Writing about Taxes Jude Wanniski December 30, 1996

Memo To: Diana Henriques,  NYTimes
From: Jude Wanniski
Re: Tax Reform

Your Sunday “Week in Review” piece, “10 Years After Tax Overhaul, the Loopholes Expand,” is hardly news. The only people who thought the 1986 tax reform was a tax reform were the lawyers and accountants who rubbed their hands gleefully over the increased complexity of the system wrought by the act. Supply-siders were horrified to find that Senator Packwood, chairman of Senate Finance, had agreed to an increase in the capital gains tax, to 28% from 20%, with no indexing provision. The deal was rushed though with the enthusiastic support of the liberal wing of the Establishment, which is no less interested in preserving the status quo than the Establishment’s conservative wing. All the supply-siders could do was resign themselves to the fait accompli and vow to come back in the 1988 elections, win a mandate, and roll back and index the capgains rate to 15%. We actually did that, persuading George Bush to run on a 15%, indexed capgains rate, and he won in a landslide, but the Establishment conspired against us, and Bush raised taxes instead.  (I refer to those years as “the Darman Administration.”)

Did you notice, in the recent presidential campaign, that Steve Forbes repeatedly pledged to drive a stake through the heart of a tax system that had grown to 7 ½ million words and was the source of much of the political corruption in Washington? Ross Perot in 1992 and 1996 pledged a simplified federal tax system for the same reason. You are right in noting that Steve Forbes campaigned for a single-rate flat tax. Jack Kemp never did, although the impression remains that he did. There is no reason in the supply model not to have more than one rate, as long as the top rate is not above 25%, which is where tax avoidance really begins to escalate. Even Keynes said that 25% was about the top. Supply-siders of course believe the rich should pay a disproportionate share of taxes. Why would anyone support the idea that the poor should be taxed more heavily than the rich? At the heart of any debate is the Laffer Curve, which is simply the law of diminishing returns applied to tax policy. If any tax rate is higher than it should be for the purpose of raising revenue, it is of course suboptimal. The burden of such a tax may seem to be on the rich, but because the rich find ways to avoid it, the burden falls on the poor. There is a big difference between the incidence of a tax and the burden of a tax.

Unless you become familiar with these unintended consequences of changes in tax law, your obvious bias in favor of closing loopholes that “benefit the rich” simply contribute to an increase in the tax burden on the poor. Because you know you have this bias, you should be especially hard on the arguments of those political people you agree with and open your mind to those who you know you disagree with.

For example, you report that Edward N. Wolff of NYU has done research finding that “higher-income taxpayers are already reaping a growing share of the nation’s economic wealth,” that between 1983 through 1992, “the richest 20% of the population saw its share of the nation’s wealth grow to 83.7% from 81.3%.” It is a convenient study for you to have so readily at hand, but I will bet you an ice cream sundae that it is full of holes. Did you ask Wolff for a definition of wealth? Does he mix income and wealth? Does he include government entitlement transfer payments as a form of wealth? Does he include the increase in future tax liabilities on the real property of all Americans because capital gains is not indexed? If you think through the implications of these questions, you may realize you know less than you should, if you are going to be the Times expert on these matters.

You quote Ted Forstmann, quite accurately, that we want to encourage people to become wealthy, not penalize them for that, but you then go on to pronounce that if we eliminate the capital gains tax, people will immediately find ways to convert ordinary income into capital gains. Did you ever think to ask Forstmann if that would be possible? Even the example you give, which has an employer paying his employes with equity instead of cash points out the weakness of your argument. It is only possible to have a capital gain by putting ordinary after-tax income at risk. Once you realize that, you may understand why the loophole you see has never been a problem in those countries which have no tax on capital gains. It is a red-herring of the economics profession. It appears in the textbooks because it gets passed down from one inept economist to another. Alan Greenspan once told me he spent 20 years trying to find a way to convert ordinary income to a capital gain, without success. You would realize how difficult it is to pay people with equity instead of cash when you understand that most capital put at risk yields a negative return. Most new businesses fail within five years.

The assertion you make at the end of your piece that exempting investment income from taxation would increase the tax system’s vulnerability to circumvention is simply an assertion without foundation. By citing Herbert Stein as your source in your closing paragraph, you give away your own bias. Stein is the fellow who helped persuade Nixon to double the capital gains tax in 1969, and when that led to economic recession, Stein was there to persuade Nixon to float the dollar. If there are ten economists most responsible for the steady decline in the real incomes of ordinary Americans over the past 30 years, Stein is an automatic for that list.