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Alternative to Bush Tax Cut

by Jalexson

copyright 2004
originally published at

President George Bush’s tax cut takes a simplistic approach to changes in the tax code. What the federal government really needs is major tax reform that among other things insures that foreign corporations pay their fair share of American taxes. Bush’s proposal to eliminate the dividend tax won’t do anything to increase jobs if investors purchase existing stock rather than newly issued stock..

One goal of tax reform should be to simplify taxes for both corporations and individuals. Tax reform should also encourage investment, particularly long term investments, and discourage playing the market like a gambling device. The desire to keep stock prices high played a major role in the Enron and Worldcom debacles.

The biggest general change in individual income taxes should be an increase in the standard deduction and the amount of exemptions for those who don’t itemize deductions. This change would eliminate the need for many taxpayers to bother with itemizing deductions. Eliminating the ability to deduction certain expenditures has been politically difficult because of popular support for many deductions. Eliminating the need to deduct would thus be the best way to simplify taxes for many Americans and reduce the cost of processing tax forms for the government.

The Republican proposal to eliminate the estate tax shouldn’t allow individuals to inherit large tax free incomes. Instead of taxing the estate, the focus of any tax should be on incomes received from an estate. All income above some specified amount should be treated as other taxable income. Property should be inheritable without a tax until the property is sold. Then the entire income over the threshold would be taxed.

Another change would involve taxing different sources of income in different ways. Gambling income, for example, should be taxed at a higher rate than other sources of income. Gambling losses shouldn’t be deductible except that net income from a single visit to a casino or race track would be taxable rather than winnings on a single game or race. Other changes would involve business related taxes which will be discussed below.

Any tax reform should include replacement of the antiquated corporate profits tax that rewards companies that incorporate outside the United States even though much of their revenue comes from within the United States. Switching to some type of Value Added Tax(VAT) would equalize the tax burden among American and foreign companies.

A VAT would tax revenue minus taxed expenses to avoid double taxation. The best form of this tax would allow a deduction for labor costs on which the corporation pays matching FICA taxes. Executive salaries would not be deductible. Neither would purchase of goods from outside the United States because no tax would be collected on the revenue of the foreign corporation selling to the American company.

A major advantage of a VAT would be that companies using revenue to purchase buildings or equipment could deduct the expense immediately if the purchase was from a VAT paying corporation. A VAT would simplify tax accounting and discourage corporations from trying to adjust spending to reduce taxes. Instead corporations would be encouraged to adjust spending to operate efficiently.

Switching to a VAT would eliminate the argument that taxing dividends amounts to double taxation of profits. If the federal government is going to eliminate the tax on dividends received by individuals from U.S. corporations it should replace that tax with a collective tax on corporate dividends. A uniform dividend tax at the corporate level would be easier to administer than taxes on individual investors and would apply to dividends paid to foreign investors as well as domestic investors.

Dividends received from foreign corporations should continue to be taxed. There is no good reason to encourage investment in foreign corporations.

Under a collective dividend tax, individual investors owning preferred stock would continue to receive the same amount of dividends they do now, but wouldn’t have to pay taxes on those dividends. Owners of common stock might receive lower dividends. The result would make preferred stock even more “preferred” for those who invest for dividend income rather than for increases in stock price.

The individual exemption from paying taxes on dividends would only apply to the average stockholder. Major stockholders like Bill Gates or the Walton heirs might still be taxed on a portion of their dividend income, for example, all dividend income from one company over $100,000 a year. This provision would insure that those with the highest incomes still pay some taxes and encourage investors to diversity their stock portfolios.

Establishing a separate dividend tax could allow corporations to deduct dividend payments from a VAT because they would be a taxed expenditure of revenue. The federal government could then apply a slightly lower tax rate to dividends than the VAT tax rate. This difference might encourage corporations to pay dividends and encourage executives to rely more on dividends than salaries for income.

At least a portion of dividend income would be tax free to executives who would pay full taxes on salaries. The corporation would also pay lower taxes on dividends than on executive salaries.

Under a VAT corporations could deduct revenue spent on new buildings and equipment. A similar approach could be used to encourage corporations to issue stock to finance improvements. After a new stock issue, corporations would be allowed to deduct the amount raised by stock sale from dividends subject to taxation. For example, if a corporation raised $10 million from a new stock issue, the next $10 million in dividends would be exempt from taxation.

For start-ups the exemption would apply to its future payment of dividends. This approach would make such stock more attractive even to owners of preferred stock because start-ups would be able to pay dividends earlier than they would otherwise.

For other corporations issuing new stock the primary beneficiary would be owners of common stock who would receive higher dividends because less money would be taken by taxes. Executives, who would likely own common stock, would find new stock issues a desirable way of raising funds for expansion. Investors would then have the option of purchasing new stock instead of old stock.

During the 1920's and again during the late 1990's stock trading experienced a boom with people investing more to take advantage of increasing stock prices than to qualify for dividends. Changing the way stock sales are taxed might reduce speculative trading.

The federal government should replace the capital gains tax for most investors with a tax on public stock transactions. Those in the stock trading business would also face individual(corporate) tax liability for net income. A potential exception allowing a tax on gains would be a windfall tax on stocks whose price increased by more than 50% in a short period prior to sale.

This change would simplify taxes for retirees, especially older retirees, who need to sell stocks to finance retirement. The government would still collect taxes, but taxpayers would be spared the need to keep records of stock transactions for many years.

The income tax deduction for capital losses would also be eliminated with some exceptions. The primary exception would be for large price drops, particularly those associated with events like bankruptcy. Some portion of long term(5 years or more) losses might also be deductible.

Changing to a sales tax would initially reduce stock prices slightly because the tax would in effect increase the purchase price. Once prices have adjusted to the tax they would begin changing without regard to the cost of the tax.

The major impact of the tax would be to discourage frequent trades in an attempt to make a profit. Traders would pay the same relative tax regardless of whether the price went up or down. The amount of the tax would depend on the sale price of the stock regardless of whether the stock was purchased on margin on not. A trader couldn’t sell one block of stock and then invest the entire amount in new stock because a portion would have to be spent for the tax on the new stock.

Traders would pay taxes on each purchase and wouldn’t be able to avoid the stock sales tax by selling some stock at a loss. Ordinary investors wouldn’t pay income taxes on stock transactions. However, regular traders(individuals and businesses) would still be liable for taxes on net income from stock transactions. Regular traders would be defined in terms of the frequency of trading rather than the income derived from trades.

The United States tax system resembles a Rube Goldberg device that is inefficient and can hamper efficient economic operations. Corporate taxes in particular are outdated and the entire tax should be replaced. Individual taxes are too complex and need to be simplified for taxpayers and to reduce costs for the government. The current tax approach to investment related income may discourage investments. Changing the way taxes are accessed could encourage investment without reducing tax revenue.



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