Copyright Ó 2003, by Alec Rawls

The Bush administration is proposing two tax cuts that aim to exempt investment income from "double taxation." One would exempt dividend income from taxation and one would broaden Individual Retirement Account programs to cover more types of individual savings in larger amounts. If passed, the effect of these tax cuts will be a drastic shift of liquidity from young to old that will greatly depress child-bearing in America. Social Security is already waging war on the young. That burden is about to be doubled.

Tax cuts are dearly needed, but we need the right tax cuts: across the board cuts that lower marginal rates or all, not targeted cuts that force higher marginal rates on the remaining tax base, and certainly not perversely targeted cuts that make people poorer during their reproductive years.

On the surface, the proposed tax changes look sensible. Take dividend income. It is currently taxed the same as earned income, while capital gains are taxed at a much lower rate. This gives shareholders a tax reason to prefer companies that retain earnings rather than pay them out as dividends. As a result, companies are flush with cash, which company officers can squander or loot, which we have seen a lot of in recent years. It has clearly been a mistake to discourage the paying out of dividends. They yield direct information about corporate performance, while retained earnings can serve as a rug under which a lot of dirt can be swept. Not that government should discourage retained earnings either. It should STAY OUT of the social engineering game.

Now pull back and look at the forest. Yes, treatment of capital gains and dividend income should be equalized, but by fully taxing both, not by exempting both. The fundamental conservative tax principle is that taxes should be broad based and low. Narrowing the tax base by granting exemptions has two perverse effects. First, it means tax rates on the taxed portion of income have to be higher to reach any particular revenue target. Second, it constitutes improper social engineering, using tax incentives to meddle with what are properly private choices. Inventing a new exemption to match an existing exemption causes the tax base to narrow even further, causing tax rates to rise even further. It is trying to make two wrongs into a right.

Given the size of capital income, exempting it from taxation will be disastrous. Historically, total income has consistently broken down into about 2/3's labor income and 1/3 return to capital. If all income is taxed the same, taxes on labor will supply 2/3's of the tax revenue, but if capital income is exempted from taxation, taxes on labor will have to foot the entire tax bill. To reach any particular revenue target, labor taxes will have to be 50% higher than under a broad based tax.

The social engineering implications of this change are very bad for the future. Just look at who receives capital income: the old. People borrow when young, pay off debts and accumulate assets in their prime working years, then live off capital income when they retire. Thus tax exemption for capital income creates a huge shift in liquidity from youth to old age, exactly the opposite of what people are trying to accomplish when they borrow in youth. It also creates a huge transfer of income from today's young (who have to foot the nation's entire tax bill with their labor income) to today's old (who did not have to foot the nation's entire tax bill with their labor income).

To look at liquidity effects of tax exemption for capital income independent of distributional effects, take the best case scenario. Suppose parents take their tax windfall and use it to increase the inheritances they pass on to their children. The young are not getting completely screwed over. They will get the money eventually. Just not until they turn sixty and their parents die. Instead of having money (their own money, don't forget) when they are young and could use it to buy houses and support families, people have less money to spend on making a life and more to spend on retiring from it.

The worst effect is that the young won't be able to afford children during the relatively short period when they are biologically fit for making them. A tax exemption for capital income is profoundly anti-natalist.

Non-conservatives still operate under the delusion that human reproduction does more harm than good. Conservatives, in contrast, are alert to the developing tragedy of western population implosion. Anti-natalist tax policy from supposedly conservative policy-makers is really dropping the football.

It is an easy football to drop. Defenders of the dividend exemption note that taxation of dividends constitutes double taxation, since the same corporate income is also taxed through the corporate profits tax.(1)  This is indeed a serious problem. Double taxation is not NECESSARILY inefficient. There can be reasons to employ a division of labor between different kinds of taxes, both of which can impact the same income stream. But the double taxation of profits IS highly inefficient. Not only is there a doubling tax filing requirements, but the combined marginal rate becomes punitively high (60% for the top tax bracket).(2)  Thus double taxation needs to go, but it is the profits tax that needs to be eliminated, not the dividend tax.

The corporate profits tax is the epitome of a narrow based tax that creates large distortions. Not only is the tax high (35%), creating a large incentive to evade it, but corporations have the resources to evade it, both by strategically distorting their behavior and by lobbying Congress for special exemptions. As a result, the small amount of money that the profits tax raises pales besides the distortionary harm it creates.

I can hear the left squawking now: "You would let these squanderous corporate fat-cats get away without paying taxes?" But far from reigning in indulgent corporate behavior, the profits tax creates it. Every $300 night at a fancy hotel, every $700 business dinner, every $3000 first class business flight, is subsidized 35 cents on the dollar by taxpayers. Corporate luxury by government bribe. THAT is your profits tax. Flush it.

Eliminating the profits tax while treating capital gains and dividends the same as earned income would yield a broad based tax system that minimizes meddling with private choices. Childbearing would be neither encouraged nor discouraged.

These changes alone would not constitute much of a tax cut. (Corporate profits tax out, capital gains tax up.) But taxes SHOULD be cut, in the same proportion as government now spends on things that it shouldn't. That is, taxes should be cut DRASTICALLY. To implement this relief, the proper target is across the board rate cuts for all capital and labor income.

The taxing of profits both at the corporate level and when profits are paid out to owners is a clear case of inefficient double taxation. In their book The Flat Tax Robert E. Hall and Alvin Rabushka suggest it is also a kind of double taxation to tax investment income both before it is invested and after returns are received.(3)  This is a misnomer. Note that taxation of labor income could also be called double taxation on the same grounds, because consumption can also be seen as an investment: in future labor income. Consumption is taxed both before it takes place (i.e. it is paid for out of after-tax income) and it is taxed again when the labor income that it creates is taxed. But if we were to eliminate these kinds of "double taxation" on savings and consumption, the result would not be single taxation but NO taxation, indicating that these kinds of taxation are not actually double taxation at all. They are single taxation on each increment of income.

Hall and Rabushka effectively acknowledge this when they note that the result of exempting capital income from taxation is a pure consumption tax.(4)  Neither do they rely on the charge of double taxation to justify tax exemption of capital income. They put the argument where it should be, on the merits of the pure consumption tax that results when capital income is untaxed.(5)

A consumption tax is said to embody the principle that "people should be taxed on what they take out, not what they put in."(6)  Many people have found this to be a compelling argument for a pure consumption tax, but it is wrong, and for just the reason noted above. There is no clear distinction in terms of "putting in" and "taking out" between investment and consumption because consumption is also an investment. It is an investment in people's lives, creating future productivity, and it is not the business of government to be favoring investment in corporations over investment in people. Government needs to stop using the tax code for social engineering, period.

In particular, whether we call it a pure consumption tax or a pure labor tax, the effect of exempting capital income from taxation is to drastically shift resources from the young to the old. However unjust one thinks that would be, it will certainly have a profoundly negative effect on childbearing. This is not something that government should be trying to effect.

The recently proposed expansion of individual retirement accounts is another perverse exemption, very similar analytically to the dividend exemption. At the tree level, it seems to make sense. Since favoring savings for retirement has an anti-natalist effect, allowing savings in general to receive the same tax exemptions that retirement savings presently receive would seem to be a step in the right direction. But just because favoring savings for retirement is especially bad does not mean that favoring savings in general is good. Per dollar, a general exemption for investment income does not do AS MUCH anti-natalist harm as a special exemption for retirement income, but it still does anti-natalist harm by shifting liquidity to the old. It is still government social engineering in the wrong direction and would greatly expand the scope of this perversity.

We are already stuck with a horribly anti-natalist Social Security program that strips income from the young to support the old. Even if the young get the money back in their inheritances (a big if) it comes too late to support the productive part of their lives and greatly depresses their ability to afford children. The population implosion being experienced by all advanced societies has many causes, but surely one of the largest is the socialization of retirement.

If the socialization of retirement has caused people to stop saving for their own retirement to the point where tax incentives to save seem to be called for, the obvious solution is to get rid of social security. Make it need based rather than a retirement program. The principle is very simple: two wrongs do not make a right! To compound the socialization of retirement with tax exemptions for capital income would DOUBLE the anti-natalist burden that Social Security imposes on the young.

As for the distributional injustice of making working people pay all the taxes while those who live off of capital income pay nothing, we don't even have to go there. Tax exemption for capital income is even more wrong on other grounds. Instead of broad and low taxes that minimize distortions, we get narrow and high taxes that impose the worst possible distortion: the non-reproduction of western society.

Alec Rawls is a columnist for The Stanford Review. Contact him at alec@rawls.org. This article was originally published in the Review, 1/2003.

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Endnotes

1. See for example, the arguments put forward by Americans for Tax Reform in their position paper "Top 10 Reasons Why Double Taxation Of Dividends Must Be Abolished" (available at www.atr.org/opeds/012903atr.html).      Return

2. For each dollar of profit, the profits tax leaves 65 cents. When distributed as dividends, shareholders in the top (38.6%) tax bracket get to keep .614 x 65 = 40 cents.     Return

3. Hoover Press, 1985, p. 57.     Return

4. Ibid.      Return

5. That a pure consumption tax implies a pure labor tax and vice versa can be seen by following a number of equivalences. Start with the Hall-Rabushka plan, which exempts investment income from taxation by allowing investment expenditures to be fully expensed by companies (deducted from taxable corporate profits) at the time that they are made. Income streams from investment are then taxed through a business profits tax as they are received by businesses. To see that this constitutes a consumption tax, note that an equivalent scheme would be to deduct savings from taxable income in the personal income tax while eliminating the business tax for the investment spending that personal savings pay for. To see that both of these formulations give rise to a pure labor income tax, note that they both employ an up front deduction for savings/investment while taxing the income streams that investment generates when those streams come in. Equivalent tax schemes can be generated by eliminating the up front deductions and replacing them with downstream deductions. The Hall-Rabushka scheme, with up front expensing of investment expenditures, is equivalent to having no up front expensing but eliminating the taxation of profits as they come in. Similarly, a personal tax deduction for savings with taxes paid on dividends, capital gains and other capital income streams as they come in (or alternatively, in conjunction with a business profits tax) is equivalent to having no up front personal deduction for savings while exempting capital income from taxation as it is received. In both of these cases, where the up front deduction is replaced with a downstream deduction, savings/investment comes out of after tax income, but the increment of income that it generates is not taxed at all. That is, they achieve a pure labor tax. Ergo a pure consumption tax implies a pure labor tax and vice versa.      Return

6. Ibid.    Return