Monday, May 10, 2010

A More Just Tax, Part I: The Case for Taxation

By Norman G. Kurland, Dawn K. Brohawn, and Michael D. Greaney

It's time for tea. The "Tea Party" phenomenon is the most graphic evidence, short of armed revolt, that the United States federal government has failed to justify its monetary and fiscal policies in the eyes of its citizens. Judging by the fact that confidence is also at its lowest point in years, the obvious conclusion is that the government has failed to justify its very existence and the increasing level of functions and control over the lives of people it currently exercises.

This functional overload, a serious danger in and of itself, is evident in the increasing government regulation and direct interference in the lives of the citizens, but also in the indirect control the State has over money and credit, and the tax system. Misuse of any of these institutions, money and credit, the tax system, and the State itself, inevitably leads to widespread disaffection and, ultimately, chaos if the problems go unchecked and uncorrected.

Nowhere is the State's increasing power over the lives, fortunes and sacred honor of its citizens more evident than in the monopoly over access to money and credit it fosters and vests in the hands of a shrinking private and growing public elite. By this means the State has created a "despotic economic dictatorship," (Quadragesimo Anno, § 105) that exercises such control they "have so firmly in their grasp the soul, as it were, of economic life that no one can breathe against their will." (Ibid., § 106.)

By means of the control it exercises over money and credit, the State effectively who owns, what is owned, and how that ownership may be exercised. In out day, ownership of the means of production is increasingly concentrated in fewer and fewer hands, with the general trend being to vest effective ownership — control — in the hands of the State itself.

The tax system necessarily complements and supports this concentration of economic power in the hands of a private elite and, increasingly, the State bureaucracy. At no time in history have we come closer to the establishment and maintenance of the "Servile State" (Hilaire Belloc, The Servile State. Indianapolis, Indiana: Liberty Fund, Inc., 1977), all the while paying lip service to democracy, freedom, and, inevitably, the vague "capitalism" with the infinity of adjectives preceding it to try and make it palatable. The efforts of the Tea Party movement have, if nothing else, issued a wakeup call to our nation's leaders that our leaders would do well to heed.

The problem is that few, if any of the Tea Party people have a clear idea of what to do to correct the situation. This is understandable. The system is unnecessarily complex, in many cases arbitrary, and the underlying principles so distorted and contrary to the realities of private property, the money and credit necessarily derived from private property, or even the basic principles of taxation that not even the people running the tax and money systems understand the fundamental principles of the system, have a firm grasp on its complexities, or even know how to operate the system properly.

Few Americans today would label the U.S. tax system as either simple or fair. Many Americans believe, and rightly so, that tax breaks are mainly benefiting the extremely wealthy. While the top 5% of Americans account for more than half of all personal income tax revenues, through advantageous arrangements wealthy taxpayers frequently are able to avoid paying anything but a token amount of taxes on their capital incomes. The payroll tax and sales and excise taxes take a much bigger share of disposable income from middle and low income Americans than from wealthy Americans, according to the Institute on Taxation and Economic Policy. (E.J. Dionne, Jr., "Low-Income Taxpayers: New Meat for the Right," The Washington Post, November 26, 2002, p. A29.)

The Source of Capital Financing

Policymakers and academic economists justify favorable tax treatment of property incomes under the erroneous assumption that there is no other way to stimulate new investment in capital and create jobs. Under the current United States Internal Revenue Code, capital gains are given favorable treatment under the assumption that existing accumulations of savings, by definition a virtual monopoly of the currently wealthy and of the State via its presumed monopoly over the creation of money and credit, are required to form new capital.

The reasoning is a little convoluted, as befits the complicated tax system it justifies. Take the example of capital gains. Absent the speculative influence of the stock exchanges, capital gains are in large measure generated by corporations retaining earnings. The theory is that retained earnings are used in the financing of new investment. This, in theory, increases the value per share which, when the shares are sold, generates a short- or long-term capital gain. This gain is then, presumably, used to finance additional new capital, which allegedly creates jobs.

To encourage new capital formation, and presumably create jobs for non-owning workers, capital gains are traditionally given favorable tax treatment, either a lower tax or no tax. Since the rich, by definition, control the vast majority of directly held corporate equity and thus the source of capital gains, favorable tax treatment of this source of income generates substantial tax breaks for the wealthy. This exacerbates the wealth gap and the rigid stratification of society into a small minority of capital owners and a large majority of capital-less workers.

The problem, of course, is that retained earnings are not the source of new financing for capital. This can easily be demonstrated by the application of basic accounting principles. The financing of new capital formation is not charged to retained earnings or any other type of owners' equity. Claiming that retained earnings are used to finance capital formation confuses property (the natural right to be an owner and the bundle of rights that define how an owner may use what he or she owns) — owners' equity — with the thing that is owned — assets. Instead,
• If the new capital is paid for in cash, the charge is to cash, an asset account, not retained earnings, an equity account.

• If the business finances new capital by borrowing, assets are increased, offset by an increase in liabilities, not by a charge to retained earnings.

• If the business finances new capital by an issue of shares, assets are increased, offset by an increase, not a charge, to capital stock, not retained earnings.
Revenue generated by operations is used to defray current expenses, meet debt service payments (the principal being expensed through depreciation), and distribute profits by the payment of dividends. Retained earnings and other equity accounts are not a measure of cash, but of net assets, of which as little as possible should be in the form of cash. Owners' equity represents the net value of the business enterprise, as we see from the classic "accounting equation": assets equals liabilities plus owners' equity.

The net value of an enterprise can be used to secure a loan for the purpose of financing new capital formation. The net value of the firm, already in the form of capital assets, is not typically liquidated to finance acquisition of replacement capital assets, but used as collateral for additional capital assets. From an accounting point of view there is no justification for treating property income any differently than income from wages or any other source for tax purposes.

The Purpose of Taxation

Any reform of today's overly complex, inherently unjust tax system must start with the simple question, "Why do we have a tax system?" From the standpoint of Capital Homesteading, the answer is simple: to yield the revenue to pay the costs of limited government, without damaging the incentives for maximum production of wealth and the broadest distribution of capital ownership. From this, a whole new set of conclusions follow:

The bias in the present tax laws against property accumulations by those who currently lack ownership of the means of production, and the disproportionate tax on property incomes should be removed. The bias in favor of redistribution of the fruits of ownership (income), as a practical matter, must be more gradually phased out, as redistribution of income is supplanted with an effective program of redistributing future ownership opportunities. The tax system and federal laws generally should be restructured to encourage the creation, accumulation and the maintenance of property, its widespread distribution among all households, and the maximum generation of new wealth and improved technology within the free enterprise system.

Government should announce a target goal for the economy of a minimum floor of capital self-sufficiency for every household to achieve within the next thirty years. A national ownership plan, including new tax laws, would be launched to reach that goal, similar to the manner in which government assisted Americans in the building of our agricultural base through the Homestead Act of 1862. The target date for enacting this Capital Homestead Act should, for both practical and symbolic reasons, be 2012, the 150th anniversary of Abraham Lincoln's original Homestead Act.

The original Homestead Act generally limited a homesteader to a quarter section of land — 160 acres. This 160-acre ceiling made sense in distributing shares of our necessarily finite land frontier. The amounts that could be accumulated under the proposed Capital Homestead program, however, are limited only by our talent, our know-how, our technological potential, and our ability to mobilize all our resources in building a new and more productive industrial frontier during the next several decades. Hence, in today's world, a target floor of assets that can be accumulated on a tax-deferred basis, tentatively set at $1 million, is more appropriate than a ceiling as the focus of government initiatives under a national ownership program.

An effective tax system would offer incentives for the enterprise system itself, as the principal source of wealth production, to become a more direct and efficient distributor of mass purchasing power for all consumers in the economy.

Under Capital Homesteading, the need for income redistribution and governmental intervention within the private sector will lessen to an irreducible minimum. The functions and costs of government should thus drop progressively. Eventually government activity and expenditures will fall to the tolerable levels projected by the Founding Fathers. Instead of constricting private initiatives and production, as under today's tax laws, government under a soundly conceived national ownership strategy would become the catalyst for stimulating expanded production of a more competitive free enterprise system.

Since the wealth necessary to cover the costs of government is a product of private labor and private capital, taxes should be viewed as charges to consumers for essential services not available through the private sector. Unlike other services, however, the buyer of public services is compelled to buy. Further, the government remains the sole seller, at least until these same services can be satisfactorily provided through the competitive enterprise system. This seemingly minor change in emphasis could open up some new ideas for privatizing (democratizing) government services and new opportunities for creative businessmen.

Taxes: A Basic Problem

Viewed from the challenge of bringing about lasting and just economic recovery, the tax system in the United States is, to all intents and purposes, an abomination — and the United States is generally recognized as having one of the most just tax systems in the world! "Most just," however, does not necessarily mean "just." It means only that the U.S. tax system may be in general less unjust than in many other places. To take a single example of injustice embedded in the system, by separating Social Security taxes from the general tax rate, individuals whose wage income is inadequate or barely adequate to meet common domestic needs adequately pay a heavy regressive tax on every dollar they earn, while individuals who derive their incomes from non-wage sources escape taxation for Social Security and Medicare altogether.

To correct this specific injustice, then, we advocate merging the Social Security and Medicare taxes into general tax revenues, while keeping all promises to Social Security and Medicare beneficiaries through an expanded federal tax base sufficient to cover current levels of benefits. This would put an end to the nation's most regressive tax by vastly increasing the standard exemption and eliminating all deductions. This "two-tiered" exemption (one level for non-dependent taxpayers, and one level for dependent taxpayers) plus the Capital Homestead deferral would apply to all income from whatever source derived. The myriad of other personal tax deductions, credits, and other "tax expenditures" would be eliminated, so that a family could fill its annual federal tax return on a postcard-sized form (some supporting schedules may need to be prepared and adequate accounting records maintained in case of audit; this refers strictly to filing requirements). The single reformed tax rate would then apply across the board to all income from whatever source derived above the standard exemption plus the Capital Homesteading deferral.

We also advocate reforming Social Security and Medicare, as well as other entitlements that account for two-thirds of the Federal budget, in accordance with CESJ's Capital Homesteading proposal. This "social safety net" will then be properly understood as a supplement to wage and investment income, instead of the primary source of income for so many. Our proposal has the potential to cut the federal budget by as much as two-thirds, while gradually phasing out taxpayer-supported entitlements to workers and the poor when their Capital Homestead incomes equal or exceed entitlement incomes. It would also increase in the short run individual incomes of the poorest Americans by instituting a "negative income tax" supplemented with vouchers for health insurance and education. Further reductions in the federal budget would result from the fact that direct payments to the poor (until they begin to earn Capital Homesteading incomes) are easier, less dehumanizing, and less costly to administer than the current entitlement system.

At the same time, we advocate the imposition of a single rate tax on all personal income above the standard exemption plus a deferral for every citizen to begin to save and accumulate income-producing assets through tax-sheltered vehicles like Capital Homestead Accounts. Further, by making corporate dividends tax deductible to the corporation, yet fully taxable at the single rate to individuals, the corporate tax can, for all practical purposes, be eliminated in a way that would ensure more equitable access to ownership rights by every citizen.

Making dividends deductible at the corporate level would eliminate the double and sometimes triple tax on corporate profits. This is a form of discrimination against corporate profits that erodes the institution of private property. The only political justification for double or triple taxation of corporate profits is that, since most members of society have little or no access to capital ownership and the profits to which owners are entitled, there is no widespread public outcry against the obvious injustice of taxing income more than once.

These injustices can largely be corrected if we:
• Increase the number of people who have a significant stake in corporate equity, thereby increasing the number of people who have a stake in reforming the tax system along more just lines,

• Eliminate reliance on the accumulations of the wealthy in the form of retained corporate earnings as the principal source of new investment,

• Make dividends tax deductible at the corporate level, and taxable as regular income at the personal level — after merging the regressive Social Security and Medicare taxes into a general single tax rate,

• Replace reliance on retained earnings as the principal source of financing of new capital with money created through the banking system backed by the newly formed productive assets that are financed with the newly created money — a process in which every citizen has an equal and democratic opportunity to participate, limited only by the per capita amount of financially feasible capital formed each year, and the financial feasibility of specific investments in which a citizen has the opportunity to invest, and thereby,

• Create incentives for corporations to pay out profits in full in the form of tax-deductible dividends that will enable the most wealthy Americans to increase their consumption spending instead of reinvestment, increasing effective demand throughout the economy, creating more private sector jobs in companies that are more competitive in global markets, and opening up more opportunities for broad-based ownership of the newly added means of production.
As a result of incentives for corporations to pay out profits in full, companies will need to seek new outside sources of funds to finance corporate growth and transfers of existing equity shares. Ownership-expanding vehicles such as the proposed Capital Homestead Accounts (or workers using leveraged ESOPs under current laws) will fill the hole left when retained earnings are paid out for consumption instead of reinvestment, and interest-free "new money" is channeled into capital credit for workers, customers, and the public at large.

With guaranteed democratic access to capital credit for financially feasible projects, every citizen, whether or not he or she currently owns any capital in any form, will be empowered to purchase newly issued or transferred shares, and repay the capital credit extended for the purchases out of the "future savings" made possible from the full distribution of profits on shares acquired by the newly economically enfranchised capital owners. This is known as "self-liquidating" or "procreative" financing. Self-liquidating credit is a conventional technique that works when productive assets are in the hands of competent managers, especially within corporate cultures that conform to the participatory principles of Justice-Based Management.

The rationale for reforming the tax system and making dividends deductible at the corporate level is to surmount the tidal wave of complexity, costliness, and inequitable treatment that results from a tax system based on the erroneous assumption of the architect of the modern Welfare State, John Maynard Keynes, that only past savings (existing accumulations of wealth, or "old money") can be used to finance the formation of capital.

From this flawed Keynesian assumption, post-Depression legislators engineered a vast, intricate Federal tax superstructure that has created a multitude of tax incentives in which "capital breeds capital" . . . but mainly for existing owners. Consequently, the tax system creates new capital in ways that systematically widen the gaps in capital ownership and economic empowerment between the top 1% of Americans and the bottom 95% whose combined assets are less than that of the tiny elite of rich and super-rich.

For the bottom 95%, "social engineering" and redistributive features were added to the tax code to "persuade" people to act in ways that those holding economic power deemed socially desirable. Thus, tax policy neglected to take into account the well-established historical fact that during periods of rapid capital expansion the financing did not come from existing wealth accumulations, but from the creation of new money through the banking system. (See Harold G. Moulton, The Formation of Capital. Washington, DC: The Brookings Institution, 1935, 40-47, 104.) The present federal tax system represents a virtually insurmountable barrier to widespread participation in capital ownership, corporate governance, and the broad distribution of capital incomes from advancing technologies.

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