We Need A Tax Revolution, Not Incremental Tax Reform

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Includes: HRB, INTU, ITB, JETS, PEJ, XHB, XLY, XRT
by: Kevin Wilson

Summary

The income tax was created to accommodate the fact that the means of production had switched from primarily land to mainly industrial labor over 100 years ago.

We are again at a major turning point, because returns to labor have declined over 40 years; thus, the middle class tax base is declining and only 57% pay anyway.

The presidential candidates are proposing essentially minor tax reforms; this is unrealistic in the face of diminishing returns to labor, and we need a tax revolution to fix it.

We need to tax the main source of production: capital; the current taxes on labor (income) should be cut, freeing households to increase their spending and thereby boost economic growth.

In addition, a "VAT" system would replace sales taxes with production and consumption taxes, and boost government revenues; increased spending would be good for XRT, XLY, XHB, ITB, PEJ, JETS.

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Recently, I wrote an article about the potential threat to capitalism caused by the rise of increasingly efficient but also increasingly disruptive robotics technology. One of the commenters on the article ("hawkeyec") pointed out that before 1900 the primary factor of production was land, so real property was the production factor that got taxed. Later, as "hawkeyec" noted, the rapid rise of industrialization and the urbanization associated with it led to switching the taxation scheme to one that taxed the new primary production factor, which was labor (specifically, earned income; see first chart below). Now, after over 40 years of declining returns to labor (see second chart below), it is clear that something big has changed.

This set of observations by "hawkeyec" is truly profound, and the present article is an attempt to incorporate this insight into my recent musings on the economy. The trend towards globalization has been a major driver in this returns-to-labor downtrend, but automation, computer software development, and the robotics revolution (see third chart below) have exacerbated the damage being done. It is likely that these trends will continue in the coming years, especially automation and robotics.

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The middle class is getting squeezed, as I have discussed elsewhere, and as a result we may be seeing creeping demand destruction on a large scale (see first chart below; note that monetary velocity is a component in the equation for GDP growth, which has also seen declining rates for decades). The sluggish recovery after the Great Financial Crisis is probably due to a number of different factors (such as demographics, the debt overhang arising out of the crisis, healthcare reform's perverse effects on labor (see second chart below), etc.), but one of them is likely the relentlessly diminishing returns to labor over time, as just discussed, because it has limited the growth in consumer spending. Another factor has been the welfare state's increasing demands on taxpayers, especially in the form of the rising impact of taxes on the middle class. The third chart below illustrates the impact of payroll and income taxes on the middle class. Runaway healthcare costs, which have actually been exacerbated by the passage of the "Obamacare" reforms and by massive increases in drug costs after the passage of the Bush Medicare Part D law, are also hitting the middle class hard, as shown in the fourth chart below.

M2 Monetary Velocity Is In Structural Decline

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The Massive Hit to the Middle Class from Payroll and Income Taxes:

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The current income tax system has tried to accommodate the declining returns to labor with tax exemptions and tax credits for the lower income brackets. Ironically, this may be the best evidence available that the system is failing, because by 2013 fully 44% of Americans were paying no income tax at all, and 34% were actually getting a federal check for tax credits when they had paid nothing in (see chart below). This reminds me of Bastiat's famous dictum, shown in the second chart below (i.e., there is no free lunch). Taxes are now extremely progressive, with the top 20% income bracket paying about 94% of taxes as of 2009 (see third chart below). Clearly raising taxes on the rich is not going to fix anything at this stage, although it would probably make other people feel better. But if we are to avoid the calamity of pure socialism, we must do something about all of these structural trends that are harming the middle class. One partial solution that should be in the mix is major tax reform.

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Bastiat's Dictum:

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Source: The carpe diem blog

Evaluation of the US federal government's revenue sources (see chart below) indicates that corporate taxes make up a much smaller share of the federal revenue pie than they did in the 1950s. This doesn't make any sense since in the intervening decades the returns to capital have soared, and the returns to labor have plummeted. Obviously business is better at lobbying Congress than labor is, at least in the last 50 years or so.

But be that as it may, this cannot be the way we handle taxes going forward. I have recently discussed the rising sense of moral outrage amongst voters at this phenomenon of lower tax contribution of corporate taxes to federal revenues over time, the simultaneous diminishing returns to labor, and the public's realization that this has occurred against a backdrop of near record profits for years on end (at least until recently). I commented then that this may make corporations vulnerable to calls for higher taxes on them coming from many voices in many countries.

I will now move to what I think is the next logical step, which is to explore a radical change in the way we look at taxation. Our current system is piling ever higher taxes on a middle class that has seen no real wage increases in decades, is being threatened by automation, robotics and globalization, and is suffering sky-rocketing costs for education and healthcare. We are gradually squeezing the life out of the economy, and literally killing off the proverbial golden goose (i.e., the middle class).

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Continuing on the present path, even if incremental tax reforms pass, is clearly untenable, as further evidenced by completely inadequate tax revenues and growing deficits (despite very progressive rates), a decreasing taxable base, a structurally weak economy, and the decreasing potential for many (formerly) in the middle class to obtain high paying jobs. By recognizing that the primary means of production has long since switched towards capital and away from labor, and that therefore capital is what should be the focus of the tax system, there may be a way to solve several of our structural problems and reinvigorate our economic growth.

It is thus a bit off-putting to see the incremental tax reforms proposed by all of the presidential candidates (see chart below), which either don't solve anything, or actually exacerbate the problem. What the candidates are backing is some variation on "business as usual," but I believe that this is a myopic and somewhat clueless approach that will ultimately prove to be counter-productive to the pursuit of equal opportunity amidst renewed American prosperity. What we need is a tax revolution, not incremental tax reform. The American people know that something big is wrong, not just with taxes, but with the entire economic system, which is why we have witnessed the rise of Donald Trump and Bernie Sanders. Given this rise of a populist brand of politics, it seems likely that the public would be receptive to some kind of major change to tax laws. There has been a nearly 30-year debate over concepts like the flat tax, and at one time I supported such an approach as the best way forward. But now it is my opinion that the writing is clearly on the wall for a much bigger change even than that. That doesn't mean we should abandon the idea of flat taxes, but rather that we should consider other, more radical measures as well.

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First, let me stipulate that it is unlikely that even a major tax revolution would end up tossing out all components of the income tax. Rather, a low flat tax of some type might well replace the current income tax brackets. After all, we still tax property at the local level in spite of the change in the primary means of production (to labor) about a century ago. But assuming that income taxes no longer take center stage in generating federal revenues, what will? Clearly something could be done with capital gains taxes, perhaps by lowering rates slightly but applying them to more situations, which should boost overall revenues (at least according to the famous Laffer curve).

There are probably several other ways to address the problem, but one that immediately comes to mind is the Value-Added Tax ("VAT"), sometimes also called a Goods and Services Tax ("GST"). It is widely used around the world (indeed, all OECD countries except the US already have a "VAT" system), and basically it taxes production and consumption rather than income. In that sense it replaces sales tax at presumably no net cost to business (except for the additional accounting work involved).

In practice it appears that a "VAT" is applied fully to imports but not at all to exports. This has obvious advantages to American manufacturers. The "VAT" provides much of the total tax revenue in some countries (e.g., India, France, Canada, and Norway). Many countries have made portions of the "VAT" tax progressive by providing for exemptions on certain items (e.g., food, newspapers, public transport, postal services, loans, education or medicine).

Obviously the ultimate payer is still the average citizen, who in certain circumstances might possibly then see rising prices over time; but then, isn't that the goal of every central bank on earth? However, there would also be more widespread direct taxation of corporations than we see under our current corporate income tax scheme. This wouldn't necessarily mean a higher nominal rate, as US corporate taxes are nominally amongst the very highest; rather, it would mean much less effective tax dodging by some players, and much better relative contributions by corporations to annual federal tax revenues, something that is sorely needed. Off-shoring would probably virtually disappear if the new laws are constructed properly, since there would quite possibly no longer be any tax advantage to it. There would of course be many details to be worked out. It is not my purpose here to fully delineate a new tax system, but rather to get the conversation on this topic restarted in some part of the US financial community.

From an investment point of view, incremental tax reform of some type seems highly likely after the election, and a bi-partisan plan would likely pass within a year, in my opinion. If we assume that reform will only involve incremental change this time, then it is likely that lower corporate taxes and a flat personal income tax system could be on the table, given the views of the surviving candidates and the House and Senate leadership.

A flat personal income tax would probably be fairly bad for tax consulting firms like H & R, Block Inc. (NYSE:HRB) and Intuit, Inc. (NASDAQ:INTU). But if the economy (temporarily) started to surge because of increased spending by a (temporarily) reinvigorated middle class, consumer discretionary stocks - Sector SPDR Consumer Discretionary ETF (NYSEARCA:XLY) , SPDR S&P Retail ETF (NYSEARCA:XRT) - might do very well for a while. Travel services would probably surge as well, favoring the airlines, car rental outlets, and hotel chains, i.e., PowerShares Leisure & Entertainment Portfolio ETF (NYSEARCA:PEJ), and U.S. Global Jets ETF (NYSEARCA:JETS).

What would happen if a real tax revolution occurred, and we ended up eliminating personal income taxes as the central part of the tax code, and replaced them with enhanced capital gains taxes and a "VAT"? I think there would be a surge in all of the things just mentioned above (in an incremental tax reform scenario), plus an additional boost in purchases of the main engine of household wealth, the personal single-family residence.

This would boost the housing sector - SPDR S&P Homebuilders ETF (NYSEARCA:XHB), iShares U.S. Home Construction ETF (NYSEARCA:ITB) - furniture, and all things related to housing. I realize that even talking about this is a bit far-fetched, but sooner or later, the leadership of the U.S. is going to come to the realization that a tax system based on returns to labor is a losing proposition. One of the most viable alternatives is probably a "VAT" or something like it. A flat income tax system could supplement it. Improved economic growth would be the probable outcome if the tax revolution is handled properly.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.