This should be a short post, because my comprehensive view on tax reform is found here. The summary is that the problem is not tax rates. The problem is the definition of income. Just as in ancient times, people would make themselves look poor when the taxman came, so do the wealthy do today. “Income? I hardly earn any income.”
And that is because of loopholes in the tax code for social engineering purposes, but even more for the ability to defer taxation of what should be income. My view is that we should all be taxed like traders, with no opportunity to defer taxation. No tax deferral for IRAs, HSAs, 401(k)s, DB pensions, insurance, annuities, endowments, stock (even private stock will have to report transactions). As asset prices rise, you would get taxed. No deferral.
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You might think this is an ugly system, and it is, though Zillow would have one amazing business when the government uses it to tax increases in housing values, with a true-up at the eventual sale. They might even find new business by creating pricing grids for other sets of illiquid assets.
The idea is that taxation should follow value creation, which is income, even if it is not cash income. Gone would be the days where one has an appreciating asset, and borrows against it, and pays no tax. All increases in value would be taxed, and assets where the increase can’t be measured would assume a 15% annual return for taxation purposes, with a true-up at the sale of the asset.
Deferred tax liabilities would be made payable in a few years, and deferred tax assets would receive payment in the same period. Deferred gains in stock would be immediately taxable. Hello, Mr. Buffett, you want the rich to pay taxes, here is your bill.
This would include an elimination of all deductions, corporate and individual. And, I would beef up the IRS to enforce this. Once the concept of income gets simple and immediate, enforcement gets easier. The IRS could focus on one question: how much are they prospering? Tax in proportion to that.
A proposal like this could rapidly balance the budget without raising tax rates. Now none of the midgets running for President would adopt such an idea — it offends both the left and the right. But it would raise taxes on the rich, unlike what anotherwise bright guy like Buffett proposes. Rates aren’t the question, the question is the definition of income.
And until we focus on the definition of income, we will continue to drift as a nation, at least until a crisis hits that reveals our weakness.
By David Merkel CFA of Alephblog