with after-tax income would be excluded from additional
tax.
This same simple USIA device can also be used to remove the
double tax on $22 trillion of existing investments in market-traded
stocks, securities and other cash equivalents - and also to
generate revenues sufficient to pay for the rest of tax reform.
The owners of existing investment portfolios would be allowed
to pay a voluntary toll charge for putting stock and securities
in a USIA - as if they had sold them, paid the tax on the
sale, put the after-tax cash in a USIA, and purchased financial
assets inside that exempt account.
A reasonable toll charge would be 10% of the current market-value
of the stock and securities (i.e., 10% of the present value
of the future stream of dividends, gains and interest). The
tax having been prepaid, all future dividends, gains and interest
received in the account would be returns of capital taxed
at a zero rate.
If investors act rationally, as they are notorious for doing,
nearly all of them would see the wisdom of paying the toll
charge. Because of the current 15% tax rate on dividends,
a stock that is expected to produce a future stream of pretax
dividends worth $117 is actually worth only $100 after tax.
Cash Flow
But if the owner were to pay a $10 toll charge, bringing
the cost of the stock up to $110 - and then put the stock
in a USIA, which exempts all future dividends from tax - the
present value of that future stream of dividends (and the
stock) would go up to the pretax level of $117. In effect,
the owner would have paid $10 in order to get $17.
Given that advantage - and the prospect that the present 15%
maximum tax rate on dividends and stock gains outside USIAs
will soon increase - the transfer of eligible financial assets
into USIAs could be close to 100%.
But even if only 75% were immediately moved into these accounts,
the 10% toll charge would produce a one-time revenue pickup
of $1.6 trillion.
That cash infusion into the Treasury's coffers is sufficient,
on a present value basis, to pay for the projected future-year
revenue cost of many important reforms - including the USIAs
themselves, first-year expensing, repeal of the AMT and effectively
reducing to zero the tax rate on nearly all dividends, capital
gains and interest.
There is no mystery about the likely consequences of enacting
these changes in the tax code. Common sense as well as econometric
models say that productivity and GDP growth rates would accelerate.
If The Price Is Right
What is new to some people (but not necessarily to the Tax
Reform Advisory Panel or to the most knowledgeable members
of Congress) is the ability to make these salutary changes
in a self-financing way that provides sufficient offsetting
revenues to eliminate the need for an actual tax increase.
Before Congress can take advantage of this opportunity, the
amount of revenue gain from the toll charge must pass muster
with the staff experts who "estimate" the revenues
for the Treasury and the Congress - often 10 years out.
These technicians function in an area of inherent uncertainty
by relying on common sense and reasonable probabilities. Despite
its "voluntary" nature, the revenue gain from the
one-time toll charge can be estimated using the same assumptions
these experts are accustomed to working with in projecting
the revenue effects of other changes in the current tax code.
For example, in estimating the revenue effect of tax-reducing
credits or deductions, these experts assume that taxpayers
will act rationally and take advantage of the opportunity
offered to them to pay less tax.
Even when the option is to pay more tax - as in the case of
the ubiquitous "user fees" that were so famous a
few years ago - the experts assume people will pay more money
to the government to get what they want in exchange, provided
that the price is right.
From the perspective of those standard assumptions, the logic
behind a large and realistic revenue pickup from the toll
charge is compelling. If savers and investors are informed
about the opportunity and if too many bureaucratic obstacles
are not put in their way, nearly every one of them will pay
the toll charge just as surely as anyone would choose to pay
$10 to get $17.
In short, the need for a reliable revenue estimate should
not be a barrier to paying for real-world tax reform with
a voluntary onetime toll charge.
Christian is a former Treasury tax official who is now
director of the Center For Strategic Tax Reform in Washington,
D.C.
|
