SEIFFE:  Taxing Objectives

Thursday, November 10, 2005

By Ralf Seiffe

Last week, this column -- and many others -- excoriated the President’s Tax Commission for timidity, limited vision and for political expediency.  The Commission’s work has, deservedly, sunk faster than the Arc Royal, though one hopes with more survivors.  

The trouble is that after finding that the present system is an impediment to a growing American economy, the Commission managed to recommend two plans that confirm the status quo.  With the exception of ending the Alternative Minimum Tax, their two recommendations don’t look much different than a stripped-down version of our current code.  The two plans, advertised to simplify tax preparation or to create capital, aren’t enough to separate the United States from the rest of the world and give us the advantages we’ll need to succeed in the ultra-competitive 21^st century.  

One possible reason for the Commission’s limited vision may have been the charge given it by the President; he insisted on progressivity and an incentive for home ownership.  This may explain why their proposals involved only income taxes and that the specifics included only income and deductions or credits.  Only indirectly do the proposals aim at reducing consumption and improving capital formation.   

Nevertheless, the Commission’s limited vision does not serve the American economy.  It leaves income as the basis for taxation, it is still too complex and, perhaps worst, it does not do enough to directly protect American living standards in a rapidly industrializing world.   

Our economy faces a paradox over the next generation.  On the one hand, jobs continue to move off-shore and the jobs that remain are under pressure from rapidly improving productivity.  This is an inevitable by-product of the industrial economy and continues the exodus that began in New England more than a century ago.  Textile and shoe-making first moved south then overseas to lower costs.  Many products went to China but the process continues there; low-grade manufacturing is moving to even lower cost economies, leaving Chinese workers displaced.  

The other side of the paradox is that our birthrate is so low that we are experiencing a labor shortage, especially in unskilled or semi-skilled jobs.  That’s why the immigration problem is so intractable; we would like to close the borders for reasons ranging from security to jingoistic but we really do need the labor.  

Designing a new tax system needs to recognize this dilemma and junk the current tax system.   Even if it tramples on some of the current beneficiaries -- politicians, insurance companies, lawyers and accountants -- the greater good demands that our leaders have the courage to change. The very real inefficiencies the Commission identified need to be rectified.   

We need to go back to the drawing board and design a visionary, new tax system.  The question is where to start?  I suggest what we need is to recognize why our country has been successful in the past and do more of it.  So for what it’s worth, here are a few suggestions for setting objectives for a new tax system.  

There are as many reasons for American success as there are Americans but a couple of themes emerge that help explain this country’s extraordinary accomplishments.  At the top of my list is the concept of American ingenuity.  The basic design of any new tax system should first be one that treats capital better than any other market.  This was easy when the US economy was 25% of the world’s economy and the rest of the world suffered under illiberal governments.  Now, however, foreign economic thinkers are designing tax systems to be part of their economic strategies and arsenals.  We need to do more than match these capital-friendly systems -- we need to beat them by making investors a better deal.   

Financial capital now moves with the speed of light as capital markets are developing across the world.  A generation ago, the US markets were the definition of opportunity and safety but now, bourses in Eastern Europe, Asia and India offer alternatives.  Because their markets are less efficient, returns in these new markets have more risk and, therefore, greater average returns.   

China has now become the world’s most attractive capital market with net inflows exceeding those to the United States for the first time.  Since returns are the sole reason for investment, anything that reduces investment returns has the hydraulic effect of reducing investment.  By placing a 35% tax rate on US investments returns, we handicap ourselves because new ventures must overcome our competitors’ cost and increasing technological advantages but also the outstretched hand of the tax collector.    

This is the primary reason to abandon income as the basis for taxation. By lowering taxes, we directly increase returns to capital and that will encourage more to occur.  For this reason alone, any long-term fix must jettison income, especially investment income, as the basis for taxes.   

Another reason to abandon income as the basis for taxes is to remove the temptation politicians feel to adjust the system.  Each time there is a change in rates or the regulations, the expected value of an investment changes.  Changes in expectations is the definition of risk so one object of a 21^st Century system should be to eliminate taxes as a source of risk.  Here’s why.  Consider two investments, each taxed at an average rate of 15%.  One has a rock-steady rate while the other has a rate that’s up one year and down the next.  Long-term investors, the kind that create jobs, will choose the former every time.  

Humans respond to freedom in the same way.  Since the very first ship arrived with settlers at Jamestown, the world’s most inventive, adventurous and smartest people have come to America.  Our gain has been the rest of the world’s loss and any new taxation system should recognize that immigrants have an extraordinary capacity for self-improvement and their achievements bless us all. Rather than build fences and deny entrance to all, we should build obstacles that test the resourceful and keep the quality of those coming here high.  

Ralf Seiffe advises business start-ups and product launches from Chicago, Illinois and is a political analyst and columnist for the Illinois Leader.