Shifting, not reducing, the tax burden

The more rhetoric I hear this election season, the more I’m reminded just how little the government can do to fix the economy in the short term. It can pour money into shovel-ready projects, but those don’t seem to be long-term fixes, and they won’t right the ship in time for the midterm elections.

A unique wrinkle to this economic recovery has been the stark contrast between unemployment and corporate earnings. The unemployment rate stays stubbornly where it is while corporations report significant profits. Why aren’t they hiring? It’s because growth prospects are so gradual that there’s no need to ramp up the headcount just yet. What company would hire hundreds if it can count on only very gradual economic growth over the next few quarters?

“A jobless rate hovering close to 10 percent is shaking consumer confidence and shackling spending, the biggest part of the economy.”

After reading that statement in a Bloomberg article on manufacturing last week, I paused. Why exactly is consumption such a huge part of the American economy? How did we get here?

Some point a finger at the tax code. Sure, there’s plenty of talk about lowering taxes; it’s election season after all. But I’ve heard a few people go beyond the predictable taxes-are-evil jabber. Taxes aren’t evil. I like roads, for instance.

Last year Bert Ely, a veteran bank watcher, gave The Economist magazine some interesting insight on financial reform and taxes. “If you have to regulate intensely, then that means incentives have not been designed correctly. You’re trying to steer human behavior through rulemaking, and individuals don’t respond in the desired fashion, and you get unintended consequences.

“The number one incentive is in the tax law. You want a tax law that lessens the incentive to leverage.” The tax code, he said, basically subsidizes leverage for households, small business, and financial institutions. The greatest tax incentives are given to those who invest in stocks, essentially betting company earnings grow down the road. It just so happens that the tax rate for these capital gains is lower than that of real earned income.

In other words, the tax code’s incentive structure is out of whack. It gives bigger breaks to betting on future earnings (capital gains from stocks) and fewer breaks to past earnings, with high corporate income tax. Past earnings are real. They already happened, and they aren’t based on shaky predictions. So why are past earnings (a certainty, usually) taxed so much, while winnings from bets on future earnings (that is, capital gains) are taxed so little? Shouldn’t it be the other way around?

Several years ago Robert Reich, a Berkeley professor who was labor secretary under President Clinton, proposed eliminating the corporate income tax altogether. In his book Supercapitalism, he proposed essentially making every business like an S Corporation, in which shareholders are taxed but not the company itself.

Then just a few weeks ago, Paul Ryan, a Republican representative from Wisconsin, told BusinessWeek magazine that he’d simplify the income tax with a simple, two-tier system. Income would be taxed at 10 percent on the first $100,000 for couples, 25 percent for couples earning more. Meanwhile, a family of four earning $39,000 or less a year wouldn’t pay any income tax. He’d eliminate the corporate income tax and replace it with an 8.5 percent national consumption tax.

These ideas aren’t as much about reducing taxes as they are about shifting the burden. Government still gets its money, just from different places. Reich, a Democrat, wants to get rid of the corporate income tax, too, but his plan shifts more taxes to company owners and investors. Ryan, a Republican, wants to eliminate corporate income tax too, but his proposed consumption tax shifts the tax burden to consumers and retailers.

These and similar ideas may do some good because they shift the economy’s incentive structure away from consumption and toward production. Pundits have preached about how America needs to shift away from a consumer-driven economy and become more production-oriented. To rebalance things, it may make sense to tax consumption more and businesses less.