In his State of the Union message for 2015, President Obama is proposing changes in taxes. The president seeks to increase the top tax rates on dividends and capital gains to 28 percent, after having previously increased it from 15 to 23.8 percent. This increase will not just tax the rich more, but will damage the economy.

There is a reason why the tax rate on dividend income is lower than that on other income. The US imposes a double taxation on corporate profit. A corporation pays an income tax as a legal entity, and then when some of the remaining profit is paid to the shareholders, it gets taxed again as personal income. If a corporation pays the top tax rate of 35 percent, and then the shareholder pays 28 percent, the combined tax rate is more than half the profit. Some corporations have credits and deductions that reduce their tax payments, but for those firms that pay the full amount, the 28 percent tax rate is misleading, because the shareholder owns his portion of the full corporate profit.

The problem with a high effective tax rate on dividends is that this shifts corporate finance in a bad way. A company that seeks more funds has a choice of borrowing with bonds, or issuing more stock. Interest on bonds is tax deductible, while paying dividends is not deductible. So the tax induces excessive borrowing, making the firm vulnerable to bankruptcy if business declines.

The problem with a high effective tax rate on dividends is that this shifts corporate finance in a bad way. A company that seeks more funds has a choice of borrowing with bonds, or issuing more stock. Interest on bonds is tax deductible, while paying dividends is not deductible. So the tax induces excessive borrowing, making the firm vulnerable to bankruptcy if business declines.

Secondly, a high tax on dividends induces firms to have more retained earnings. Some companies hold billions of dollars in savings. Sometimes they buy back their shares rather than pay taxable dividends. The problem is that dividends should be the main reason to own shares of stock. Reliable dividends makes a financial investment in stocks more secure, because the price of a share will not drop much so long as the dividend return is good. Destroy dividends, and the stock becomes more speculative and volatile.

The best reform, given income taxation, is to eliminate the double taxation by making the whole corporate profit taxable in the personal income tax. Then the tax rate on dividends can be the same as in other income. But the abolition of the corporate income tax would appear to favor corporations versus individuals, even though in reality, this would even the tax field.

As to capital gains, the lower rate is justified from inflation. Suppose you buy a stock for $100, and sell it ten years later for $200. Suppose also that prices generally doubled during those years. Then the nominal gain comes from the price inflation; the real gain is zero. But the government taxes the nominal, not the real gain. To offset this inflation effect, the tax rate is lower. But the lower tax rate kicks in after only one year, when the inflation problem is small. The best reform is to index all capital gains to inflation. Then the tax in this example would be zero.

The president seeks to offset these tax increases with tax credits. The tax credit for children would be increased to from $1000 to $3000 per child up to the age of five. There would also be a credit of $500 when both spouses work. The President is also proposing other changes that would further complicate the tax code.

A tax credit for young children makes some sense, since the burden of income taxation is greater on families with the expense of children. On the other hand, government should ideally be neutral regarding the choices of individuals, whether to work or not, or whether to have more children. Government should neither promote nor retard population growth.

The basic problem here is income taxation itself. There is no way to tax earned income equitably.
Image Credit: Ken Teegardin: http://www.seniorliving.org/

The basic problem here is income taxation itself. There is no way to tax earned income equitably. A flat rate tax is simpler, but a graduated tax like the current system takes more from those who can better afford to pay more. On the other hand, a high tax rate on wages or investment income stifles work effort, entrepreneurship, and investment. The best tax rate is zero for earned income.

If the President and Congress seek more productivity and more economic justice, they should remove all taxes on earned income and shift all taxation to income that is completely unearned, including income that comes from subsidies. Production that pollutes is subsidized when the price of the goods do not include compensation for the damage. Therefore a pollution tax would both benefit the environment and make production more efficient by removing the implicit subsidy. Yet the president, supposedly an environmentalist, is not proposing pollution charges.

The money one pays for land is a subsidy to previous owners, and the rent one receives now, either explicitly in rental money, or implicitly in the rental value, is a subsidy from the rent generated by the community and its public goods.

Land rent is unearned income, because the landowner did not produce the land. The money one pays for land is a subsidy to previous owners, and the rent one receives now, either explicitly in rental money, or implicitly in the rental value, is a subsidy from the rent generated by the community and its public goods. An overall reduction in taxes on wages, offset by higher taxes on land rent, adjusted so that no landowner has a net loss, would raise wages and increase employment. But the President is not proposing such a prosperity tax shift.

Tax credits sound good, but all the credits, deductions, exemptions, and special cases make the tax code complicated and end up enriching tax preparers, lawyers, accountants, and the producers of tax software. The President's tax proposals demonstrate the use of the income tax by politicians to promote some activities and penalize others. Any tax on earned income harms the economy and violates one's right to own one's labor. Taxes on wages also violate the 9th Amendment, properly understood to recognize natural rights. Therefore fiddling with tax rates and credits ultimately is an exercise in combinatorics that ignores the greater issue of basic social justice.

© Text Copyright Fred Foldvary, Ph.D. rights reserved.
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