How Capitalism Will Save Us

by Steve Forbes

  A flat tax would sharply reduce Washington’s waste of resources on tax-related activity—the 115,000 agents (and climbing) of the IRS, as well as the lobbying that is the source of so much corrosive corruption. With its endless and ever-changing latticework of loopholes, the current system has spawned an industry devoted to influencing tax policy. One in six private-sector employees in Washington is employed by the lobbying industry. Half of their efforts are directed at wrangling changes in the tax code.

  Members of Congress fight like cats and dogs to gain a place on the House Ways and Means Committee, which originates our tax legislation. Those who do are set for their political lives. Courted by lobbyists, trade groups, and individuals seeking to influence the writing of new tax legislation, lucky members rake in more contributions each election cycle than do most of their peers.

  The flat tax would do away with the loopholes and tax shelters that produce useless economic activity and often rip people off. According to the Government Accounting Office, some 6,400 individuals and corporations have “bought abusive tax shelters and other abusive tax planning products” in recent years.

  The flat tax would also kill off the death tax. It would end the draconian unfairness of the alternative minimum tax. It would lower the tax rate on business profits, while abolishing corporate loopholes and encouraging greater transparency. The personal tax on dividends would be eliminated. Companies would thus be able to increase the dividends they pay to shareholders.

  The tax would allow the United States to once again become a business-friendly environment. Nations around the world that have instituted a flat tax—from Lithuania and Romania to Mongolia and Russia—have seen their economies roar almost immediately. Russia’s depressed economy boomed after enactment of its flat tax, even before the commodities boom of 2004–2008. All flat-tax countries experienced impressive growth right up until the credit crisis. There’s no reason why the United States can’t have the same experience.

  The flat tax would also return free choice to individuals who are now forced to make financial and personal decisions they wouldn’t have made in order to lower their taxes. Yaron Brook of the Ayn Rand Institute writes,

  Government’s job is not to dictate your values but to protect them. In a free country, you choose values and then use your own money as a tool to achieve them. But a value-rigged tax policy reverses this cause and effect—it uses your money against you, bribing you with tax breaks that let you keep some of your earnings in exchange for abandoning your preferred values.17

  The flat tax would end this moral distortion, enabling you to live life in a freer society.

  REAL WORLD LESSON

  The flat tax would boost the economy not only by lowering the cost of economic activity but also by freeing up more intellectual energy and manpower for entrepreneurship and innovation.

  Q WHY NOT A CONSUMPTION TAX LIKE A NATIONAL SALES TAX OR A VALUE-ADDED TAX (VAT)?

  A BOTH WOULD PRODUCE IMMENSE HIKES IN THE PRICE OF GOODS, PRESENTING SIGNIFICANT ENFORCEMENT ISSUES AND INCREASING YOUR OVERALL TAX BURDEN.

  Another plan proposed to address the economic distortions created by today’s monstrous federal income tax code is the National Retail Sales Tax—or what proponents call the “Fair Tax.” This sales tax is intended to replace the federal income tax and payroll taxes. It would be collected on the sale of new goods and services. But used goods and business purchases would be exempt. Business purchases would also be exempt. The Fair Tax, which has some support among conservative politicians and pundits, calls for a 30 percent tax on virtually all consumption, including new houses, as well as on services from haircuts to legal advice to open-heart surgery.

  Supporters of the idea have their hearts in the right place. They understand the economic damage caused by excessive taxes on income. On its face, a sales tax can look appealing. It does not create the social and marketplace distortions created by income taxes. But instituting the Fair Tax would bring numerous, Real World complications.

  The enforcement issues are endless. For instance, what is the precise definition of the goods and services that are “new” and therefore should be taxed? What about people selling items on eBay that they claim aren’t really new and should be tax exempt? There’s also the problem of having to answer the question, What constitutes a business? What about individuals who incorporate simply to avoid paying the tax? The plan also assumes that government entities, such as the Pentagon for example, will pay a 30 percent sales tax when they buy an aircraft carrier or purchase supplies for our troops overseas. That’s a totally unrealistic assumption.

  Exactly how would a national sales tax be collected? Will states really devote resources to collecting a 30 percent tax that goes to the federal government? What federal agency will ensure that the hundreds of thousands of retailers in America are complying? Or that a business is indeed a business?

  The greatest argument against the Fair Tax is that it will drastically raise prices. The price of nonexempt goods and services purchased at retail would instantly increase 30 percent. Partisans reply that such price hikes will be offset by the fact that people would have more take-home pay because the income tax and other taxes would be abolished. And companies freed from the burden of corporate income and payroll taxes could charge less. Really? We have to admit we’re skeptical. Have you ever heard of a tax—one that’s essentially a surcharge—making a product less expensive?

  Key sectors of the economy, such as housing, would be devastated. Who would want to buy a new home, for example, when it would cost 30 percent more than a preowned one?

  Critics say that a sales tax, especially one this size, would be highly regressive, hitting hardest those with the least. Designers of the Fair Tax acknowledge this drawback, which is why their plan includes a scheme of monthly rebates to one and all. They call them “prebates,” which would give to everyone money equal to poverty-level income to cover necessities such as food and clothing. This “prebate” would require an entirely new bureaucracy, even if we somehow got around the problem of enforcement. Rebates are also likely to further politicize the tax system, with interest groups of all kinds pressing for more favorable rebates based on “need,” either real or perceived.

  In a recession a national sales tax is especially unfair. Income taxes decrease in hard times if your salary declines. But with a sales tax, you still have to pay a 30 percent tax on your basic living expenses—such as mortgage, food, clothing—even if you’re less able to afford it.

  Finally, the fair tax requires repealing the Sixteenth Amendment to the Constitution. Otherwise, Washington continues to have the right to impose an income tax in addition to a national sales tax. Without repealing the Sixteenth Amendment, we will end up with the situation that exists in most states and in most other countries—that is, having both an income tax and a consumption tax.

  Our Founding Fathers deliberately made amending the U.S. Constitution a time-consuming, cumbersome process. Getting people to accept the idea that a substantial sales tax—either the Fair Tax or a VAT—won’t raise their cost of living will require considerable time and powers of persuasion.

  Another alternative to income taxes—in use in Europe—is the VAT, or value-added tax. A value-added tax is imposed not only on the retail sale of items to consumers but also on the purchase of materials by businesses to manufacture their products. It is insidious because it imposes an invisible layer of taxation that inflates the cost of living. The French were the first to enact the VAT because it’s hard to avoid: it is applied to every transaction, including services. A sales tax applies only on a final purchase, whereas a VAT is incorporated into every step of the manufacturing process—no exemptions anywhere.

  A VAT increases the cost of doing business and hits all consumers. Another downside is that a VAT always ends up being an additional tax instead of a replacement tax. France, for example, imposes the VAT in addition to ferocious income taxes. As they say over there, quel horreur!


  REAL-WORLD LESSON

  A 30 percent national sales tax or a European-style value-added tax would likely end up being an addition to our income taxes—just as such taxes are in most states and virtually every country around the world.

  Q AREN’T “DEATH TAXES”—AKA, INHERITANCE TAXES—NECESSARY TO PREVENT ARISTOCRACIES?

  A NO. DEATH TAXES HAVE ACTUALLY HELPED PRESERVE THE FORTUNES OF THE WEALTHIEST PEOPLE, WHILE PREVENTING THOSE ON THE WAY UP FROM BUILDING WEALTH AND PROTECTING THEIR FAMILIES.

  Originally, the Bush administration wanted to abolish the death tax.

  But Congress insisted—erroneously—that it would cost too much. To get his tax cuts passed, the president struck what was supposed to be a compromise: the inheritance tax would disappear for one year in 2010. Then it would return at the higher—and onerous—rate of 55 percent. The Bush administration went along with this in the hope that the single year of tax relief would fuel public demand for the permanent abolition of the death tax. They were wrong.

  Instead, the need to pay for today’s soaring spending has created pressure to keep the tax. President Obama has proposed keeping the top rate at 45 percent in 2010 and thereafter. If nothing is done, then in 2011 the top rate would increase to 55 percent. The levy would also kick in sooner: today’s $3 million exemption will decline to $1 million.

  Actually, death taxes—or inheritance taxes—raise a minuscule amount of money for government coffers—about 1 to 2 percent of tax receipts for the federal government, if that, according to the Tax Foundation. Then why bother with them? The argument is supposed to be “fairness.” The first death taxes were devised in 1916 to raise money to beef up the military as World War I loomed. The tax was supposed to prevent the kind of entrenched aristocracies that dominated Europe by preventing estates from being passed to “unworthy” heirs.

  In fact, the death tax has helped to perpetuate such fortunes by forcing the wealthy to hire high-powered lawyers and accountants to preserve their money via tax-avoiding trusts. If they were not compelled to resort to such protective devices, large estates would be subject to the normal forces of creative destruction and dissipate more rapidly. Those unworthy heirs would have a far easier time frittering away their inheritances.

  Many of the people affected by the tax are far from wealthy. Studies show heirs to be often less affluent than the relatives who leave them their property. Thus, the tax is “much less progressive than its supporters believe it to be.”18

  The Tax Foundation has found that, in many ways, a high death tax functions much like excessive income taxation. It discourages entrepreneurship and wealth creation:

  The estate tax’s 55 percent rate …had roughly the same disincentive effect as doubling an entrepreneur’s top effective marginal income tax rate. … At some point the threat of estate taxation causes entrepreneurs to become more likely to retire early rather than continue to work. If the estate tax encourages entrepreneurs to stop working and saving, not only does this reduce federal income and payroll tax revenue, but also results in less overall wealth creation in the U.S. economy.19

  Fewer jobs and opportunities end up being created for the broader economy by entrepreneurs who end up selling their businesses and retiring sooner than they otherwise would have.

  A typical example: fear of the death tax forced the Mavar family of Biloxi, Mississippi, to sell its sixty-two-year-old Mavar Shrimp & Oyster Co., Inc. to H. J. Heinz in the late 1980s. Selling the business at that time allowed the family to pay a lower capital gains levy—avoiding a 55 percent death tax that would have required selling assets and breaking up the company.

  The Mavar family had hoped their buyer would have continued to operate the business in Biloxi. But Heinz soon moved the company’s operations—and its jobs—out of the state. Family member and former company vice president Victor Mavar recalled in written congressional testimony:

  Obviously, most of our employees, who had lived in Biloxi for all of their lives, were not able to simply relocate with the new owners. While a handful did move, the majority simply lost their jobs and had to start new careers. Today, I regularly meet folks on the streets of Biloxi, who tell me that they used to work in our business, and state that they wished it had never been sold….

  I’ve avoided making any investments in other new businesses, which may not turn a profit for several years. I have chosen to do this despite my interest in supporting the rebuilding of Biloxi, which was ravaged by Hurricane Katrina in 2005.

  In fact, I have received requests for investments in several local businesses, including a housing development that would help lower and middle income families who lost their housing due to the hurricane. However, I have been forced to turn them all down, lest I burden my children with the same death tax that we sold the business to avoid. As I see it, the death tax has encouraged a “wealth-redistribution,” not from the rich to the poor, but from the local community to the national corporations.20

  Mavar also complained about the overwhelming costs of deathtax compliance:

  Even with the sale of our business, I am still concerned about being able to pay for the death tax. I’ve spent a fortune on attorneys, accountants, life-insurance and tax avoidance measures, such as early gifting to my children and charitable endeavors.

  One 1992 study by economists Henry J. Aaron and Alicia H. Munnell estimated the cost of complying with estate taxes to be one dollar for every dollar of revenue raised—nearly five times more costly per dollar of revenue than the notoriously complex federal income tax. According to the authors of the study, “the ratio of excess burden to revenue of wealth transfer taxes is among the highest of all taxes.”21

  In the end, the death tax costs society far more than the trivial revenues it raises. It undermines the very “fairness” its designers were trying to achieve, as entrepreneur and radio commentator Herman Cain can attest to. His late father, Luther Cain, was a grandson of slaves, had no college education, and worked jobs as a barber, janitor, and chauffeur. In the beginning, Luther Cain was the kind of low-income person advocates of tax “fairness” profess to care about—except that he did too well, building a nest egg of slightly under $1 million by the end of his life in 1982. Hermain Cain wrote to Congress,

  By the time of my mother’s death in 2005, my father’s assets had grown modestly leaving his family with a death tax liability of $1.3 million. My father would have been proud to have known that his hard earnings had been well-managed and used to propel his family to ever greater heights. Somehow, I do not think he would be nearly as pleased to learn that nearly half of it never made it into the hands of his grandchildren.

  As his son acknowledges, Luther Cain is a powerful example of how excessive taxes destroy economic growth and hurt the very people they’re supposed to help.

  My father is only one example of thousands. Most Americans who have earned over a million dollars in their lifetime have done it through hard work and rigorous discipline. It is easy for members of Congress to talk about wealth disparity and to gloat about their grand schemes to ensure “fairness.” It is another matter when they confront the individuals whose “wealth disparity” they are actually seizing. 22

  REAL WORLD LESSON

  Death taxes have the unintended consequence of forcing the very wealthy to protect their fortunes, while keeping individuals of moderate means from building wealth.

  Q WHY NOT JUST COLLECT MORE MONEY FROM “SIN” TAXES ON CIGARETTES AND ALCOHOL?

  A SIN TAXES AND OTHER ATTEMPTS AT “SOCIAL ENGINEERING” THROUGH TAXATION USUALLY FAIL.

  If taxes on income are bad for the economy because they discourage constructive, wealth-creating transactions, what’s wrong with financing government by taxing behavior most people agree is destructive—like smoking, for example? After all, supporters argue, so-called sin taxes deliver a two-for-one benefit: they generate needed revenue for government while discouraging undesirable activity.

  That rationale accounts for the trend over t
he last twenty-five years toward targeted excise tax increases—sin taxes on tobacco and alcohol—in place of raising income and sales taxes. According to the New York Times, “across the country, politicians, eager to avoid anything that looks like a tax increase, are turning to levies on… ‘unhealthy behaviors’ to finance education. Kentucky, Maryland, Missouri, Tennessee, Utah and West Virginia are among the states that have shifted part of the cost of schooling from income, sales and property taxes to levies on gambling and nude or topless dances in the last few years.”23

  Not only are states turning to sin taxes to fund programs and services. They’ve also begun developing a whole spate of new “sins” to be taxed—from polluting to eating junk food, playing video games, or even drinking bottled water.

  As Daniel Clifton and Elizabeth Karasmeighan explain in a recent report on this trend for Americans for Tax Reform, sin taxes are palatable to people who would like to see less of the behaviors the states are taxing. After all, you don’t have to pay if you don’t indulge in the “sinful” activity being taxed. As the authors point out, “By targeting their tax increases to narrower segments of the population, legislators divide taxpayers into smaller groups and minimize voter backlash.”24

  Sin taxes are what economists refer to as a “Pigovian tax” intended to correct a market’s “negative externalities.” That’s economist speak for undesirable behavior. Sin taxes are supposed to be justified because, the thinking goes, they “adjust” a product’s price to reflect its “actual cost” to society.

  Pigovian taxes are named not for the swinish behavior they’re supposed to control but to honor economist Arthur Pigou, who developed the thinking behind such taxes. Because sin taxes provide a disincentive to negative behavior, many people see them as a more palatable alternative to regulation. Creating a tax disincentive does not require the costly bureaucratic manpower that would be needed to enforce a new law.

  The problem is that sin taxes don’t really work as advertised. They present a host of unintended economic and social consequences—in addition to raising moral questions.