Pundits in Washington from time to time like to debate how to make the tax system more “fair.” At one level, this is comical. Asking the tax system to be more fair is like asking Barack Obama not to use a teleprompter: theoretically possible, but not going to happen in the real world.
There is simply no “fair” way to steal one-third of the nation’s output and give it to people who never earned it. It’s theft at the barrel of a gun, just an Army-issue one.
On the other hand, there are ways to make the tax system less unfair. Our tax system punishes the very activities we most want to encourage. It’s a good use of time to examine how our tax system is the most unfair, and think of free-market solutions to do something about it.
Let’s start with small businesses. If an entrepreneur decides to start up a firm, he’ll have to pay profit taxes at his top marginal tax rate. This seems fair enough, unless the small business owner is (say) a wife starting a side venture. If her husband’s income puts them in the 25 percent bracket, that’s the income-tax rate of dollar one of her profits. She doesn’t get to benefit at all from a graduated-rate structure, and a firm with very low profits may find itself with very high start-up tax rates.
Even worse, she will have to pay the 15.3 percent self-employment tax on the first $105,000 or so of profits (2.9 percent after that). Add in state income taxes, and our budding entrepreneur faces a profit tax approaching 50 percent — and all this from a middle-class family. In the more high-earning households that reside in high-tax states, the initial profit tax can easily hit 60 percent, which would make even the French and German tax collectors blush.
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Small business start-ups face some of the highest marginal tax rates of any taxpayer. Considering small businesses create somewhere between one-third and one-half of the jobs in America, this is crazy. The simplest way to correct this inequity is to simply repeal the self-employment tax, or at least the biggest part for Social Security (12.4 percent).
What about investing? Surely savings and deferring consumption is something we want to encourage. With the imminent implosion of Social Security and Medicare, one would think our government would be doing everything possible to encourage savings. This is to say nothing of the oft-repeated analysis that America needs to become a nation of savers again if we are to avoid any further credit crises.
Given this, it might surprise people to learn that the tax rate on capital gains and dividends (the equity return to capital) is higher than that of Patriots’ quarterback Tom Brady’s weekly game check.
Anyone receiving a capital gain (retained corporate earnings) or dividend (distributed corporate earnings) should know this first comes from after-tax corporate profits. Thus, the 35 percent corporate-tax rate is the embedded first layer of savings tax.
The 15 percent capital-gains and dividends rate is cascaded onto this. The result is an “all-in” rate of nearly 45 percent. If the Obama budget becomes law, the capital-gains and dividends rate rises to 20 percent, and the all-in rate goes to 48 percent.
Tom Brady’s federal wage rate today is 37.9 percent. Under the Obama budget, it would 42.5 percent.
The capital-gains and dividends rate should be zero — not because savers need a tax cut, but because they are paying a cascaded double tax today. The only savers not facing double taxation are those who put deposits in savings accounts. Those that finance the capital needed to grow businesses on the equity side face a crippling disadvantage. This is how the tax code biases in favor of corporate debt financing, and against corporate equity financing.
The third-best way to make the tax code less unfair is to give America’s big employers a chance to compete in the global economy. When Washington isn’t trying to monkey with executive compensation or regulate whole industries out of existence, it’s slapping onto large employers the highest corporate income-tax rate in the developed world (tied for first, actually, with Japan).
Besides making American companies and their 35 percent corporate rate compete with the Irelands (12.5 percent) of the world, Washington also imposes a “worldwide tax system” that exposes much international profit of U.S. firms to double taxation.
The result is a toxic brew of tax incentives for companies to relocate overseas and take American jobs with them. As late as the 1980s, it really didn’t matter how America treated its biggest businesses — they were stuck here (large capital investments, work force deemed to be irreplaceable and few greener pastures elsewhere, to name a few reasons). Now, though, companies are mobile and can locate anywhere. Work forces are global. Countries must compete for employers, and the U.S. is not playing to win.
As a down payment on a more globally competitive tax system, the corporate rate should be immediately cut from 35 percent to 25 percent (the average rate of our European competitors). Additionally, we should learn the lesson virtually every other nation has and seek to tax on a territorial basis.
If these tax improvements were made, the tax code would still be manifestly unfair. But the sting of a thorned whip might be improved to a mere flog.
• Ryan Ellis is the tax policy director at Americans for Tax Reform.
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