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Written by: David Nelson, CFA CMT
Make no mistake: Capitalism and the current world order are under attack and, like most bad arguments, not all of the opposition talking points are wrong. A wealth gap at its widest point in history and a system that encourages corporate boards to reward chief executives at levels reaching 300x the pay of their employees are easy targets. Solutions like raising marginal tax rates or taxing wealth do little to solve the problem and ultimately will lead to a failed economy and state.
It's an election year and both sides of the political aisle will offer solutions that rearrange the deck chairs playing to their political base extremes.
Chapter 1 lays out the first of three steps needed to help make our economy more dynamic and balanced. Chapters 2 and 3 will follow, all with the goal of improving — not replacing — the greatest economic system the world has ever known.
Step 1: Tax capital the same as income
For most of the last century, capital and/or investments have enjoyed preferential tax treatment. In large part it helps explain the statement by Warren Buffett: I pay a lower tax rate than my secretary.
The intent was to encourage capital investment which would translate into increased economic activity and, of course, more jobs. A hundred years ago, in the early stages of the industrial revolution, maybe that made sense. Unfortunately, today the unintended consequences outweigh the benefits. Today the capital base is massive and, to a large degree, sits mostly in the hands of those at the top of the food chain.
Why should a hedge fund, private equity or real estate investor be taxed any differently than someone working on an assembly line at Ford or Boeing? The answer is that they shouldn't. Income is income.
No one is suggesting that by eliminating the preferential treatment of capital gains that you are going to magically solve income inequality, and I'm certain that shouldn't be the goal. There will always be a gap between the successful entrepreneur who is putting capital at risk and the on-the-line employee, but the playing field should at least be level at the start of the game, and today the current tax code is inherently unfair.
It wasn't always this way. Before the tax acts of 1921, capital and income were taxed the same. There have been countless permutations and adjustments through the years and today, more than ever, it seems time to trash the current system and eliminate the preferential treatment investors get over their working brothers and sisters.
Today politicians and activists who want to change the system unfortunately are focused on the wrong part of the tax code. Raising the marginal rate from 37% to 45% or even higher does little to move the needle. Do you think the world's richest man cares if the income tax rate at the top end is raised to 70%? According to Market Watch, Jeff Bezos, founder and CEO of Amazon, with a net worth of $180 billion, received a salary of just $81,840 last year and has received the same for decades. Obviously, his lifestyle and standard of living are supported by something other than ordinary income.
If you work at a business and receive a salary, you are taxed at the graduated income brackets that capture your salary base. However, the owner of the business might take very little in ordinary income paying relatively lower taxes letting his or her wealth accumulate in the business. When that business is potentially sold in the private market or for shares of public companies, the capital gains rate is often used. Even if the cap gains rate is raised to 28%, it's a fraction of what might be paid if it was ordinary income. The only real hurdle is that the asset was held for more than a year.
Again, I'm not advocating for higher cap gains rate or even higher income taxes, but let's level the playing field. Income is income.
Evolution or Revolution?
As the gulf between top and bottom rungs of our society continues to widen, the danger of our nation turning to another economic system increases every day. Some will applaud the change and others will fight, but over time the very foundations will be challenged. The danger ahead is to do nothing and defend the status quo. Evolution or revolution are the only paths forward. Only one of these choices will preserve the greatest economic system the world has ever known.
The above is meant to be an invitation to a conversation not a confrontation. I welcome any constructive criticism or ideas.