The Gingrich Tax Plan

I have a new essay on the Atlantic.com on Gingrich’s tax plan.

Here’s the essay:

“It starts very simply: Taxes, lower taxes.”

That was the first line of Newt Gingrich’s explanation of how he would create jobs, given at the December 10 Republican debate in Iowa. Gingrich talked about his desire to end the capital gains tax and cut the corporate income tax to 12.5%. In addition, Gingrich has proposed a 15% flat tax as an option for all Americans, going further than the 20% flat tax advocated by Rick Perry.

On one level, Gingrich’s intense focus on lower taxes fits current dogma in the Republican party, which puts tax cuts above almost everything else. He is playing to the conservative base, as a way of counteracting some of his other personal liabilities.

If enacted in their entirety, Gingrich’s proposed changes would turn the U.S. tax system from progressive to regressive. Someone earning $40,000 in wages could pay a higher tax rate than another person who made $400,000 a year in capital gains.

This shift from progressive to regressive is not acceptable, of course. The tax system should be a tool for reducing the stresses of inequality in the economy, not increasing it. That’s especially true now, coming out of such a devastating recession where so many American are unemployed or underemployed.

But these tax cuts, which lie at the heart of the Gingrich program, would have another striking implication as well, which has not yet been remarked on. He is targeting precisely those taxes — like the corporate income tax and capital gains tax — that capture the gains from globalization. In other words, Gingrich is waging war on Washington’s ability to tax “globalized” income, which is likely to grow faster than domestic income for the foreseeable future.

What do I mean by “globalized” income? By my definition, globalized income means funds that come directly or indirectly from the operations of U.S. companies in the global economy. The most obvious example of globalized income is the money that companies report as “rest-of-world” or foreign profits. Today, the Bureau of Economic Analysis reports that “rest-of-world” profits are running at a $450 billion annual rate, small potatoes compared to a $15 trillion economy.

However, the category of globalized income includes a lot more than foreign profits. For example, suppose that a U.S-based company is highly profitable in Asia. Even if those profits are not repatriated, the company’s share price is likely to rise. If an American stockholder sells those shares and collects a $5 million capital gain, that gain is reported as domestic income. But in fact, it’s due purely to the operations of that company overseas. Similarly, when the CEO of that company cashes his or her stock options, it’s the same thing. The stock option gains get reported as domestic income, even though they are directly connected to the company’s operations overseas.

Here’s another example. Suppose that a U.S. furniture retailer switches suppliers. Instead of buying from a domestic manufacturer, they now get their furniture from a cheaper foreign manufacturer. Because of this outsourcing, corporate profits rise, and the CEO gets a big bonus. To the government statisticians, that bonus looks like pure domestic wage and salary income. However, it flows purely out of the company’s ability to take advantage of the cheaper prices on the global market place.

Ordinary workers generally don’t have globalized income–their wages and salaries are purely domestic, unless they happen to be working directly on exports. Globalized income flows to those people whose incomes rise when the company as a whole does well–shareholders and high-ranking executives . And those are the people who are affected by capital gain taxes, corporate income taxes, and progressive tax rates on high earners.

And here’s where we get back to Newt Gingrich and his plan. The U.S. population is being separated into two groups: Those people who are benefiting from the increased globalization of the U.S. economy in their work lives, and those who are not. This is the big divide in the economy right now–and we don’t need a tax proposal that just widens the gap.

Needed: A ‘Global-Compatible’ Tax System

President Obama is thinking about a broad overhaul of the income tax system, closing loopholes and lowering rates. (“Obama Weighs Tax Overhaul in Bid to Address Debt”).

But in today’s global economy, any attempt to ‘fix’ the U.S. income tax system is fundamentally doomed. Financial and product markets are so deeply globally integrated that multinationals and wealthy individuals can easily  recognize their income in lower-tax countries, if they choose.

One simple statistic: In 2009 40% of U.S. imports and exports was ‘related-party trade’ –“trade by U.S. companies with their subsidiaries abroad as well as trade by U.S. subsidiaries of foreign companies with their parent companies.” That means companies are effectively trading with themselves, so they can choose which side of the transaction books the profits.

To put it another way, the global economy is the biggest loophole of all, and it can’t be closed without layer after layer of intrusive rules and regulations.  In a global economy, you can’t have a simple income tax system.

What we need is a ‘global-compatible’ tax system: That is, a tax system which acknowledges the existence of a global economy, so it doesn’t continually need to be patched to close loopholes.

The best global-compatible tax system that I know of is the value-added tax. The value-added tax, as the name suggests, taxes the value added in a country, not the income. Equally important, A VAT  taxes imports but not exports.  As a result,  it offers far less chances for gaming the system.

Now, countries can still compete on their level of VAT. Moreover, there are a lot of controversial issues that can seriously affect competitiveness. These include: How to make the VAT progressive; whether medical care and housing should be exempt; how to treat capital investment and R&D spending; and so on. Big important questions, but ultimately solvable.

If you want tax simplicity and fairness, global-compatible is key.

Tax Cuts and Growth

Ezra Klein writes:

If you’re worried about stimulus, joblessness and the working poor, this is probably a better deal than you thought you were going to get.

That’s my feeling too.  My short-term optimism about 2011 has gone up several notches. Klein also notes:

last week, all Washington could talk about was the potential for a deal on deficit reduction. This week, it actually got a big deficit deal — but it was a deficit-expansion deal. In the world that politicians claim they live in — where the deficit is the overriding issue — the deal couldn’t have worked. But we don’t live in that world. In this world, tax cuts, not deficits, are the Republicans’ central concern, and stimulus, not deficits, obsesses the Democrats.

Two responses. First, both parties have the economic literature on their side, which says that deficits don’t have negative consequences  in the short-run as long as they are not “too big.”  The deficit talk was just posturing.

The real issue is not the budget deficit, but rather balancing out  two competing forces:  Having the government intervene where needed to help people while making sure that innovation and growth is not crushed under the weight of excessive regulations.  That’s the debate we should be having.

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