A New Year’s Wish for Taxes

Happy new 2023 everyone.

As we enter the new year, one thing has been bothering me for years: Shockingly, we tax active income at a higher rate than for passive income. Everything of value in our culture comes from active income. This year I have only one request: please understand what a bad idea this is.

There are two main ways of making money: active and passive.

Active work is a job. A person is paid for services rendered. There is a rate per unit of time: hour, day, week, or month. Sometimes there are fixed-price bids, but the underlying basis is that a resource is provided — usually exclusively — for an amount of time. There are 168 hours in a week, generally 40 are considered full time. Some people work more, maybe 60 maybe in extreme cases 80, but there is a hard limit on the amount of time available.

Passive work is where money is invested and the person receives a dividend or possibly a capital gain when a stock is sold. Only people with money can invest it to get the return. The only limit for a single person is how much money they have.

Everything of value is produced by active work. Carpenters create cabinets. Composers write music. Musicians play music. Mechanics fix automobiles. Teachers helps student learn critical skills. Doctors and nurses help people with their health. Legislators pass laws. Judges hear and decide on cases. We would like a culture where everyone produces as much as possible, because ultimately we all benefit from total increase in production. The more roads we have, the more students taught, the more meals prepared, the better we are ALL off.

Investment income produces nothing. Because of the way finance works, we need investments and venture capital, but that investment itself inherently produces nothing: all the value in our society is created by people doing a service.

Motivation for performing active work is critical. The worst possible society would be one like the USSR had under communism where nobody did much more than the bare minimum. When you perform a service, it takes time from you. That it time that you can’t spend on your family, taking care of kids or the elderly. It is time you don’t spend improving your house. A worker is then compensated and it is a fair deal: the worker gives up time in exchange for pay.

Free Market has been shown the best way to find tradeoffs in a complex system, so I am not proposing that wages should be controlled by a central committee. Clearly a worker has to provide a service of sufficient value, and should be paid according to the value. The thing we need to remember is that on the very low end of the spectrum, people are choosing between working a job and taking care of kids or elderly or saving expenses by doing things themselves instead of buying them. The things they give up because of time spent on a job is a cost that must be taken into consideration relative to the wage.

Investment income is essentially free money for those with money to invest. Getting a 5% return is easily doable in a typical year(see [1]), which means a person with $1M will get a return of $50K/year for doing absolutely nothing. A person with $10M can sit on the beach and sip cocktails all the time receiving $500K / year for doing nothing. A person with $100M can lay about the pool doing nothing and bring home $5M/year. Of course you can work a bit at it and achieve a better return, but these are the rates for basic return without any specific expertise.

Shockingly, active work income is taxed at a higher rate than passive income.

Tax on active income is a disincentive to work. It lowers the wage, making work less competitive against the other costs of giving up that time. Arranging for day care, or special handling for housework, or getting someone to look in on elderly, can be real costs that compete with wages. Taxes here can cause a worker to decide that the wage just isn’t enough to cover the added costs of giving up the time.

Tax on passive income is not a disincentive on investing. If you have $10M, you are going to invest it. If you want to spend it, you will spend it. But all the money left over will be invested, because the return is essentially free without personal cost of time, effort, or inconvenience. There is no 168 hours a week limit. There is no tradeoff with other activities that must be stopped in order to invest.

Proposal: active income should be taxed at a lower rate than passive income of any kind. Making low income workers pay a higher tax rate than rich hedge fund managers makes absolutely no sense.

Wealthy people have captured the system. The only reason our system is this way is because wealthy people make most of their wealth on passive income, and rich people have hired lawyers and politicians to pass laws lowering the taxes on passive income so that they get richer. Hedge fund managers have a special law classifying the money they make as “retained interest” to pay even lower taxes than capital gains. Remember, there is no limit to the amount of passive income, it is not limited the number of hours per week. Little by little the system is altered to make it easy for the wealthy to get more wealthy, and all at the expense of the American worker.

This is supported by a couple of big lies:

Lie #1 – if you tax capital gains people won’t make investments. This is obviously a lie if you consider simply that not investing means you are not going to get any return which is like 100% tax. Obviously, getting some return is better than nothing. The key point is: you don’t have to give up anything to get the return. No time is needed. Just invest it and wait for the return while sipping your favorite red Bordeaux.

Lie #2 – big investors are job creators. No, it is good business managers that work an active job to create an organization that provides more jobs than would be there otherwise. Investment is part of the financing, and of course they get a return on that, but the investment itself is not the critical cause of job creation. Wealthy people would like you to believe that they deserve the return on investment, and so they spread this story, but it is largely just a means of justifying their wealth.

Lie #3 – Workers cost companies a lot of money. If the company makes a profit, then you take all of the revenue for a month, and subtract the total wages for all employees, plus all other costs, and the remainder is the profit. This means that the value provided by all the workers (total revenue) is worth more than their wages (part of the expenses). With no workers, you would have no revenue. All businesses — that are actually in business — benefit from a worker more than the wages they pay.

Lie #4 – Capital gains taxes hurt the little old grandmothers. Many Americans will experience gaining value of the family home — but there are provisions to avoid taxes on the house you live in. Truth is, household value increase is a tiny fraction of the entire passive income in the country. The vast majority of capital gains are received by wealthy people, not your struggling grandmother. Claiming that poor people are hurt most by taxes on capital gains serves only to manipulate the pubic to justify wealthy people retain more money.

Lie #5 – The average worker benefits more by the wealthy getting wealthier. This is the trickle down theory: cut taxes on the wealthy because the benefit will trickle down to workers. This lie is proposed obviously to persuade the average person that we should cut taxes on the ways that wealthy make money. The truth is that the rich and everyone benefit by having more people working and producing, and high taxes on workers gets in the way of that.

Think about it: When someone gives their time to deliver a service they provide a net benefit to all of society by the fact that they work, and that benefit is worth more than the wage they are paid. That work is good for them. It is good for us. It is good in general to have everyone working that we can get to work. So lets lower taxes on workers. Investment income is essentially free to anyone that has some wealth, and it provides no intrinsic value. So let’s make sure that income this way does not pay a lower tax than income that actually benefits us all. This is one way to improve the system.

If the system works best for the average American, it will work best for the wealthy Americans as well.

I am not suggesting centralized control of wages or dividend rates or anything else. We need to keep a concept of a minimum wage and I don’t suggest changing that. I am just saying that taxes should not be higher than passive income.

I am not suggesting a new tax system based on consumption, or purely on wealth, or eliminating income tax, though those might be good, this is only a relatively small change to the system we already have.

I am not suggesting that passive income is not worthwhile or evil. The current finance system is complex and I am not suggesting an overhaul of it. Instead, I welcome people to make money through investment, just pay your fair share of tax when you make that pile of money.

I am not suggesting changing the amount of total tax collected. Although that might be worth consideration, this proposal could be completely revenue neutral. All we are doing is adjusting where the tax is coming from.

Simple Proposal: income tax on active income should be lower than tax on passive income. Income tax should be lowered, and tax on capital gains, dividends, and retained interest should be raised to be higher than regular income tax. That will provide the best incentive for people to work and produce things. Wealthy people will still make a fine return on investment and will continue to sit back and receive their free returns. This system is more fair, and provides the right incentives, to assure that we have an many people as possible working.

Points to remember:

  1. all value of a society comes from active work
  2. each worker has a limit on time that can be spent working
  3. giving time to a job takes time aware from other things that can be a cost
  4. passive income is unlimited in size for a given person
  5. passive income provides no actual inherent value to society
  6. our tax system taxes active income at a higher rate than passive income
  7. we should charge lower tax on things we want more to be done

References

[1] Piketty, “Capital in the 21st Century”

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