by Steve Forbes
Equity funds have benefited from a similar tax break, thanks in part to the efforts of Senator Charles Schumer of New York, who has helped preserve the capital gains rate for the industry—at least until the financial crisis hit. These tax breaks can be defended objectively—as we’ve done on occasion. But they never would have been enacted without powerful political lobbying.
With government spending soaring as a result of the financial crisis and recession, even some conservatives are saying that taxes must go up. After all, they argue, a top tax rate raised to 40 percent of income would still be far below the 70 percent that Reagan found when he took office. That would give us about the rate we had in the prosperous 1990s. Others advocate a European-style consumption levy called the Value Added Tax (VAT). These individuals have fallen into the trap of concluding that government outlays are inevitable and that therefore, we have no choice but to raise tax levies to “help pay for it all.” They have forgotten their basic lesson—that low, reasonable rates generate a wealthier economy.
It is precisely because of coming crises in Social Security and health care that we need more incentive for innovation and growth. A moderate increase in tax rates may produce higher revenues. But it will nonetheless stifle economic expansion, resulting in a smaller economy and lower tax receipts.
No one denies that the services of government are vital and must be paid for. But the only way we will continue to afford them is through reasonable taxation that allows people control of their behavior and leaves them free to generate wealth—for themselves and others.
Q SHOULDN’T THE RICH PAY MORE TAXES? (OR: WHY SHOULD WARREN BUFFETT PAY A LOWER TAX RATE ON HIS INCOME THAN HIS SECRETARY DOES?)
A THE RICH ALREADY PAY MORE.
The conventional wisdom of many politicians is that the rich don’t pay their share of taxes. Investor Warren Buffett made headlines when he complained about this to an audience of wealthy executives at a Democratic fundraiser in 2007: “The 400 of us [here] pay a lower part of our income in taxes than our receptionists do, or our cleaning ladies, for that matter. If you’re in the luckiest 1 percent of humanity, you owe it to the rest of humanity to think about the other 99 percent.”6
Buffett explained that he had been taxed on only 17.7 percent of the $46 million he had made the previous year. Meanwhile, his secretary had to fork over 30 percent of her sixty-thousand-dollar salary.
Buffett and others who deride “tax cuts for the rich” ignore a little-known fact: rich people already pay more in taxes. And their share of the nation’s total tax bill has increased since Ronald Reagan cut taxes in 1981.
Consider this: In 1980, before the Reagan tax cuts, the top 1 percent of American income earners paid 18 percent of federal income taxes. Then rates were reduced from a high of 70 percent to a low of 28 percent. What happened? The share of the national tax burden paid by the wealthy actually went up. They produced 23 percent of national income and paid 36 percent of federal income taxes.
They pay even more today. That top income tax rate is now 35 percent. The top 10 percent of income earners pay 71 percent of the federal income taxes.
What about those who say that the rich should pay a higher percentage of their incomes? They already do. Some 43 percent of the population, overwhelmingly people with lower incomes, pay no federal income taxes.
Warren Buffett’s complaint is disingenuous. If he paid himself a salary, he would, indeed, be paying a higher rate than his secretary. That 17.7 percent, however, is not an income-tax rate. It’s the capital gains rate he pays on investment income from Berkshire Hathaway, the company he manages and in which he is a major shareholder. Critics like Buffett ignore the fact that dividend income to shareholder/owners is taxed twice, first on the corporate level and then on the personal level. Not only does a shareholder pay personally; his or her company does, too.
Why are the capital gains tax rates that Buffett pays lower than the income-tax rate paid by his secretary? Because, as we discuss later in this chapter, capital gains income is different from salaried income. Salaried income means you get paid regularly, say, every week or twice a month. As long as you are not laid off and your company doesn’t go broke, you get that paycheck. By contrast, capital gains are generated only after you have placed your capital at risk and the venture has succeeded. The gain is far from guaranteed. Most new businesses fail. And as people discovered during the financial crisis, investing in stocks is no sure thing. Stocks can plummet in value and you can end up losing money. A lower capital gains rate constitutes your “reward” for taking that risk on ventures that produce jobs and other benefits for the economy.
Conversely, raising capital gains taxes penalizes this kind of risk-taking. You ultimately get less investment and entrepreneurship, a smaller, less wealthy economy with fewer jobs. How does that help the poor? According to Wall Street Journal economics writer and editorial board member Stephen Moore, if the tax cuts of 2003 proved anything, it’s that cutting taxes is the best way to “soak the rich”:
Between 2001 and 2004 (the most recent data), the percentage of federal income taxes paid by those with $200,000 incomes and above has risen to 46.6% from 40.5%. In other words, out of every 100 Americans, the wealthiest three are now paying close to the same amount in taxes as the other 97 combined. The richest income group pays a larger share of the tax burden than at anytime in the last 30 years with the exception of the late 1990s—right before the artificially inflated high tech bubble burst.
Millionaires paid more, too. The tax share paid by Americans with an income above $1 million a year rose to 17.8% in 2003 from 16.9% in 2002, the year before the capital gains and dividend tax cuts. The most astounding result from the IRS data is the deluge of revenues from the very taxes that were cut in 2003: capital gains and dividends. Capital gains receipts from 2002–04 have climbed by 79% after the reduction in the tax rate from 20% to 15%. Dividend tax receipts are up 35% from 2002 to 2004, even though the taxable rate fell from 39.6% to 15%.7
Despite myriad statistics from many sources, there is a refusal by many to accept the importance of capital creators to a healthy economy. They point to economic downturns, such as today’s fierce recession, as evidence that “trickle-down” has failed. They ignore the decades of prosperity that preceded the downturn—and the fact that, over the long term, the economic pie has grown steadily. Except for the 1930s, every expansion has exceeded the peak of the previous expansion. Even with fluctuations, the standard of living of the American people has moved steadily upward.
Warren Buffett may feel guilty about paying lower capital gains tax and divided rates. But that doesn’t mean government should cripple other critical entrepreneurs and businesses whose health is vital to pulling the nation out of bad times.
REAL WORLD LESSON
Contrary to public perception, the rich in fact pay the greatest percentage of taxes. Their share of the nation’s tax burden has increased, not decreased, when taxes were cut.
Q WHAT’S WRONG WITH TAXING CORPORATIONS TO AVOID A HEAVIER BURDEN ON INDIVIDUALS?
A HIGHER CORPORATE TAXES END UP BEING PASSED ON TO INDIVIDUALS AND KILLING ECONOMIC ACTIVITY.
Populist politicians traditionally score points by bashing the idea of tax cuts for corporations. In the 2008 presidential campaign, then-candidate Barack Obama said of himself and John McCain, “We both want to cut taxes, the difference is who we want to cut taxes for.” Obama said he wanted to cut taxes for the “middle class,” while McCain wanted to reduce rates for “some of the wealthiest corporations in America” including the big oil companies. The implication was that McCain was out of touch and cared little for the needs of the average citizen.8
However, had McCain been elected and been able to carry out his promise to lower the corporate tax rate to 25 percent, he would likely have delivered a charge to the economy that might have helped to lift it out of the recession brought on by the 2008 financial crisis.
That’s because high corporate taxes, like ot
her levies, destroy economic activity. As Thomas Sowell explains so aptly, taxes make transactions more expensive. Thus, fewer take place. In the case of corporate taxes, they leave businesses with less capital to invest. Taxes also lower the net return on investments. Consequently, companies become reluctant to take risks and less likely to expand. High tax rates also increase the mortality rate of small businesses because they have less access to capital. They’re less likely to grow large enough to attract outside investment.
American corporate taxes are the second highest in the developed world. According to the Tax Foundation, the total American corporate tax rate—including state taxes—exceeds 39 percent, second only to that of Japan among developed countries. The top statutory corporate tax rate in the United States reaches as much as 47 percent in some states, such as high-tax Iowa.9
That’s a stark, ironic contrast to the nations of Europe, which, despite high personal income taxes, have lower corporate rates. Even semisocialist countries such as Sweden, for example, have more reasonable business taxes. They understand that allowing companies to generate profits helps maintain a healthy economy better able to afford government social schemes. Sweden’s corporate tax is a moderate 28 percent. Even France’s rate is lower than the U.S. statutory rate. In recent years these nations have actually lowered rates to attract business investment.
The consequence? Businesses that might have located or invested here are going elsewhere. After all, why would any intelligent CEO decide to invest here if his corporation will only end up paying taxes that are 5 percent or 10 percent higher than in other countries?
Little wonder companies are moving to places like Ireland, with its corporate tax rate of 12.5 percent. Once the poorest country in Western Europe, that tiny nation has been able to transform itself in barely two generations into an economic miracle. Though it has been hard hit by the recession, Ireland’s per-capita income has surpassed that of Britain, France, and Germany.
High corporate tax rates drain businesses not only of capital but of productivity. They divert resources from business development and expansion into tax-avoidance efforts. These include so-called abusive tax shelters—elaborate, often convoluted strategies and transactions created for the sole purpose of avoiding taxes. The Enron fraud was in large part a huge tax-avoidance scheme. The New York Times reported that the energy company created 881 subsidiaries abroad, almost all located in tax havens. The strategy enabled the company to evade some $2 billion in federal income tax—and thus report false profits.10
In contrast, when corporate taxes are cut, businesses become more productive. More of them spring up. The result: increased tax collections. Cato Institute fellow Alan Reynolds has noted, “countries with corporate tax rates from 12.5% to 25%, such as Ireland, Switzerland, Austria and Denmark, routinely collect more corporate tax revenue as a share of GDP than the anemic 2.1% figure the Congressional Budget Office projects for the U.S.”11
Politicians like to imply that taxing corporations is “fairer” and will somehow leave individuals with a lighter burden. The reverse is actually the case: higher corporate taxes end up increasing the financial burden on consumers. After all, where do businesses get money to pay those corporate taxes? Where else? From their customers.
When you buy a tie or a blouse, you’re not just paying for the fabric and the labor. You’re indirectly paying the manufacturer’s—and the retailer’s—payroll taxes, Medicare taxes, excise taxes, fuel taxes, and the like that are passed on as part of “the cost of doing business.”
What does this mean in Real World economic terms? According to the Tax Foundation, the $370 billion in federal corporate income taxes collected in 2007 by Uncle Sam translated into an annual tax burden of $3,190 per family—more than the average household spends on restaurant food, gasoline, or home electricity in a year.12
Furthermore, the Tax Foundation’s Scott Hodge and Gerald Prante believe that supposedly “invisible” corporate income taxes impose the greatest burden on lower-income households. These low-wage earners have a lower disposable income. They are most sensitive to these pass-along levies. Hodge and Prante conclude:
A general cut in corporate income tax rates (or other taxes on capital) would provide a greater benefit to low-income households than would further rate cuts in individual taxes. Indeed, there are 43 million Americans who already have no income tax liability after they take advantage of their credits and deductions. Those households would benefit most from a cut in corporate taxes.13
Harvard economist Gregory Mankiw predicts that cutting the rate to 25 percent would unleash enough economic activity to generate revenues through other taxes to cover a major part of the $100 billion cost of the reduction. Other experts believe the cut would be self-financing.14
Capitalism bashers like to insist that only faceless corporations pay corporate taxes. But in the end, everybody pays.
REAL WORLD LESSON
Besides reducing economic activity, corporate taxes are in effect a hidden tax that is passed on to consumers.
Q WHY WOULD A FLAT TAX BE BETTER THAN THE CURRENT SYSTEM?
A A FLAT TAX WOULD LOWER EVERYONE’S TAX BURDEN. IT WOULD REMOVE THE ONEROUS COMPLIANCE COSTS PAID ON TOP OF TAXES, GENERATING MORE REVENUES AND ECONOMIC GROWTH.
Steve Forbes’s book, The Flat Tax Revolution, outlines the plan for the Forbes Flat Tax: a single-rate federal income tax and corporate tax of 17 percent. Income is taxed once and only once. The flat tax eliminates all double taxation of dividends, as well as taxes on personal savings and capital gains. The tax for individuals and families would apply only after generous exemptions for adults and children. A family of four, for example, would pay no federal income tax on their first $46,165 of income.
Adults would be able to take a $13,200 standard exemption. Single people who make less than that would not be on the tax rolls. Married couples would receive a $26,400 deduction. Heads of single-parent households would have a 30 percent higher exemption of $17,160 to compensate for the additional burden of raising a child alone. Families would receive a $4,000 exemption for each dependent and a refundable tax credit of $1,000 per child age sixteen or younger, as under the current system.
In contrast, the current system is based on a tangle of tax rates: personal rates range from 10 percent for lower-income earners to 35 percent for top earners. There’s a 15 percent tax on capital gains and a 35 percent federal corporate income tax. On top of this are piled city, state, and local taxes.
People get concerned that the flat tax would eliminate favorite deductions, such as those for mortgages and charitable contributions. That’s why individuals should have a choice between going to the new system or staying with the old. Most people would quickly realize that a simple, low flat tax would give them more resources for housing and charitable contributions.
Why is the flat tax better than the current system? Simplicity, for starters. Lincoln’s Gettysburg Address, which defined the character of the American nation, is 272 words in length; the Declaration of Independence, 1,300 words; the Constitution, nearly 5,000 words. The Holy Bible, which took centuries to produce, 773,000 words. The federal income tax code and all of its attendant rules and regulations come to more than nine million words. And nobody truly knows what’s in the code and what it means. That’s why the IRS gives taxpayers on its hotline wrong information at least 25 percent of the time.
The complexity of the code was illustrated several years ago by a Money magazine survey. It took a hypothetical family’s finances and gave the numbers to forty-six expert tax preparers, the best in the field. What the magazine got back was a shocker: no two preparers could agree on what the family owed. Each had a different estimate, and the differences came to thousands of dollars.15
Just about everyone would pay less under the flat tax than they do now. This is true regardless of the deductions they have taken under the old system. This substantial tax cut would unleash economic growth and boost tax collections. Fiscal Associates, a
consulting firm specializing in quantitative analysis, estimates that a flat tax imposed in 2005 would have generated some $56 billion more in net government tax revenue by 2015 than the existing progressive code.16
The flat tax also eliminates a hidden tax we all currently pay—the enormous cost of compliance, the immense amount of money and man-hours that we spend filling out returns and working to reduce our taxes. As we mentioned, the nation’s total compliance cost has been estimated by the Office of Management and Budget to be around $200 billion.
With a flat tax, you’d file your return by filling out a single card. No more filling out page after page of tax returns. No more anguished hours spent with your accountant worrying whether you took the right deductions. The flat tax would reduce the need for the armies of accountants and bureaucrats who are part of the public-and private-sector effort of producing and processing tax returns.
Even if the flat tax only reduced compliance costs by half, that would mean, in national terms, a total reduction of $100 billion. This immense cost saving would free up human and financial resources that could then be invested in new jobs and businesses. The billions of dollars businesses spend on tax compliance or avoidance could be reallocated into new business activity and jobs. Think of what this would mean multiplied millions of times throughout the economy. The flat tax would unleash an economic boom that would produce more wealth—not only for individuals but also for government coffers.
The flat tax would also be a great time saver. The IRS reported that in 2008 Americans spent some seven and a half billion hours filling out tax forms, the equivalent of more than three million full-time jobs.