The hoariest of tax chestnuts is that capital gains need to be taxed at a lower rate than labor to encourage capital formation and grow the economy. Because US economic growth depends on the growth of family businesses and entrepreneurs, rather than international corporations whose stock is publicly-traded, lowering capital gains threatens economic growth not enhances it. Low capital gains rates lower the cost of capital for international corporations by raising the price of publicly-traded stocks. Family business owners and entrepreneurs rely on bank financing to start and usually finance growth from their earnings. Under current law, however, grocery store owners, for example, would pay a 35% income tax on any profits from reinvesting in their own businesses, but only a 15% tax if they invested in one of their large public company competitors like Walmart or Target. This shows the failure of the current tax system.
As we discussed before, most family businesses and entrepreneurs pay taxes at individual income tax rates. The Bush cut in the dividend tax rate by more than 60% to 15% provides almost no tax benefit to family business owners; those subject to the corporate tax would prefer elimination of the restrictions and taxes on conversion to a "pass-through" entity. The one benefit to famly businesses of a low capital gains rate is the ability to sell the business at a reduced cost. Once sold to a public company local jobs are often shipped overseas. (Small businesses such as farms that have been unable to fund tax-free retirement benefits might need a capital gains exclusion if the business is sold to allow transfer to a retirement fund.)
In 1986 the Republicans and Democrats united to apply a top rate of 28% to both ordinary income and capital gains. However, they failed to take out the distinctions between the two types of income and it soon returned. Whenever income is taxed in two different ways or at different rates, an entire industry develops to change income from one type to the other. The only way to prevent this manipulation is to eliminate these differences that tax lawyers like myself tend to legally exploit.
Congress often uses the tax system to promote a favored policy -- solar power, hybrid cars, farming, home ownership, education, business investment -- the tax break for capital gains and dividends only favors investment in public companies rather than family companies. It does nothing to ensure investment in productive or American businesses. The reason for the lack of economic growth during the Bush years despite unprecedented tax cuts and government spending is that most of those cuts went to investors who do not create jobs, grow businesses or invest in communities. The key to revamping the tax system and producing economic growth is to lower the tax rate on PRODUCTIVE, EARNED income and raise the tax rate of UNEARNED income such as capital gains. The result will be a lower tax rate for individuals, on labor, entrepreneurship and more investment in family businesses.
The problem is that too many Democrats see the top individual income tax rate as an indication of whether the wealthy are paying their fair share of taxes. This is frankly a mirage; the wealthy can just convert their investment income to capital gains, real estate income sheltered by depreciation and interest or tax exempt municipal bonds. Eliminating tax loopholes and preferencew (which the 1986 tax changes failed to do enough of) while lowering the top rate will make it more likely that the top rate will actually reflect the rate the wealthy are paying. Barack could use these types of tax changes to show that he is a different kind of politician interested in merging Republican and Democratic ideas. More importantly, this type of change links the interests of labor and family businesses on Main Street as compared to corporate interests on Wall Street. This type of tax reform would allow the corporate tax to go to 25% as John McCain has proposed without producing a huge tax revenue loss. Lowering the corporate tax also would mitigate the stock market decline from raising the capital gains tax.
Finally, raising the capital gains tax historically has produced a significant revenue bump if sufficient time is given to sell assets at the lower rate. That revenue increase will help fund a middle income tax cut. Next time we will discuss changes to the FICA and Medicare tax to further correct the unfair taxation of productive, earned income and eliminate the current tilt toward lower taxes for unearned income.
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