I recommend a very recent one Posted by Matt Iglesias This caught my eye on taxes:

My preferred framework for a progressive consumption tax is the one outlined by Cornell University economist Robert Frank. It would work more or less like today’s income tax, but with two major changes:

There will be no distinction based on the source of income – be it wages, capital gains, dividends, interest, rent, whatever – it all goes into the “income” bucket.

Instead of a little form where you list your 401(k) contributions and deduct them from your income, you deduct all contributions from any type of savings vehicle (bank account, brokerage, whatever).

This is different from optimal tax theory, but the way it should work is that the IRS sends you a pre-filled form that tells employers and financial institutions what they think you owe based on what’s been reported to them. In 80-90 percent of cases, you can check “yes, okay, that’s right” instead of needing to do your taxes.

This is similar to an idea I often advocate – an unlimited 401k system People can put as much of their income as they want into a 401k account and then take the money out for expenses whenever they want. It essentially converts an income tax into a consumption tax. I especially like the last part, which will save me a lot of time doing my taxes. But for many of us, that means simplifying the tax system.

So how did Iglesias get into the Capital Gains Tax controversy? Should they be taxed at the same rate as ordinary income, or at a lower rate (in the current system)?

The phrase “no distinction based on source of income” might suggest to Inglesius progressives who advocate a higher capital gains tax rate. But things are not so simple, when you reframe taxes as a function of consumption, everything looks very different.

In theory, a flat tax on wage income is similar to a flat tax on consumption. Iglesias favors direct tax spending with the 401k approach, because he fears that wealthy businessmen will evade a payroll tax by claiming that the income they earn working for their own companies is actually capital income. This is a common problem in our tax system—the problem of tax avoidance.

Oddly enough, most people don’t see a wage income tax as identical to a consumption tax. In a 401k type consumption tax setup, it looks like capital gains are taxed at exactly the same rate as wage income, even though the income isn’t taxed until it’s consumed. But this tax system is identical to a general wage tax No capital gains tax at all. How is that possible?

With payroll taxes, you prepare taxes on your future investment income before you invest the money. With a 401k approach, you pay taxes in the future when the money is withdrawn and spent. Consider an individual determined to save 40% of their wage income, which is $100,000 before taxes. Also assume that the money invested grows 5 times over 40 years before being spent.

A 50% wage tax: After-tax wage income is $50,000, of which $30,000 is consumption and $20,000 is savings. After 40 years, the savings have grown 5 times to $100,000, when it is spent on consumption.

A 50% income tax with 401k benefits: The individual saves $40,000 and pays 50% tax on the other $60,000. This leaves $30,000 for current expenses. After 40 years $40,000 grows to $200,000. When that $200,000 is withdrawn and spent, half is taxed. Future costs are $100,000.

In both cases, present and future costs are identical. The two tax systems are essentially the same. But one system looks like it taxes capital gains at the same rate as ordinary income, while the other looks like it doesn’t tax capital gains at all.

This confusion occurs because “income” is such a vague concept. In economics, consumption has a clear meaning, while income does not. We could say that both systems apply the same 50% tax rate to current and future consumption, but as for the “income tax rate”, that’s a pretty meaningless concept. What do you mean by “income”? Thus one person may claim that Iglesias advocates taxing capital gains at the same rate as ordinary income, while another may claim that he advocates abolishing the capital gains tax. No one is lying – two valid ways of seeing the same reality. He is not in favor of any taxation at the moment of realization of profits, but full taxation of expenditure.

Readers may note that the payroll tax example is similar to the Roth IRA approach to savings. You pay full tax on the money before you save it, but when the money (plus investment income) is withdrawn later, you don’t have to pay any more tax. However, the two schemes may differ in terms of tax avoidance potential. Consider the following example from Bloomberg:

If Peter Thiel can accumulate $5 billion tax free using a special retirement account, why can’t you? . . .

According to ProPublica, in 1999 Thiel was able to put 1.7 million shares of then-private PayPal into a self-directed Roth IRA. Roth IRAs have contribution limits, but the total value of PayPal shares was below the $2,000 threshold. The value of those shares has exploded since then, along with Thiel’s other investments, but because they’re in Rath, they’re not subject to tax.

For simplicity, assume 1.7 million shares were worth exactly $2000. Also assume that Thiel paid 50% payroll tax on his income. In that case, he would need to earn $4000 in wage income to deposit $2000 in after-tax income into the Roth IRA. If it were a 401k system, he could have put the entire $4,000 into a 401k, which would have doubled his Roth balance. In other words, he would have $10 billion in his 401k today instead of $5 billion in the Roth. So while it looks like he’s getting away with these huge capital gains without paying taxes, he’s clearly giving up the extra $5 billion he would have accumulated if he’d spent $4,000 on 3.4 million shares of PayPal stock instead of $2,000. 1.7 million shares of PayPal stock.

You might wonder if the $4000 option was actually on the table. After all, if $2000 can turn into $5 billion, why not invest $200,000, which would later turn into $500 billion – making Thiel the richest man in the world. Our intuition told us that this investment was not scalable. And that intuition is probably somehow linked to our intuition that this investment option was not available to the average person. That is, in some sense Thiel’s investment success reflected his prowess as an entrepreneur. This would imply that the $5 billion in profit is partially treated as wage income as capital income. Although I know nothing about this particular case, I suspect that this is the general problem that Iglesias had in mind when he suggested that the 401k approach is superior to the Roth IRA approach.

Bloomberg noted that there is no evidence that Theil did anything illegal:

Don’t assume that because the IRS didn’t challenge Thiel, they won’t go after you. First, it’s unclear whether Thiel engaged in any prohibited transactions — and he has enough wealth to hire lawyers to argue the point with the IRS. For almost everyone, the resources expended may outweigh any benefits.

Consider almost any highly successful entrepreneur who works hard and builds a very successful business. When they sell that business, some of the capital gain will be a return on the initial investment, and some will reflect the increase in business value from the entrepreneur’s hard work. This is particularly common in high-tech industries, where in some cases a clever idea combined with a relatively small capital investment can generate extraordinarily large returns. This makes an ongoing problem with our tax system even more noticeable. No one cares if a blue-collar worker buys and fixes up a run-down duplex, and then sells it for a profit that shows up as capital gain, not wage income. In contrast, the Thiel case received major news coverage.

Rest assured. I still favor supplementing a 401k-style consumption tax with a 401k-style payroll tax (and a VAT), because I believe that multiple methods of taxation make tax evasion more difficult. But the focus should always be on taxing consumption. Income should not be taxed at all.

PPS. Iglesias favors taxation of land and negative externalities. I agree.

PPPS. Have you noticed how many people suddenly have opinions about whether the IRS should get more money? I would like to ask these people two questions:

1. What is the optimal IRS budget?

2. What is the current IRS budget?

Unless they can answer both questions, their opinion is not very valuable. I suspect that most people (on both sides of the debate) cannot answer both questions.

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