Friday, December 03, 2010

The Challenge of Progressive Taxation

We've heard the sound bites. We all know by now that George Bush caused the recession (though we don't know how or why).

We also know that the Bush Tax Cuts are evil.

Oddly, despite the fact that we have the most progressive president in US history, legislatures are waffling on letting the tax cuts expire.

The BLS reported unemployment at 9.8% today. It would be higher if the BLS was honest in its definition of the unemployment and included those who gave up hunting for a job.

The fear is that higher taxes would cause a further jump in unemployment.

So, despite the fact that vilification of the Bush Tax Cuts is a primary stance of the Obama administration, the government is worried that letting the tax cuts expire would hurt a large number of people.

I am clearly an evil person because I don't blame Bush for the recession. Even worse, I favor the Bush Tax Cuts.

The problem faced by policymakers supporting a progressive tax system is that businesses make their investment decisions based on the highest tax rate.

Even though most small businesses fail to achieve a coveted position of being in the top income bracket, small businesses actually end up making many investment decisions at the top tax rate.

The top tax rate has an adverse affect on small business. There are many small business owners who live a modest life but throw everything into the business. Since their personal finances are tied in with the business, they end up paying the top rate despite a modest lifestyle.

My solution to the progressive tax challenge is to create a new tax system which I called the Object Oriented Tax. This system taxes an abstract object between income and consumption.

Basically, people would have an investment account and a spending account. There would be no taxes on investment related transactions in the transaction account. Taxation would happen when people transferred funds from their investment account into the spending account.

One could set a progressive tax rate based on the size of the investment account.

Warren Buffet would pay a higher tax rate than his secretary because he has a massive amount of investments.

The challenge of progressive taxation is that business decisions are made at the top rate. Taxes have an adverse affect on the very business decisions that generate wealth. Creating a new tax system that taxed an abstract object between income and consumption would simplify investment decisions while preserving a progressive tax.

As it stands, since businesses make investment decisions based on the highest tax rate, I believe the wise course of action is for Obama to ignore the wealth-envy rhetoric of his campaign and extend the Bush Tax Cuts. If we want to continue a progressive tax system, we might consider something like the Object Oriented Tax that cleanly separates investment decisions from taxes and taxes only consumption:

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