No to "Pay As You Go"?; Deficit Spending; Time for an Integrated Tax System?

Yesterday, Kansas City Fed Chief Thomas Hoenig stated the obvious: "The U.S. government must make adjustments in its spending and tax programs."... "It is that simple. If pre-emptive corrective action is not taken regarding the fiscal outlook, then the United States risks precipitating its own next crisis." You don't have to be an economist to know that if spending is not paid for today, it is paid for at a greater price tomorrow.

I've shared the figures in a prior blog: in 1980, gross national debt was less than a $1 trillion; now we are nearing $14 trillion with projections for it to balloon to $18-$20 trillion over the next decade. During that stretch, the federal government ran deficits each year except for a short window during the Clinton Administration. In the 1990s, the Clinton Administration and a Republican Congress utilized a "Pay As You Go" rule which led to a rare budget surplus. In the summer of 2009, the House passed a similar "Pay As You Go" bill; last month, the Senate barely passed the bill by a count of 60-40 -- every Republican voted against the measure. The Republican opposition vote is seen by political pundits as political expediency. Disgraceful. I wonder if Republicans will vote against President Obama's call to invest in nuclear power facilities and off-shore oil drilling -- two policies traditionally favored by Republicans? Environmentalists are slamming the Obama Administration on this one -- a sign again that Obama is a pragmatist by nature.

One of the great challenges we will face over the next several years is how to (1) put the U.S. economy on a sustainable growth path, while at the same time (2) increase tax revenues and (3) reduce federal spending. In the wake of the 2008 financial crisis, economists almost universally agree that federal spending (inspired by Keynesian economics) was the only thing that kept the economy from slipping into a depression because consumers were no longer spending, banks were no longer lending, and corporations were no longer investing. While there may be a time and a place for Keynesian economics, the same economists will tell you that it it too is unsustainable over the long term. As federal stimulus measures are phased out in the coming quarters, consumer spending must ramp up, banks must start lending, corporations must start investing -- AND, tax revenues must increase while federal spending must be cut to a level to create multiple periods of budget surpluses. This is an extremely difficult challenge to pull off. Is it an impossible one? It is impossible for us to solve this problem if we do not adopt a crisis mentality now, and start making some very difficult choices.

How do we put the economy on a sustainable growth path, while at the same time increase tax revenues and reduce federal spending? The answers will require hard choices -- some of which the Left will dislike, some of which the Right will dislike. On taxes, for example, here is my position:

Under current federal tax policy, corporate earnings are taxed at the front end on business income, and then are taxed again on the back end through stock sales (stock prices reflect a valuation of post-tax retained earnings) and through dividend distributions to shareholders. It is traditionally argued that this “classical” form of double-taxation distorts at least three financial and economic decisions: “(1) whether to invest in noncorporate rather than corporate form, (2) whether to finance investments with debt rather than equity, and (3) whether to retain rather than distribute earnings.” In a nutshell, this classical tax structure creates inefficiencies in the procurement and use of capital. These inefficiencies are problematic because economic activity and growth are negatively impacted.

Some propose a tax "integration" model so that corporate income is taxed only one time. Tax integrationists generally fall into two camps: (1) those who propose taxing corporate income at the corporate level, and (2) those who propose taxing corporate income only one time at the shareholder level. Under either approach, two significant challenges are raised: (1) “what should be the extent of U.S. taxation of U.S. corporate income paid to foreign investors and parent companies?”; and (2) “how should foreign taxes paid by U.S. companies on foreign income affect the U.S. taxation of U.S. shareholders on distribution of those earnings?” Tax integrationists do not agree on how to address these two problems. Some favor a series of new international treaties so that foreign investors are able to participate in the benefits of a U.S. integrated tax system; others argue for not extending the benefits of the integrated tax system to foreign investors. Further, some favor a pass-through of foreign tax credits for foreign taxes paid at the corporate level so that it is not double-taxed at the shareholder level; others oppose this approach because of the loss of tax revenue arising from foreign pass-through tax credits.

There are at least two other major issues that arise by only taxing corporate one time. First, everyone agrees that tax revenues will decline, and will have to be recouped through other means. Second, many argue that corporations have major benefits in society and that corporations should be required to pay more to compensate for those benefits. Both of these issues, as well as the two previously mentioned issues, must be addressed if a corporate tax integration model is ever going to pass the House and Senate and receive bi-partisan support.

History is always helpful for a context. From 1861 to 1873, no double taxation existed; corporate income was taxed one time at the shareholder level. Double-taxation through the taxing of dividends did not begin until the passage of the Revenue Act of 1936. But because of low tax rates on corporate income and high rates on major individual earners, the effects of double taxation did not become substantive until 1986. Following the Tax Reform Act of 1986 where maximum individual marginal rates dropped to historical lows, the relative tax burden on corporate-derived income increased substantially. [A historical perspective on individual marginal rates is also helpful: over the past 100 years, we have traditionally used a progressive marginal rate model where lowest income families were taxed at less than 5% on average and highest income families were taxed at more than 70% on average -- in between the these two levels, incomes were taxed on a progressive scale; this traditional scale dramatically changed in 1987 when top marginal rates dropped to 38.5% and lowest marginal rates increased to 11%.]

If there is going to be a serious discussion about implementing an integrated corporate tax system, then there must also be a reasonable response to the question of how the resulting tax revenue shortfall will be addressed. Everyone agrees that double-taxing corporate income creates a certain amount of capital inefficiencies, but the question is whether as a matter of public policy these inefficiencies are favorable to bearing inefficiencies elsewhere. Specifically, as the double-taxation model is phased out, taxes must be ramped up in other areas to make up the difference for the loss.

Taking account and consideration of all of these issues, I favor the mid-1800s model of taxing corporate-derived income only one time, at the marginal rate of the individual shareholder. In accord with this view, income from stock sales and dividend distributions would be taxed at the marginal rate of the individual shareholder. [As for capital outflows to foreign investors, I do not favor permitting foreign investors to take advantage of such a "one tax" system.]

Taxing corporate income only one time at the shareholder level will maximize capital efficiency and business growth. Increased economic activity will have positive derivative effects of a larger labor workforce by which additional tax revenue can be obtained. To better capture tax revenue at the individual level, marginal rates at the individual level should be changed on all levels to reflect levels that have worked historically. The arbitrary marginal rates currently in use should be phased out, and replaced with a continuum progressive rate system whereby a mathematical algorithm is used to tax income. Individual income taxation should start at the $5000 annual income level and at a rate of 1%, and for each additional dollar of income, the continuum progressive rate increases accordingly until it is maxed out at the upper end at a rate of 70% for annual income of $25+ million. Dividends and stock sales would similarly be taxed at the continuum progressive rate of the respective individual taxpayer. This model will make up for any tax revenue shortfalls of the integrated system. Moreover, this model will not negatively impact consumer spending across the the various income levels. [Studies show that income over $1 million does not contribute to consumer spending.]

BUT, I can only support such an integrated single tax system that is designed for maximum economic growth, ONLY WHEN three important conditions are met. First, by act of Congress through the construction of a new federal-based general incorporation statute (to supercede Delaware corporate law), the corporation must be stripped of its “artificial individual” status. The corporation should no longer be afforded certain Constitutional rights intended only for real, human individuals. Through this action, corporations would no longer be able to use shareholder capital to buy a political voice in Washington, for example, in the name of exercising First Amendment rights. Only the voice of the individual taxpayer should be heard in Washington. With an integrated tax system where corporate income is taxed only one time by the shareholder, the power of corporations in Washington would only increase. Measures will be needed to correct the negative repercussions of such a tax model. By act of Congress to supercede state incorporation statutes, specifically Delaware corporate law, the “artificial individual” framework can be overridden so that corporations may no longer contribute to political advertisements, political campaigns, and other lobbying and political activities. Henceforth, such activity may only be accomplished at the individual/shareholder level. As corporate power would increase through an integration tax system, this act of Congress is necessary to curb corporate influence in Washington. [Most corporate law and securities law experts will tell you that for years we have been moving progressively toward a federal-based corporate law structure to patch up problems created by Delaware law.]

Second, by act of Congress, shareholders, particularly minority-holding shareholders, must be given increased binding voting rights to have a legitimate say on a range of corporate issues such as executive compensation, board appointees, outsourcing and off-shoring operational activities, and mergers and acquisitions. Again, because corporate power will increase through an integrated tax system, corporate behavior must be curbed through a federal-based corporate law (exemplified in the previous paragraph), that, among other things, improves corporate governance and strengthens the role of the shareholder. A more democratic corporate governance structure where shareholders have increased voting rights will have significant positive effects on corporate behavior and help harness the anticipated increased business growth in a more constructive manner.

Third, and finally, by act of Congress and enforced through the Securities & Exchange Commission, all publicly-traded corporations must disclose social impact and environmental footprint data as a subsection of mandatory financial annual 10-K and quarterly 10-Q filings [as a footnote, I will tell you that I do not currently favor mandatory reporting of this data because it is cost prohibitive to many corporations; but, I do favor it if an integrated tax system is implemented]. With the benefits of an integrated tax system, specifically, accelerated economic activity, corporations must pay back to the public by partnering in the public effort to assist at-risk communities and to address critical environmental and resource consumption issues. The goal is to achieve a sustainable business and economic model; corporations must do more to help out with severe issues that call sustainability into question. Requiring mandatory “social” and “environmental” data reporting will help shareholders monitor corporate behavior toward these ends; wage rates for outsourced labor, water consumption, energy consumption, resource usage, are among the quantifiable data that would be required. Armed with these disclosures, through shareholder activism (afforded through increased shareholder voting rights), consumer activism (boycotts), and litigation via the SEC, corporate behavior can be altered so that it plays a more constructive role in helping governments and non-profits address critical social and environmental issues impacting our world.

The corporation has arguably emerged as the most powerful entity in the global public square. An integrated tax system will only strengthen its position in the world. The aforementioned congressional actions serves as compensation to society for the added benefit the corporate entity will receive as a result of maximized capital efficiencies and business growth. At the heart of this discussion is what social role ought the corporation play in the public square. The integrated tax system I propose, which will greatly improve capital efficiencies, will enable the corporation to pursue a new era of economic growth. Coupling the integrated tax system with the three congressional actions listed above, will help shape corporate behavior in a more constructive manner so that the corporation and global business activity is harnessed to serve the greater ends of the global community.

Peace

Jeremy