Objections to Simplified Capital Gains

Both the flat tax proposal and the two-tier tax proposal gain much of their simplicity by treating capital gains as ordinary income. This has raised quite a few red flags among those exposed to the idea. If we tax capital gains excessively, there would be little incentive to take risks and launch businesses. Members of both the political Right and Left have voiced this objection.

Again, refer to the Wikipedia page on tax rates. Capital gains are not wages, so there are no payroll taxes. But if you start a business as a C corporation and later sell the stock, your corporation is taxed at corporate rates (which quickly rise to 34%) and then at long term capital gains rates (assuming you hold the stock more than a year). Applying both of these rates and we get to keep (1-.34) * (1-.15) = .66*.85 = 56.1%. The total tax for someone who launches a corporation of significance (greater than $75,000 profit per year) is on the order of 44%.

If we keep corporate taxes as they are currently and have a 30% flat tax on individuals, including capital gains, then the amount kept is (1-.34)*(1-.30) = .66*.70 = 46.2%, for a total tax of 53.8%. This may well discourage risk taking.

Let’s try a 30% corporate income tax just to be consistent. Then the take home for a founder is (1-.30)*(1-.30) = .7*.7 = 49%, or a total tax of 51%. This still discourages risk vs. today’s tax code.

We can match our current tax code for corporate founders by cutting the corporate income tax down to 20%. (1-.20)*(1-.30) = .8*.7 = 56%, or a total tax of 44%. This would give small business founders the same tax incentive they have today, with the nontrivial bonus of less overhead to compute payroll. We also eliminate some of the games the very rich play to make ordinary income look like capital gains, and the complicated tax rules the IRS imposes to thwart said games.

If we have a two-tier tax system of 30% and 40%, then even with a 20% corporate income tax rate, the total return for the rich is .8*.6 = 48%, for a 52% total tax. We leave it as a meditation for the reader to decide if this is excessive, as well as to decide what income level should be considered rich.

For those on the Left who object to the idea of cutting corporate income tax rates, do note that a corporation is both the owners, workers and managers. Owners can include retirees and pension plans. As long as taxes are collected upon extraction from the corporation (either as selling stock or collecting dividends), owners of corporations are taxed. Indeed, it is well to ask why corporations should be taxed at all if individuals are taxed. A moral answer: corporations make use of an extra layer of government protection and thus businesses that avail themselves of limited liability should pay more tax than sole proprietorships and partnerships. A practical answer: having a corporate income tax helps keep corporations honest in reporting payouts to owners, workers and managers. These payouts are deductible for corporate tax purpose.

Finally, we might ask why not tax corporations more than individuals? A practical answer: with multistate and multinational corporations, it is very easy to move reported profits to the lowest tax jurisdiction. There is no market for a part manufactured by one division to be assembled by another. If a part is made in a low tax jurisdiction, then the corporation can set the price of the part high. If the final assembly is in the lower tax jurisdiction, then the corporation can set the price of the part low. Lowering the corporate income tax to 20% would affect how multinational corporations report profits substantially. We can reasonably expect a major lowering in the U.S. reported trade deficit purely from accounting changes. Currently, the U.S. ranks rather high for corporate income tax rates.