Reducing Middle Class Taxes

"There is only one way to kill capitalism - by taxes, taxes and more taxes." Karl Marx

Every time I sit down to write about taxes I get bored and fall asleep. This is sad because the way a society is taxed is important to the way it consumes and spends. Since the start of the nation, US tax code has changed thousands of times. Yet over this period the percent of GDP consumed by the Federal Government has remained consistent. For any group to point to some distant past as an ideal that is some how the best and fairest tax system is foolish, lacks an understanding of history and only supports a preconceived prejudice.

Since the 1950s the percentage of GDP consumed by the Federal Government has varied from 16% to just over 20%. Such a consistent percentage indicates an efficient US Federal Government, limits to economic growth caused by the size of government and the level at which a society will permit themselves being taxed before revolting.

What has not remained consistent is the complexity of the tax code. With each change there is a dual between tax consultants and the government carving up more and more of the tax dollar in tax avoidance. Worse, attempts to use the tax code to stimulate economic or social sectors often result in bazaar unintended consequences. The greatest burden of complexity falls on middle income earners and small companies.

Since the late 1970s there has been a trend of flattening the tax code. Where the highest tax rates in the 1950s was ~90% the highest is now reduced to a third with advocates for the wealthy arguing they are still over burdened with taxes. The greatest burden shift however occurred in Social Security taxes. The result is a squeezing of the upper middle income producer while those at the extraordinary income levels are encouraged to shift income offshore.

The genius of the 1950-60s tax system, destroyed by Reagan / Bush conservatives, encouraged the wealthy to invest in the US. All investment was directly deductible against ordinary income. Thus upper income earners redirected large portions of income towards investment creating more middle class jobs and causing the economy to boom in a win / win fashion. There was a trend away from encouraging investment and towards encouraging consumption. The boom in demand for luxury goods (often foreign) resulted from dramatic shifts in the tax code since the 1980s. Ironically each shift in the tax code has been labeled tax simplification.

The greatest shift in discouraging investment comes from capital gains tax reduction. By lowering capital gains taxes more money is encouraged out of investment channels and into consumption. This shift has also contributes to volatility in investment markets.

The key to a robust and growing economy is the re-investment of capital. Capital gains tax at any level reduces available capital and discourages capital flowing to the most effective and efficient areas of investment. As governments shave off a portion of the gains from each transaction the economic engine is penalized. Since economic growth is always confined to narrow band (in an industrial economy 4% to 10% has been historic) by taxing capital gains the government defeats the entire concept of economic stimulus. Recognizing this concept the government sets up investment programs such as IRAs and 401Ks that allow investment funds to compound tax free. But why limit capital investment if it is capital investment that causes an economy and the job base to grow. This is much like allowing the Golden Goose only to lay eggs on Sunday.

There are several changes the Federal Government could make to the tax code to encourage immediate investment and stimulate the economy.

1. Radically shift in the tax rate on above median incomes back to 1950s levels while eliminating the Marxist AMT. With the shift allow investment deductions against income with no limits.

2. Eliminate the Capital Gains Tax. As long as capital remains re-investment capital there would be no taxes. As the gains from capital investment are consumed the gains are taxed as ordinary income.

3. Eliminate the withholding for those making below the poverty line incomes.

4. Eliminate all deductions, except medical costs, including personal exemptions and mortgage interest.

Let's look at the impact of each one of these.

The first impact would be to reduce the current snafu over Wall Street bonuses. Granted these are generally excessive for people in a failed industry, but would the public be so upset if 90% of such bonuses were reinvested in America. Here I am not talking about adding another room to a Mc-Mansion, but investment in US infrastructure and industry. Yes, in effect such restrictions on investment to US companies become a de facto currency control, but it is voluntary. Instead of funding the Swiss Rolex factory higher incomes are redirected to domestic stem cell research or PV development. Eventually as the economy recovers investment deductions could be expanded to NAFTA on a reciprocal basis.

By eliminating the Capital Gains Tax all investment capital becomes 401K money. Such has been the case in real estate with the 1031 exchange. The draconian tax of ordinary income on removing capital from investment encourages re-investment while not limiting sales. In the case of stocks there would be no reason to hold a stock because of capital gains. Such would create a more robust market as capital flows to the most efficient companies. Let the investment market place determine value and not the desire to avoid capital gains tax. As long as capital remained invested it would avoid taxes.

Eliminating withholding for lower income wage earners who pay no taxes would encourage companies to hire low income workers. Much of the cost of in employing people in a small business is in withholding, matching Social Security and other costs. By shifting the Social Security burden above the poverty line those working at the lower end would have higher spendable incomes. Since low income workers spend 100% of their income eliminating the 15% Social Security tax provides an immediate boost in spending. Small companies would simply report income on 1099 forms at the end of each year greatly reducing employee costs. Most small companies pay low wages and employ people part time or even pay people under the table. Such barriers to hiring part time and entry level workers would thus be removed, making many more jobs available and making many more small businesses both viable and stable.

Under the current tax code most deductions have already been eliminated. Even mortgage interest on a principal residence now has upper limits. Phasing out the mortgage interest deduction along with charitable contributes would reduce housing costs and stop funding politician's friends and relatives. Since investment deductions are available to all tax payers, investment would substitute for consumption. The one exception is the deducting of medical expenses. A company always deducts its costs of operation to determine profits. Labor should be no different. Medical expenses are a direct cost of income producing labor. The current tax code on medical deductions is a joke at best and not representative to the net income from labor. Allowing medical deductions at 100% including insurance costs encourages people to do preventive care and at the middle income level fund medical insurance.

Here is a synergy that helps the Government save money while contributing to a robust and renewable economy. The current system collage contributes to instability and even corruption. By building a feedback system, the government benefits from a more stable and robust economy. At the same time such changes encourage the lower levels of society to pursue the American Dream.

Eric Von Baranov is the Founder & CEO of the Kondratyev Theory Letter (The Letter). Started in 1974, The Letter follows the 50+ year economic long wave theory as originally developed by the 1920s Russian economist Nicolai Kondratieff. Adherence to this cycle provides Eric with insight on a wide range of topics, including economics, politics, culture and technology. Eric has been published by Minyanville.com and the Psychic Investigator. He sponsors an online conference at http://www.kondratyev.com Please note that a new and improved web site is currently under development.