Tax Debate: Most People Miss the Point

Tax Debate: Most People Miss the Point
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Tax Debate: Most People Miss the Point

I’m going to do something different to start this post.  I’m going to highlight those that disagreed with the last post.  Thanks for disagreeing, because it makes this post better.

Response 1:

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It’s all well meaning but it’s likely to fail in practice, with unintended consequences and nasty corner cases where you have to reintroduce complexity.

For example imagine a taxpayer with one, liquid but volatile asset, which is essentially long term flat. It goes up +X in one year, -X the next, etc. So the taxpayer has essentially zero income (amortised) but must pay on the +X on the positive years. The no deferral rule prevents creating an offsetting tax credit on -X years, so he’s either paying tax on non-existing income, no good (>100% tax rate), or requires a refund on the down years, which creates a new class of enforcement problems that didn’t exist before (people creating fake losses to get actual cash, when they could only get tax credits before).

Another example is a taxpayer with a single illiquid asset, say a small business owner who owns nothing else, and the business is with tight cash flow, or a disabled/elderly person who owns their house outright but nothing else and who lives on welfare. If the business/house valuation goes up, these guys have a tax bill. So now they must raise money out of an illiquid asset just to pay tax, and as it’s illiquid and they don’t have cash flow they might have to either pay distressed credit rates on their tax borrowing, or just sell the business/house which is a bit of a harsh punishment for a tax-cashflow issue.

Income is intrinsically a tricky problem. You can clean up the crud from time to time, indeed you must as some nonsensical rules will inevitably accumulate, but a simple tax idyll is unfortunately not realistic I believe.

Response 2:

I respectfully don’t think so. The example of the taxpayer with the volatile asset could also be compared with a person who pays income taxes on a salary. If they lose their job next year (volatility) they would have paid too much this year by your model. The issue is that it seems less fair to tax work (salaries) at a higher rate than wealth (dividend income). Perhaps it could be separated from capital gains – which isn’t real income until it is sold at a profit. It could also be argued that salaried people contribute more to the economy than dividend income does. I’m not a job creator if I go sell a $100K of stock on the NY Stock Exchange – what have I added to the economy?

Response 3:

This does not strike me as a good idea. It isn’t practical to tax appreciation of illiquid untraded assets, and the overhead and intrusion involved in doing something like this fairly would be tremendous.

I don’t see why we should be so reliant on taxing income anyway. Pigovian taxes would be better for the economy, and consumption taxes would be easier to levy. Even a Henry George style single-tax would seem preferable to trying to impute income to people as a result of asset fluctuations.

I like my readers.  Why do I like my readers? One, they are bright people, even if I might disagree with them.  Second, they are relatively polite.  I was walking through Times Square with another prominent blogger, and he said to me, “When I see the comments at your blog, David, you have nice commenters, whereas those at my blog are not.”  I said to him that there were three factors in play:

  • He has more readers than I do.
  • His format did not allow for filtering.  I filter, but rarely.    Also, it’s harder to comment on my site, and that’s a feature, not a bug, because I want people who are determined to comment, not something that is off the top of the head.
  • I pointed out to him that his rhetoric had bomb-thrower tendencies, and what kind of crowd would that attract?

So, I like my readers, and commenters.  In general, if you comment here, and I don’t delete it, I respect you.  (Deletion rate is less than 0.1%.)

But now to my main point.  Much as I like Buffett, I disagree with him on tax policy, because he is a hypocrite.  Let him argue that stock holdings should be taxed annually on the unrealized increase, and I would agree with him.  He doesn’t pay as much taxes as he should because:

  • Berkshire Hathaway doesn’t pay a dividend.
  • He never sells shares of his company.
  • He engages inside his company to avoid taxes in every legal way.  He is not interested in paying taxes in the slightest.

My tax proposals would make Buffett and those like him pay, and others who game the system as well.  The critiques above miss the point in a major sense.  Much avoidance of taxation comes from having companies that are heavily indebted.  I don’t believe that having heavily indebted companies is a good thing.  If they faced taxation on the presumed increase in their value annually they would be forced to have more liquidity, and that is a good thing.

My proposal would lead to companies not being so heavily indebted.  That’s a feature, not a bug.  We need to discourage debt in the financial sector, because it tends to create booms and busts.  If you want to do a big capital investment, save for it, or borrow on a very short term basis.

My proposal on taxation should be phased in gradually.  Mr Buffett should not be presented with a bill for $12 billion, but rather a request for $1.2  billion for 10 years, reflecting the value he has obtained untaxed.  With respect to taxation, he is the ultimate hypocrite.  If he did not speak on such matters, I would respect him, because he is generally such a wise man, but he has prostituted his position to the current political scene.  Thus I don’t respect him here.

(As an aside, we could drop the estate tax after instituting this, because appreciation would be taxed annually.  As such, the cost basis at death would be very near market.  One thing that was little noted in the one year elimination of estate taxes in 2010 was that if you inherited something in that year, your tax basis did not step up to market, but remained at the cost basis of the decedent.  The taxes may be delayed, but they weren’t eliminated.  That’s still quite an advantage.)

I believe that a less levered system is better for the economy as a whole.  It is far better to disallow interest as a deduction for corporations. and allow corporations to dividend to shareholders without taxation.  Or, eliminate corporate taxation, and tax dividend receivers directly, combined with a tax that taxed profitable companies that did not pay dividends.

The economy is better off when it is less levered.  Debt obligations make the economy less flexible, demanding fixed payments, regardless of how likely they are.  For modeling, it is best to think of the unlevered economy. What is the native demand, leaving aside the  speculative demand?  Borrowing to create speculative demand should not be encouraged by the tax code.  After a phase-in, interest should not be tax-deductible, but would add to the cost basis of assets.

My views are relatively simple:

  • Taxes should be moderate, and levied on the approximate increase in value annually.
  • Corporations and individuals should avoid borrowing to finance investment/consumption, at least, it should not be tax-favored to borrow in the short run.
  • Everyone should be taxed; there is no way to avoid it.  This ensures fairness.
  • All classes of income should be taxed at the same flat rate.
  • There are no non-income deductions/credits, and no use of the tax code for social engineering.
  • This should be phased in over ten years to avoid a shock.
  • For illiquid situations, businessmen would have to plan in advance for taxation, which would impose a cost on illiquidity in the economy.
  • We would not favor savings over consumption — goodbye to the complexities of IRAs, life insurance, pensions, and all other deferral vehicles.

The overarching idea is to create a flat taxation system, where the increase in value is taxed annually, and where there is little incentive to engage in any sort of action to convert one sort of income into another.  This would level out many of the advantages that the wealthy have, while leaving in place a relatively transparent taxation system with few preferences which would be stable, and create predictability in taxation.

Those are my views.  I am trying to create something more stable, fair, and transparent (can’t hide income).  Those are desirable goals.  Why shouldn’t everyone love this, aside from the rich that use the overly generous tax code?  Feel free to comment below…

PS — this would have implications for US entities owning foreign assets, but I haven’t figured out how to make this work globally without making people/firms flee the US.  Ideas are welcome.  Thanks to all readers/commenters, I appreciate all of you.


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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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