Currently, in the United States, income from different sources is treated very differently for tax purposes. For example, capital gains are taxed according to a different schedule than regular income. And, long term capital gains are taxed preferentially to short term gains. I believe that we are making a mistake by treating different types of income differently.
I believe that we should treat ALL individual income equally, whether that income comes from punching the clock, earning a fixed salary, receiving bonuses, or as a return on investment. You may notice I said "individual" income --- I am specifically talking about the income earned by individual taxpayers (or married taxpayers filing jointly), but NOT corporations. I will address corporations later on in this piece.
An enterprising individual, in the effort to earn money and amass personal wealth, will put all available resources to work in that effort. For someone with little or no savings to invest, this probably means getting a job and earning an income, either by the sweat of his brow or the sweat of his neurons, but by sweat nonetheless. However, with some success and prudent spending habits, that same individual can quickly become an investor who can begin to earn income by investing his savings. To my mind, there is no reason to distinguish these activities from one another -- both are crucial and central to the growth of the economy and I challenge anyone to demonstrate that one deserves favor over the other. With a good deal of success, an individual may find that by investing his money he can earn more than he could by laboring in a traditional job, and may eventually earn most or all of his income in this way, which is perfectly good and fine.
However, all this income should be treated the same the for purposes of federal income taxation. This means that Social Security and Medicare taxes (so-called payroll taxes) must be applied to this income, up to the limits provided by law. Buy stock in IBM for $100 and sell it a year later for $120? You will owe $3 (15%) in payroll tax on that gain, plus your marginal tax rate times $18.50 (the $20 gain less half of the payroll tax paid). This is how self-employment income is treated in this country, and someone who is investing his savings and earning a profit is effectively "self-employed" in this regard. Similarly, money spent researching stocks, hiring financial advisers, paying commissions, etc., can be used to increase the cost basis of the investment and reduce taxable income, subject to limits set by law.
Earlier, I mentioned that I would touch on the issue of corporate taxes. Currently, when a corporation earns a profit it pays a corporate tax on that profit, then distributes its after-tax profit in the form of dividends to shareholders, who in turn pay a tax on that money. Therefore, corporate profits are subject to double-taxation. It is my opinion that earnings from C-corporations should NOT be taxed until they are distributed in the form of individual income as dividends. For example, if a U.S. corporation earns $1.00 per share and pays in dividends $0.25 per share (thereby retaining $0.75 in cash as working capital), the $0.75 per share that they earn will not incur a tax bill and can be applied to the expansion of the business. However, the $0.25 must be subject to U.S. federal income tax, regardless of the tax jurisdiction in which the recipient resides. Ultimately, all the income of a corporation flows to individuals, be it in the form of share price appreciation or dividends, and will ultimately be taxed. However, this money should not be taxed while it is still actively at work in the balance sheet of the corporation.
However, what is stopping a U.S. corporation from stockpiling cash, tax-free, then merging with an off-shore entity operating in a tax haven who can, in turn, pay the cash in the form of dividends to foreign shareholders, effectively avoiding U.S. taxation? U.S. tax law will need to take into account this possibility and should obligate the U.S. entity to file a tax return and declare this income prior to the merger, resulting in a tax bill. What about foreign shareholders of U.S. corporations who do not currently file a U.S. tax return? Dividends paid to foreign investors would have to be taxed at the highest individual marginal tax rate at the time that they are distributed, otherwise a huge loophole would exist permitting corporate profits to escape our borders tax-free.
Also, what is stopping a C-corporation NOT listed on the open market from conducting a stock sale below par value (below the value of assets and cash, less liabilities) to a foreign entity, effectively moving the corporation off-shore, profits in tow, and avoiding a tax bill? Currently, there is no legal obstacle to this practice, so the transfer of shares below par must be prevented. In the open market, corporations often trade below par value, especially if they are facing serious legal problems or if the market for their goods and services has moved against them. However, this loss of shareholder equity is related to a decrease in "goodwill" and this goodwill offsets the intrinsic value of the entity. As long as the shares are liquid and traded in the open market based on accurate public information, the share price will tend to reflect this calculus and no other public policy mechanism should be needed.
Finally, what is stopping a U.S. corporation, with subsidiaries around the globe, from banking profits in a tax haven and absorbing costs in the United States in order to avoid paying corporate income taxes? Well, that is what they do today and my proposal would eliminate the need for this practice, since U.S. corporations could amass profits tax-free right here at home, money that would be held in U.S. banks and which would provide valuable capital for domestic investment.
While there are clearly details to be worked out to avoid possible tax evasion, I believe that my proposals can both simplify and make more equitable the taxation of income. Other parts of the tax code, such as the mortgage interest deduction, the marginal tax rates, the individual and family exemption, etc., are not addressed here. However, I think that by treating all income the same regardless of its source, and by allowing corporations to reinvest their earnings tax-free, the tax code will be fairer and more effective in stimulating economic growth.
In a future post I will explain why the U.S. tax system, which generates almost all revenue by taxing income, creates perverse incentives to consume and not save and why a national sales tax is a good idea.
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