Taxes and Fairness

I heard someone say recently that it isn't fair to tax money twice. This person is of course referring to taxes on dividends and investments. The theory is that the income from the company is already taxed, and that income is then used to pay dividends to investors. So the investors should not then be taxed.

I feel like there is some nuance as to when the income is actually being taxed twice - in other words only when it is dividends and not when the stock value appreciates and the stock is sold, but I need to think that through some more. But that isn't even the real point. The real issue is over how we understand fairness.

Now, on one level, I could just say that we have different understandings of this very subjective term "fair" and leave it at that. But you know I can't really do that. So let's look at what is fair or unfair about taxing investments.

First of all, who would this tax be unfair to? Who gets hurt by being taxed twice? The money is being taxed twice, but money is inanimate, so it can't feel oppressed or burdened. So it must be unfair to the investor. The person who is investing is typically wealthy, so why is it unfair to tax their money? Is it more fair to tax what someone earns through work than what someone earns without doing work but by giving someone money? I would think it the other way around. I would rather tax the investor than the worker - the teacher, the police officer, the farm worker, the construction worker, the miner, etc. Or I would rather tax them both and at the same progressive rates.

In fact, let's compare apples to apples. Say there is someone who goes to work everyday as a Wall Street trader and makes $5 million a year in salary and bonuses. And there is someone else who has a trust fund or made a ton of money they earned previously and makes $5 million a year from investments. Why should the investor who stays home everyday while his money is working pay less taxes? I can't think of a good reason.

But does the person really think it is unfair to the investor? Maybe what they really mean is that it provides a negative incentive to the investor. I am sure there are some more detailed analysis by economists on how a higher tax rate - or a tax at all - on investments will affect the level of investment. But let's look at one simple example instead.

Imagine someone with net worth of $250 million. Let's say his name is Bitt Nomrey. Now, would he refuse to invest that money just because there were taxes on the income? A 15% tax rate didn't stop Mitt Romney from investing. Would a 30% tax rate stop him?

Sure if the taxes were 90% he might not invest. But if the taxes were the same as our current income tax rate, he would definitely invest the money. He makes income, pays some taxes, but still retains the overwhelming amount of what he earned from the investments.

So I ask again, who is this unfair to? Or how does it affect investor choices?

Buffet Rule: Not a Fan

I'll be honest - I don't love the way Obama is pushing the Buffet rule.


The problem with the Buffet Rule is that, even if we think it is being proposed genuinely (and not as a political stunt - which is what it really is), it doesn't come close to solving the problem we all know exists, which is that the wealthy don't pay as much in taxes as they should if we are really to have a progressive income tax.

There are proposals to solve that problem. They include eliminating some tax deductions and increasing taxes on capital gains. Since nothing Obama proposes (not the real solution I just mentioned nor the Buffet Rule) is likely to get passed, it seems to me Obama should propose the one that is a real policy solution. But he doesn't want that. He doesn't want a big detailed plan that might have some unpopular elements. Instead, he wants a quick, and absurd, political win.

This is going to be a long and disappointing campaign.

The Reason for Taxes

Democrats are often accused of favoring redistribution of wealth. I think that is inaccurate. Some liberals may feel this way, but I think most do not. And I especially do not feel this way. Instead, I believe in having energetic government that protects rights (courts, regulatory oversight), provides for growth (education, research, and infrastructure) and helps those at the bottom (by providing social safety net, food and housing) and helps them move up (education, job training).

In order to achieve this, we need to raise revenues. If we agree that we need these programs, and I think a majority of Americans do agree, than we need to pay for it. And to do so, the burden should fall on everyone, but the rich should pay more. This is why we do, and should, have a progressive income tax structure. It isn’t to punish the rich. It is to pay for necessary programs.

Furthermore, talking about who should pay for the services we need, and pointing out that the rich keep trying to get tax cuts at the expense of the poor is not class warfare. Implementing policies that actually do increase the burdens on the middle and lower classes so the rich can pay less is class warfare.

Flat Tax v. Simple Tax

There has been a log of talk lately about the need to simplify the tax code. Let's start by assuming that is true (at the end of this post, I'll briefly address whether it is true). Right now, we have a tax code that is both progressive - meaning tax rates change as income changes - and has a lot of exemptions and deductions.

What makes the tax code complicated are the exemptions and deductions, which are numerous and the wealthy can use to decrease their tax liability. The progressive nature of the code is not what is complicated. In fact, without exemptions, figuring out your tax liability would be simple. You pay a certain percentage on your income below a certain amount, and a higher percentage on income above that amount.

What we are seeing from Republican candidates are proposals for flat taxes, which eliminate deductions and the progressive tax code. They are trying to make it sound like a flat tax is necessary to simplify the code while hiding that what will really happen is a tax cut for the wealthy. They are also adding back in some exemptions (Herman Cain's 999), which seems to be the worst of both worlds - a regressive tax that remains complicated.

Before I end, I do want to address whether the complication is necessary. The exemptions and deductions are used to incentivize certain behaviors. We can argue the merits of each exemption, but in general, we should decide whether we want a simple code and forgo providing incentives for things like homeownership, donations to charity, and affordable housing to name a few.

I don't have a strong opinion at the moment. I would rather affordable housing be provided through direct spending rather than tax spending. However, I realize tax spending is easier to implement than direct spending - contrary to rational economics models, there appears to be a psychological difference between the two. And I think charity spending is often to museums and private colleges, which may not be the most deserving or urgent needs. But I could be convinced that we need the incentives if there are better examples.