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A Genuine Tax Reform: Increased Use of the Estate Tax and Integration of the Corporate And Personal Income Tax
Raymond Richman, 12/14/2012

Congress makes changes in the personal income tax code annually. This affects the behavior of investors violating the basic principle of certainty. For example, effective January 1, 2013, the rate of taxation of realized capital gains will increase from 15% to 20%. For many years, capital gains had a different treatment. Fifty percent of long-term realized capital gains was counted as taxable income.and was subject to a maximum tax rate of 25%. Congress changed the treatment several times since then and for the taxable year 2012, there was a single tax rate of 15% applied to long-term realized capital gains. During some years, gains from the sale of dwellings were untaxed if a new dwelling costing more than the realized gain was purchased within two years. During the Clinton administration, the condition that a new dwelling must be purchased within two years was eliminated. As we have shown, there is only one correct treatment of capital gains, namely that realized gains be taxed as ordinary income if consumed and left untaxed if reinvested. A realized appreciation of capital is income only if the proceeds are not reinvested. Capital gains of a decedent escape taxation when the capital asset is inherited. The U.K. until a few decades ago did not tax capital gains believing that an appreciation in the value of capital is not income at all. Indeed they began to tax realized capital gains but not under the income tax. Most American economists have been raided to believe that accrued (unrealized) capital gains are also income but if that were true, an accrued capital gain is simultaneously the source of income and income itself. An accrued capital gain can be defined as the present value of an increase in the expected stream of income as we have shown previously in our book and on this blog. Economists can be wrong. If the economists advising the Congress and the administration offer such disparate advice, how can we expect rationality from the Congress and the federal administration? .

The owners of corporations are their shareholders. Corporations pay income tax and shareholders pay income tax on corporate dividends. It is not surprising that shareholders try to convert some of their corporate income into capital gains which have been taxed at lower rates than dividends. Corporations pay income tax on income generated domestically and on income earned abroad when and if the income is repatriated. A great deal of corporate income earned abroad is never repatriated. Many governments have a territorial definition of income and do not tax income earned abroad at all. But our unitary definition of income holds that income wherever earned is subject to tax.  It is to be expected therefore that the political parties change policies whenever they win an election.

The parties also differ on the estate tax. The conservative opposition to the federal estate tax is misguided. By all the criteria or principles of taxation, the estate tax is one of the best taxes. It accords with ability to pay, it is not arbitrary, it has good interpersonal equity both horizontal and vertical, its economic effects are good or at least not bad, it is economical to administer and to comply with. Many of these principles date back to Adam Smith’s principles of taxations which should be familiar to conservatives. In his view,   

1. The subjects of every state ought to contribute towards the support of the government, as nearly as possible … in proportion to the revenue which they respectively enjoy under the protection of the state. This is the ability-to-pay principle. It suggests taxation should be proportional to ability to pay. The notion of progressive taxation was a later development.

2. The tax which each individual is bound to pay ought to be certain, and not arbitrary.

3. Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it.

4. Every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state.

A modern set of principles would include the notion that taxes should be used to redistribute income which is distributed so unequally. Therefore the notion that a good criterion is a tax’s progressivity. The tax system should be a progressive as possible up-to-the-point where the marginal benefits of additional progressivity becomes equal to the marginal cost of diminished productivity.

Another criterion is the benefit principle. A taxpayer who receives a special benefit from government should pay for the service rendered, e.g., the use of streets and highways. The tax on motor fuels is justified by this principle. Another principle is equal treatment of equals. Taxpayers in like circumstances should be taxed alike. And as Adam Smith suggested, a good tax is one that has few negative economic effects

We believe these principles suggest that the corporate income tax should be integrated with the personal income tax. This would avoid double taxation and would benefit consumers as well. Corporations should be treated as partnerships. Corporate income per share should be included in the shareholders’ personal income tax returns just as partnership incomes are..

 The estate tax is a highly progressive tax and unlike the income tax has no bad economic effects. High rates of income tax discourage investment by reducing the marginal rate of return on private investment.  By contrast, the estate tax does not change the rate of return on new investment and therefore does not affect the decision to invest.

Republican members of the Senate’s Joint Economic Committee published an analysis entitled Costs and Consequences of the Federal Estate Tax An Update on July 2012 which makes the case against the federal estate tax. It argues that the estate tax results in a smaller stock of capital, causes dissolution of family enterprises, does not reduce inequality of wealth and income, does not increase revenues overall, raises a negligible amount of revenue, and should be abolished entirely.

It neglects to note that all taxes reduce the taxpayer’s capital. The purpose of taxation is to transfer resources from the taxpayer to the government. Conservatives correctly point out that too much is transferred from the private sector to the public sector. A transfer in the form of an estate tax has less negative incentives than a transfer in the form of a tax on income. The latter discourages investment.

The study correctly points out that it sometimes forces the heirs to sell the business or part of it to pay the estate tax. But this is rare. Where is the evidence that this is a significant or usual result of the estate tax? More often than not, heirs sell all or part of the assets inherited in order to consume more and live in the style to which they want to become accustomed. Should the heirs want to continue operating the farm or business, there are innumerable ways to do this, e.g., borrowing capital, taking in a partner, etc.

The study asserts that the estate tax does not reduce inequality of wealth and income. The transfer of resources from wealthy heirs to government is necessarily progressive. Depending on how the heirs decide to spend their inheritance after tax. They are richer than they were while the decedent was alive.

The study’s assertion that the estate tax does not increase revenues overall relies on a theory that the taxed resources if left in the hands of the heirs would be invested and produce more than if spent by the government. While waste is characteristic of government spending, there are also many instances of waste in the private sector. But the waste would be as great in the public sector regardless of the source of revenues.

The study argues that the estate tax raises very little revenue. Yes, compared to the personal and corporate income tax, the excise taxes, etc. The cost of estate tax administration and compliance was estimated to be about 7 percent of receipts in two independent economic studies. This compares favorably with all direct taxes. In 2006, the estate tax exemption rose to $2 million ($4 million per couple) and in 2009 it rose further, to $3.5 million ($7 million per couple). Currently, 2012, there is an exemption of 5.12 million and a maximum rate of 35 percent on the amount in excess of the exemption. This is scheduled to change in 2013 to an exemption of one million and a maximum tax rate of 55 percent.  In 2008, the estate tax collected about $29 billion from fewer than 20,000 estates. From 1999-2008, the estate tax yielded $266 billion. These are not trifling amounts. But there is no reason why most of the loss of revenue that accompanies the unification of corporate and personal income taxation should not come from the estate tax.

After a small exemption ($1 or $2 million, all estates should be taxed at progressive rates. The rates should be sufficient to raise revenue on the average to at least the revenue that the corporate income tax yields on the average. We believe that the integration of the corporate and personal income tax and greater reliance on the estate tax would make the tax system more equitable, achieve greater horizontal and vertical equity, have many good economic effects, and be economical to administer and to comply with. 

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Comment by Michael Creighton, 12/18/2012:

I don't want to borrow!  I don't want to take on a new partner!  I just want to continue farming with my family and provide the USA with the best food in the world!  Then this non-sequiter: "The study correctly points out that it sometimes forces the heirs to sell the business or part of it to pay the estate tax. But this is rare. " SO??It is no argument to say it is "rare" ----it is still an injustice! It is like saying, hypothetically, "wiping out the life work of a few people is OK because it's only a few people who are wiped out!"  Or, hypothetically speaking, "Let's tax the tallest person in the country and make sure he or she has nothing. It's just one person; it's  rare, and we'll get some money." It is not fair to that person, or to the businesses who are forced to sell their family farms, even if it is just a few farmers.  You are wrong; it is not easy to avoid the estate tax. Families have to agree on the form of ownership and there are expensive and complicated legal hoops one must jump through.  I just want to farm!  So it is rare and only a few are wiped out! That doesn't make it right. This is an unholy injustice to family businesses, ranchers and farmers.

Response to this comment by Sean, 9/19/2013:
i totally agree with you!! Why borrow!? let me work in peace and farm like every other farmer out there! Sean @ My Site

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  • [An] extensive argument for balanced trade, and a program to achieve balanced trade is presented in Trading Away Our Future, by Raymond Richman, Howard Richman and Jesse Richman. “A minimum standard for ensuring that trade does benefit all is that trade should be relatively in balance.” [Balanced Trade entry]

    Journal of Economic Literature:

  • [Trading Away Our Future] Examines the costs and benefits of U.S. trade and tax policies. Discusses why trade deficits matter; root of the trade deficit; the “ostrich” and “eagles” attitudes; how to balance trade; taxation of capital gains; the real estate tax; the corporate income tax; solving the low savings problem; how to protect one’s assets; and a program for a strong America....

    Atlantic Economic Journal:

  • In Trading Away Our Future   Richman ... advocates the immediate adoption of a set of public policy proposal designed to reduce the trade deficit and increase domestic savings.... the set of public policy proposals is a wake-up call... [February 17, 2009 review by T.H. Cate]