I wrote a couple of weeks ago about the real fiscal cliff that threatens to send the American economy into a steep decline – which is not the prospect of the top marginal rate on wage income rising by nearly five percentage points, but the prospect of the tax rate on corporate dividends rising by nearly 30 percentage points and the tax rate on capital gains rising by nearly 10 percentage points.
If President Obama and Congress do nothing, current law will jack top federal tax rates on some investment income up to 43 percent (including the surcharges imposed by Obamacare). America will have the highest combined rates on corporate investment in the developed world, as well as relatively high rates on overall capital formation and estates.
Smart investors, CEOs, and entrepreneurs are already bracing for impact. As Triangle Business Journal recently reported, “large numbers of business owners are scrambling to sell their companies before January” because “for many, the currently lower tax rate translates into tens or even hundreds of thousands of dollars.”
This is what happens in the real world when politicians indulge the prejudices they harbor in their fantasy world. Taxes affect the prices of labor, resources, and capital. They push people into making decisions they wouldn’t otherwise have made, with largely deleterious consequences for the economy as a whole.
There are two reasons why the tax code, in order to be neutral with respect to economic decisions, must treat wage income differently from investment income.
First, a significant portion of investment income comes from owning stock in taxable corporations rather than pass-through entities such as partnerships, subchapter S corporations, or LLCs. When the corporate tax was first enacted in the 1890s, Congress was responding to a U.S. Supreme Court decision striking down a new personal income tax as unconstitutional. Taxes on corporations didn’t have the same legal problem, so Washington imposed a tax that everyone knew was really an indirect means of taxing the personal income of those who owned corporate stock.
Once the 16th Amendment was added to the constitution, allowing for the reintroduction of a federal tax on personal income, Congress should have nixed the corporate tax as duplicative. Naturally, it did not. Multiple bits on the same apple yielded what was, to them, a greater amount of juicy fruit.
The accounting really isn’t complicated here. When corporations pay wages, that money is deductible to the business and taxable to the worker. But when corporations pay dividends to shareholders, the money is taxable on both ends. That’s unfair, illogical, and economically destructive.
The second reason why investment income is trickier to tax than wage income has to do with the flow of funds. If government taxes the resources used to generate income, and then taxes the resulting income, it is also engaged in double-taxation. With workers, costs such as office space, raw materials, supplies, electric power, and on-the-job training are deductible, while the resulting income paid out to workers is taxable. So far, so good.
But with investment, the tax treatment is inconsistent. Government should either tax the principal of the investment (the money you put into your mutual fund or savings account) or the return (the money you receive in interest, dividends, or capital gains). Current IRA and 401-k rules provide for this as long as you meet certain limitations, income caps, and program regulations. If you don’t – and many large-scale investors legally cannot – then both your principal and your return are taxable, with deleterious results.
It might surprise you to learn that most industrialized countries have a better handle on the tax treatment of investment than America does, including many European countries that are otherwise hostile to free enterprise. For example, Belgium’s integrated tax rate on capital gains from corporate stock, all levels combined, is currently 34 percent. In the U.S., that integrated tax rate is currently 51 percent and will rise to at least 57 percent in 2013 under current law.
If Belgium can get this right, why can’t we?
Hood is president of the John Locke Foundation and author of Our Best Foot Forward: An Investment Plan for North Carolina’s Economic Recovery.