Tuesday, October 4, 2016

Rich People Pay Consumption Tax

Suppose the owner of a medium-size business makes $1M profit in a given year, before taxes. If the owner takes that money out of the business directly, e.g. as a dividend or salary, then it gets taxed as ordinary income. But what if the owner decides not to take all that money as income? Instead, maybe the owner takes home just $200k for spending money, pays ordinary income tax on that, and leaves the rest in the company. The remaining $800k is reinvested in the business - perhaps by buying new equipment, opening a new branch, etc.

Alternatively, suppose an executive at a Fortune 500 company makes $10M worth of stock options. With the right contract structure, they can hold their $10M of stock for a year, then take home that money and pay capital gains tax on it. But what if the executive decides not to take all that money as income? Instead, maybe the executive takes home just $500k for spending money, pays capital gains tax on that, and leaves the rest in stock. The remaining $9.5M stays invested in the company, and the executive can even reinvest any dividends to avoid paying income tax on them.

In these cases, and others like them, people effectively pay taxes not when income is earned, but when it is spent on personal consumption. Any income invested is not taxed until the investment is cashed in and spent on consumption. There is a name for this sort of tax: consumption tax. Consumption taxes are like income taxes, except that tax is only paid on income "consumed", as opposed to income invested.

Economists tend to like consumption tax, because it incentivizes investments over consumption. That means people spend more on economic growth, promoting consumption tomorrow over consumption today. Opponents of consumption taxes argue that they would fall disproportionately on the poor, since lower-income people have to spend a larger fraction of their income on living costs. Of course, in practice, any consumption tax would likely be graduated much like today's income tax, charging a much higher percentage to the wealthy, so this opposition position is rather weak.

Now let's talk about the 1% for a minute.

The wealthy elite generally do not get paid primarily through salary or wages, but instead through company ownership. This could mean anything from a successful entrepreneur who owns their mid-size company outright, to a Fortune 500 CEO who gets paid mainly in stock options, to a real estate developer who owns a large share in various holding companies created for specific deals.

We hear all the time about how the wealthy avoid paying their "fair share" of taxes. Income through ownership vs salary or wages is the key distinction, but you won't find the reason written down anywhere in the tax code. Contrary to popular belief, it's not about capital gains vs income tax, and it's nothing to do with the alternative minimum tax. It's about reinvestment, just like the examples above.

In today's world, the wealthy pay a de-facto consumption tax. The biggest de-facto tax difference between the wealthy and the rest of us is that we have to pay tax on our investments *before* investing, while the wealthy only have to pay *after* cashing out. To make the system reasonably fair, either the wealthy should pay tax on investments, or the rest of us shouldn't. Economists will argue for the latter as providing better incentives, but there's a more important reason too: taxing the investments of the wealthy simply isn't feasible.

Consider the example of the mid-sized business owner. If the owner decides to buy new equipment, that's a business expense. The business' profits today are reduced due to the investment in new equipment. How can you tax that? Tax the revenue? The problems with that idea should be fairly obvious. Short of nationalizing all the nation's businesses, there's just no way to stop business owners from avoiding taxes on investments in their own business. As long as there are business owners, they can pay consumption tax. This doesn't just apply in the US - business owners worldwide use the same tricks, whether in ultra-progressive Europe or nominally-communist China or free-for-all Hong Kong.

Business owners get to pay consumption tax, one way or the other. The only way to make taxation fair is to switch from income to consumption tax. Conversely, if you personally would rather pay consumption tax than income tax, then you need to either own a business or arrange to be paid mostly in stock options.

One disclosure: the main reason I'm thinking about all this is that my income is now at the upper end of the salary scale - i.e., I'm borderline wealthy myself. I pay around 40% in taxes (state and federal). I had read that the wealthy pay under 20%, and I wanted to know how to get in on that.