How The Tax Code Picks Winners And Losers

It’s never optimal for the government to sway private decision making one way or the other, even if it’s encouraging actions we support. This can be tough to process even for the most libertarian-leaning minds.

This is especially true for tax policy, since there are many pro-growth policies that encourage one behavior over another.  Pro-growth policies should be encouraged, but not at the expense of private decision making and economic freedom. Yes, there is a way to achieve both.

Here are some ways the government is currently picking winners and losers through the tax code: as well as how we can reduce government intervention as much as possible while, concurrently, maximizing economic growth and personal freedom.

Corporate Tax Exemptions And Credits

Corporate tax exemptions and credits are the definition of crony capitalism. They are not in place to ensure anyone’s freedom, nor to provide a better tax system; instead they are forced into law through heavy lobbying by special interest groups, to gain an advantage over their competitors.

These tax credits put companies on an uneven playing field, causing businesses to succeed or fail – not based on the merits of their business – but rather their ability to navigate the regulatory landscape.  This will never lead to an efficient allocation of resources, and it hurts consumers more than anyone else.

Smart corporate tax reform would simply remove all exemptions and credits from the corporate tax code and lower the tax rates.

If, for whatever reason, the government still needed to step in to provide support, they could do so outside the tax code in a fair and transparent way.

Taxing Types Of Income Differently

Currently, income earned via salary is taxed at the normal rate, while income earned through qualified dividends and capital gains is taxed at a lower rate.  The general conservative argument for this is that it encourages more business investment and thus spurs job and economic growth.

Unfortunately, it also disrupts the equilibrium of a balanced market.  It encourages reclassification of income in order to seek the lowest possible tax rate. It also complicates the rest of the tax code, and forces income tax rates to be higher than they otherwise would be.

Simpson-Bowles suggests we lower income tax rates and treat all income the same.  The government shouldn’t artificially encourage more business investment nor discourage wage earners.  This simpler, fairer and freer system would allow people to decide what’s best for their own situation without considering arbitrary tax implications.

Treating Interest And Dividend Payments Differently

When a company needs cash, they can raise it either through debt, or through equity investors.  However, investors need a return on their investment, whether through interest payments or dividend payments.  Currently, companies are allowed to write off interest payments as an expense (lowering their taxable income) but they are not allowed to write off dividend payments.

All else being equal, this encourages companies to choose debt over equity.  This incentivizes over-leveraging.

Additionally, equity investors must provide relatively better terms to win the investment, while banks and debt investors can act in a more predatory fashion; this disrupts all debt and equity markets from their true equilibrium.

There are two ways to balance things out– either eliminate the deductibility of interest payments, or allow dividends to be deducted as well.

The University of Michigan school of law suggests we should allow dividends to be deducted, because it would equalize debt and equity while also eliminating the double-taxation of dividend payments.

Treating Large Expenses Differently Than Smaller Expenses

If a company buys an asset that will be used for a long time, it must spread out the cost over the asset’s life. This is called a depreciation schedule.

Even though a company may have been at a cash-flow loss after buying an asset, they would still have a tax bill to pay.  Additionally, these depreciation schedules are complex and set in a seemingly arbitrary way, which opens up the possibility of cronyism through further lobbying.

By including 100% expensing in any corporate tax reform, we could remove the disincentives for businesses to invest in themselves and allow them to make the right decision for their business, without any tax consequences.

Conclusion

While a lot of these rules and regulations are put in place with good intentions, they unnaturally distort private decision making and disrupt markets.  By removing these distortions, we allow people and businesses to make decisions based on what’s best for themselves and their stakeholders, rather than what’s best for their tax bill. Everyone wins!

* Stephen Steinberg is the Founder of Raw Athletics, a company that develops products to help athletes lead healthier lives, and Ventured Media, an online publishing company that covers hyper local startup news and how startups interact with the local industries.  He studied Economics at the University of Maryland.

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