How I would have improved tax policy (2 of 2)

In my previous post, I introduced some ideas for how to change a few tax policies to improve our economic headwinds. In short, they boil down to the following:

  1. Capital gains. Increase the top long term capital gains rate to 45% for households generating $1M or more. Start taxing active and passive gains differently.
  2. Corporate taxes. Reduce corporate income tax rates to below 20%, based on a profit-per-employee formula. Shift the tax burden away from companies that demonstrably create jobs.
  3. Payroll taxes. Lower payroll taxes to around 12% (from over 15% today). 
  4. Depreciation and debt deductions. Lower capital depreciation and interest deduction exemptions, such that only 30% of interest and depreciation expenses are deductible.

These tax changes are designed to be revenue neutral, meaning that they don't increase or decrease the amount of revenue the federal government generates from taxpayers. But the changes would meaningfully improve corporate behavior, increase incentives to hire, and shift the tax burden away from labor and onto wealth.

We should lower capital gains taxes for entrepreneurs, not passive investors.

Capital gains taxes are lower than taxes on ordinary income in order to incentivize investment. However, because savings will always seek the highest risk-adjusted returns, households and consumers do not need added incentive in the form of lower taxes to invest their excess capital.

Today’s tax policy also doesn't draw a distinction between active and passive gain: some capital gains accrue to hardworking managers and innovative entrepreneurs, while other capital gains accrue toward wealth owners who often do little other than write a check. This is a mistake. Managers and entrepreneurs who labor daily to build or improve a business should enjoy a significantly lower tax burden than wealthy investors who collect gains while relaxing at their vacation homes.

For those ultra wealthy passive investors, shifting the tax burden toward higher capital gains is an implicit increase in their tax bill. This is due to the fact that over 70% of net taxable capital gains accrue to households making $1M or more in taxable income. While this approach adds roughly $100B in taxes to the top 1%, shifting the tax burden to capital offsets the hazardous systematic outcome of gains accruing to those who are already wealthy.

We should lower corporate taxes for companies that rely on jobs, not software.

Corporate taxation is the subject of all kinds of debate because corporations are considered to be our country's ‘engines of job growth.’ However, not all companies have the same job producing feature. Google and UPS both generate single digit billions of USD in profit annually. However, Google hires around 40,000 US-based employees while UPS employs over 360,000 [5][6]. Tax policy needs to reflect disparity in corporate job creation. Not all companies are created equal.

We should shift the flat corporate tax rate to a labor-based, stratified system to ensure that the companies that create the most jobs per dollar of profit get the most tax breaks. This serves to offset the payroll tax’s negative impact on jobs and wages. However, a large disparity in tax burden across sectors will emerge. The proposed labor-based approach to corporate taxation intentionally attempts to create an economic distortion in corporate behavior that favors labor. The proposed measures would not tip the scale away from investments in capital toward investments in labor, given that the long term value of investments in capital always outweigh investments in labor. However, this approach would more closely align incentives of businesses and investors with the country’s social objectives (wage growth and high employment).

We should cut back the tax burden on low and middle income workers.

While non-labor investments like machinery are easily financeable and given favored tax treatment, investments in human capital are extremely difficult to finance and are punished by the tax code. Companies and their employees each pay the federal government about 7.5% of the employee’s salary. This undoubtedly puts downward pressure on both employment and wages, while likely passing the added costs onto consumers through price increases — it also further incentivizes reliance on non-US labor [7].

A cut to the payroll tax means less regressive taxation in two ways. It places less of a burden on lower income workers, who pay a larger share of their incomes in payroll taxes. It also supports small and new businesses, who spend more of their operating budgets on hiring and retaining human capital. All else being equal, my proposed cut to payroll taxes would likely hurt the budgets of Social Security and Medicare (after all, they draw their budgets from payroll taxes). However, combined with a corporate tax rate that favors labor and a reduced depreciation exemption, total payroll tax revenues are likely to increase. The reduction in rate could be outweighed by higher employment and upward pressure on wages because of added incentives to increase hiring.

We should reduce the giveaway for interest and depreciation deductions.

Capital and equipment are often financed through debt, given that capital is often easily collateralized. Capital and machinery then depreciates over time, creating a tax deductible expense. Because the interest expenses used to finance this capital is also deductible, investments in capital are doubly (and unnecessarily) rewarded in our tax code. Companies already have the incentive to invest in machinery, and to encourage it further through tax breaks is redundant and likely not that useful. 

My proposed drop from 100% to 30% depreciation and interest expense deductibility would have massive implications for certain capital-intensive sectors. Energy, transportation, and materials companies all rely significantly on depreciation to reduce their tax burdens. However, most companies in these sectors already enjoy dramatically low effective tax rates [8].

Final thoughts

I've definitely created more questions than answers here. But despite the outstanding questions, what is clear is the acute need for the federal government to evaluate how to best correct for wealth consolidation and shrinking labor market demand. If wealth continues to concentrate and compound into the hands of fewer households, the tax base will continue to erode while federal budget deficits balloon. If wages continue to remain flat relative to rising household expenses, the federal government will need to step in and further subsidize consumer spending through larger program budgets, or risk neglecting a rising poverty rate. The most precise policy instrument for correcting this dangerous trajectory is tax policy. By broadening and more effectively taxing assets, shifting the tax burden away from business and toward passive shareholders, and reducing the private sector incentive to invest in capital over people, the federal government can stimulate job growth and naturally increase wages while encouraging productive investment.