California Governor Jerry Brown is dealing with a "taxing" headache these days. Within the last week, Brown has taken a jarring one-two punch.
[1] The state is projected to run budget deficits for years to come. Despite rosy economic assumptions, Brown's 2012-13 budget was expected to result in a $9.2 billion deficit. A report issued today by the nonpartisan Legislative Analyst's Office concludes that Brown's forecast is overstated by approximately $6.5 billion.
Brown was looking at roughly a $9 billion budget gap. Now he's looking at $15 billion. To quote another governor wunderkind: "Oops"!
Silicon Valley is experiencing a "mini-bubble," and Facebook's pending IPO is expected to create hundreds of new millionaires. Brown's revenue estimate assumes that "social networking" entrepreneurs and investors will pay billions in state taxes on capital gain income. The LAO report emphasizes that capital gain income is highly variable and notoriously difficult to project. California has been down this road before. Those who cannot remember the past are doomed to repeat it.
California is lurching down a path towards Greek-style insolvency. Here's the basic formula. Politicians create an expansive state bureaucracy. The state employees organize into dues-paying members of public employee unions. The unions funnel dues into political elections to support candidates who promise to keep the gravy train running. The politicians become pawns of union bosses. They borrow money to cover budget deficits as state employees become increasingly detached from the public sector.
In the long run, the cycle is unsustainable and doomed to implode. California cannot afford to pay its recurring bills and satisfy its health and pension commitments to retired state employees. However, that's a problem for the next generation. Brown is a political careerist, and he has no interest in disrupting the cozy relationship between Democratic politicians and public employee unions in California.
[2] Brown wants to solve the $9.2 billion budget gap with a two-pronged tax increase. He wants state voters to approve an initiative to raise tax revenue. The "Brown Tax Initiative" would raise the sales tax by half a cent and raise tax rates on families who earn more than $250,000. In a savvy -- but disgusting -- political move, Brown would link a failure of his initiative to automatic cuts in the K-12 education budget.
Does the income threshold sound familiar? Yes, another Democratic politician defines a working family with $250,000 in income as nouveau riche. To give Brown some credit, his initiative would at least "spread the pain around." Everybody pays sales taxes; a vote to increase the sales tax is a vote to tax me and the "man behind the tree." I'm more disgusted by Brown's decision to hold K-12 teachers and students ransom for his tax increase proposal. (Full disclosure: my wife is an elementary-school teacher.)
The LAO report complicates Brown's overall strategy. The Brown Tax Initiative will not cover the LAO's projected revenue shortfall. Brown will have to go back to the drawing board. Or play games with the numbers, which is usually the "solution" to problems in Sacramento.
[3] Meanwhile, recent poll data suggests that the Brown Tax Initiative may be caught in the crossfire among competing initiatives. Someone pass the Tylenol!
Brown is not the only advocate for higher taxes on the "wealthy." Public employee unions are pushing a "Millionaire Tax Initiative." They want to increase tax rates by 3% for incomes over $1 million, and by 5% for incomes over $2 million.
A wealthy lawyer (Molly Munger) and the state PTA is pushing the "Munger Tax Initiative." The Munger Tax Initiative would progressively raise taxes on all taxpayers, and would funnel the revenue into education.
According to the recent poll, likely voters express support for the Millionaire Tax Initiative (63%) and the Brown Tax Initiative (58%). More likely voters oppose (48%) than support (45%) the Munger Tax Initiative. No big surprise. The first initiative provides a "free lunch" courtesy of the highest-income taxpayers. The second initiative echoes Team Obama's drumbeat to raise taxes on the top 3%. The third initiative would require increased taxes for everybody, which triggers some soul-searching among voters.
If you need to guard the entrance to Hades, I'd recommend a three-headed monster named Cerberus. However, a three-headed tax initiative may confuse and fatigue California voters. Team Brown conducted an unofficial poll suggesting that voters will play "knock out" and select one plan while rejecting the others. If so, voters may fragment their support for the initiatives and tank the entire process. (Team Munger disputes Brown's logic.)
A final remark on the California initiative process. Why exactly do we elect state politicians, when they put any tough decision on the ballot?
Showing posts with label capital gains. Show all posts
Showing posts with label capital gains. Show all posts
Monday, February 27, 2012
Wednesday, September 28, 2011
Prioritize and Compromise
On Monday, Michael Durst elaborated on a previous tax reform proposal (see Durst, "An Employment, Equity, and Competitiveness Tax Act," Tax Notes, Sept. 26, 2011; discussing Durst, "Radical Centrism and the Corporate Income Tax," Tax Notes, Sept. 5, 2011).
Durst describes his proposal as "a two-pronged, radically centrist tax package" with two key elements:
Our corporate tax rate is uncompetitive by international standards. Capital is mobile and ruthlessly unpatriotic. As such, it migrates to the highest after-tax return opportunities. The uncompetitive U.S. tax rate discourages capital allocation to U.S. businesses by decreasing after-tax returns to investors. This has a pernicious ripple effect that hits the capital-intensive manufacturing industry particularly hard. Less capital means a higher cost of capital. A higher cost of capital means higher input costs. Higher input costs mean higher-cost products and services. Higher-cost products and services are less competitive in domestic and international markets (and more expensive for domestic consumers).
Compounding matters, the U.S. transfer pricing regime is porous, favoring multinational enterprises that can migrate intangibles offshore over U.S. businesses with tangible assets, operations and employees in the United States. The deck is effectively stacked against U.S. businesses relative to their multinational and international competitors.
A growing consensus of tax professionals, academics and economists has acknowledged the need to reform the corporate tax system by lowering rates. Hopefully, that message will begin to resonate with legislators, who are struggling to cope with our lapsed economic hegemony. Although I don't expect a "grass roots" movement for corporate tax reform, I hope that the most zealous advocates of high corporate tax rates achieve irrelevance.
Meanwhile, there is no free lunch. Although corporate tax reform is a priority, we can't escape the fact that government obligations will continue to swell as the Baby Boom generation enters retirement. Realistically, we'll need to offset a decrease in corporate tax revenues with another source of revenues. Legislators should consider a VAT, and they should consider progressive increases in average tax rates as a trade-off for corporate income tax reform.
In particular, a reduction in the corporate tax rate could be partially offset by eliminating the tax preference for certain investment income. Corporate earnings are taxed at a 35% top marginal rate, and the 15% rate applicable to qualified dividends and long-term capital gains reduces the overall tax burden on the underlying business income. By lowering the corporate tax rate, legislators would undermine the conceptual justification for the 15% rate.
The existing political climate is depressing to those of us who don't extract power or lobbying money from gridlock. Tax reform seems virtually impossible before 2012. However, we don't need a "Buffett Rule" to jump start the process. Corporate tax reform is possible if legislators would simply prioritize and compromise. A reduction in corporate tax rates, offset by taxing investment income at the same rates as ordinary income, could be an important step towards fundamental tax reform.
Stay tuned for more details on my own corporate tax reform proposal.
Durst describes his proposal as "a two-pronged, radically centrist tax package" with two key elements:
1. A reduction in the corporate tax rate to 15 percent, along with elimination of opportunities to shift income to tax havens and other significant corporate base broadeners. The goal would be to increase U.S. job creation, both through the effects of the lower rate and by eliminating current tax haven techniques that encourage job creation outside instead of within the United States.I don't agree with Durst's entire reform proposal, but I agree with Durst that legislators need to prioritize and compromise. Our tax system is a ramshackle structure decomposing from within, and I'd love to strip it down to the studs and begin renovation. However, if we have to renovate incrementally, I'd start with corporate tax reform.
2. A reform of the individual income tax that would make the tax more progressive, primarily by increases in rates applying to the highest-income taxpayers. Maximum rates nevertheless would remain low by historical standards....
Our corporate tax rate is uncompetitive by international standards. Capital is mobile and ruthlessly unpatriotic. As such, it migrates to the highest after-tax return opportunities. The uncompetitive U.S. tax rate discourages capital allocation to U.S. businesses by decreasing after-tax returns to investors. This has a pernicious ripple effect that hits the capital-intensive manufacturing industry particularly hard. Less capital means a higher cost of capital. A higher cost of capital means higher input costs. Higher input costs mean higher-cost products and services. Higher-cost products and services are less competitive in domestic and international markets (and more expensive for domestic consumers).
Compounding matters, the U.S. transfer pricing regime is porous, favoring multinational enterprises that can migrate intangibles offshore over U.S. businesses with tangible assets, operations and employees in the United States. The deck is effectively stacked against U.S. businesses relative to their multinational and international competitors.
A growing consensus of tax professionals, academics and economists has acknowledged the need to reform the corporate tax system by lowering rates. Hopefully, that message will begin to resonate with legislators, who are struggling to cope with our lapsed economic hegemony. Although I don't expect a "grass roots" movement for corporate tax reform, I hope that the most zealous advocates of high corporate tax rates achieve irrelevance.
Meanwhile, there is no free lunch. Although corporate tax reform is a priority, we can't escape the fact that government obligations will continue to swell as the Baby Boom generation enters retirement. Realistically, we'll need to offset a decrease in corporate tax revenues with another source of revenues. Legislators should consider a VAT, and they should consider progressive increases in average tax rates as a trade-off for corporate income tax reform.
In particular, a reduction in the corporate tax rate could be partially offset by eliminating the tax preference for certain investment income. Corporate earnings are taxed at a 35% top marginal rate, and the 15% rate applicable to qualified dividends and long-term capital gains reduces the overall tax burden on the underlying business income. By lowering the corporate tax rate, legislators would undermine the conceptual justification for the 15% rate.
The existing political climate is depressing to those of us who don't extract power or lobbying money from gridlock. Tax reform seems virtually impossible before 2012. However, we don't need a "Buffett Rule" to jump start the process. Corporate tax reform is possible if legislators would simply prioritize and compromise. A reduction in corporate tax rates, offset by taxing investment income at the same rates as ordinary income, could be an important step towards fundamental tax reform.
Stay tuned for more details on my own corporate tax reform proposal.
Thursday, August 18, 2011
The Buffett Bandwagon (Part Two)
Warren Buffett recently published a lecture on tax policy in the New York Times. I discussed Buffett's article here, and a response from the Wall Street Journal here. Today is my last day beating this dead horse.
The Double Taxation Dilemma
In sum, Buffett's main concern is the preferential tax treatment of capital gains for "millionaires and billionaires." Unlike the WSJ, I agree that we should tax capital gains at the same rates as ordinary income. That remains a topic for another day. For now, a relatively quick observation, beginning with Corporate Tax 101.
Most public companies are C corporations, and most of those C corporations pay some U.S. tax on their earnings. The earnings are taxed a second time when the C corporations pay taxable dividends to their shareholders. We refer to this tax law mechanic as "double taxation."
(Likewise, if a shareholder disposes of her shares at a gain which reflects the increased value resulting from the corporate earnings, the gain is subject to tax, resulting in an effective "double tax" on the shareholder. This entire double-tax "problem" could be solved if we treated all corporations as flow-through entities, taxed shareholders on their interest in corporate earnings, and gave shareholders a basis increase for the underlying earnings. Yet another topic for a later post.)
Under current tax rules, qualified dividends and long-term capital gains are subject to preferential tax rates. As the WSJ correctly observes, the lower tax rates reflect a crude attempt to blunt the impact of the "double taxation" dilemma. If a C corporation pays tax at a 40% blended federal-state tax rate, it seems like an overreach to tax dividends at ordinary income rates (35% under current rules). So far, so good.
At this point, the WSJ oversimplifies the commercial and tax landscape. It is true that some amount of capital gains reflects sale of stock in public C corporations (resulting in double taxation). However, I suspect that a large amount of capital gains are derived from the sale of other assets.
For example, if I purchase a bond, and the value of the bond increase because Treasury rates decline, capital gain from the sale of the bond would qualify for a preferential tax rate. However, unlike the shares in a C corporation, which derive their value from the after-tax earnings of the corporation, bonds reflect the valuation of pre-tax cash flows. The WSJ argument falls over when you introduce capital assets other than shares in a C corporation. We don't have a "double taxation" dilemma to solve!
As I'll discuss later, I would tax capital gains at the same rates as ordinary income. In connection with that change, I would reform the tax code to treat all business entities (including public C corporations) as flow-throughs. This one-two punch would eliminate the "double taxation" dilemma. More to come on all of the above.
The Double Taxation Dilemma
In sum, Buffett's main concern is the preferential tax treatment of capital gains for "millionaires and billionaires." Unlike the WSJ, I agree that we should tax capital gains at the same rates as ordinary income. That remains a topic for another day. For now, a relatively quick observation, beginning with Corporate Tax 101.
Most public companies are C corporations, and most of those C corporations pay some U.S. tax on their earnings. The earnings are taxed a second time when the C corporations pay taxable dividends to their shareholders. We refer to this tax law mechanic as "double taxation."
(Likewise, if a shareholder disposes of her shares at a gain which reflects the increased value resulting from the corporate earnings, the gain is subject to tax, resulting in an effective "double tax" on the shareholder. This entire double-tax "problem" could be solved if we treated all corporations as flow-through entities, taxed shareholders on their interest in corporate earnings, and gave shareholders a basis increase for the underlying earnings. Yet another topic for a later post.)
Under current tax rules, qualified dividends and long-term capital gains are subject to preferential tax rates. As the WSJ correctly observes, the lower tax rates reflect a crude attempt to blunt the impact of the "double taxation" dilemma. If a C corporation pays tax at a 40% blended federal-state tax rate, it seems like an overreach to tax dividends at ordinary income rates (35% under current rules). So far, so good.
At this point, the WSJ oversimplifies the commercial and tax landscape. It is true that some amount of capital gains reflects sale of stock in public C corporations (resulting in double taxation). However, I suspect that a large amount of capital gains are derived from the sale of other assets.
For example, if I purchase a bond, and the value of the bond increase because Treasury rates decline, capital gain from the sale of the bond would qualify for a preferential tax rate. However, unlike the shares in a C corporation, which derive their value from the after-tax earnings of the corporation, bonds reflect the valuation of pre-tax cash flows. The WSJ argument falls over when you introduce capital assets other than shares in a C corporation. We don't have a "double taxation" dilemma to solve!
As I'll discuss later, I would tax capital gains at the same rates as ordinary income. In connection with that change, I would reform the tax code to treat all business entities (including public C corporations) as flow-throughs. This one-two punch would eliminate the "double taxation" dilemma. More to come on all of the above.
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