John C. Goodman

If the White House has its way, the next election will be about taxes on the rich. Or, rather, the super rich.

The amount of money involved will be trivial. But this isn’t about money. It’s about envy, resentment and class warfare. The very same president who won the last election by promising to bring us all together, will try to win the next one by dividing us. The candidate who last time around promised to appeal to our highest motives, will appeal to our basest instincts on the next go around.

In his corner the president will have Warren (I’m-not-taxed-enough) Buffett, who claims he pays a lower tax rate than his secretary. I and other economists disagree with that assertion. But here’s the problem: How does an ordinary mortal wade through the labyrinthine provisions of the tax code to understand who is right and who is wrong?

Answer: I’m going to help you by showing you the right way and the wrong way to levy taxes.

Imagine an evening at a casino. We carefully keep track of who comes and who goes and record their winnings and losings. Let’s suppose that among the winners, someone really cashes in big — netting, say, $100,000 for the evening. Most people, however, lose. In fact, if most people didn’t lose, the casino would go out of business.

Now here is the question: How should the IRS treat this information? If you think of gambling as a sort of investment, you might be inclined to think of the winnings as the profit on that investment. If so, you might conclude that the winners should pay income taxes on their winnings — especially the $100,000 winner. But, if you think that, consistency would require you to allow the losers to deduct their losses as business expenses. Otherwise, the tax code would be rigged so that it’s heads-the-IRS-wins-tails-you-lose.

Since losses exceed gains at most casinos, however, the Treasury would actually lose money if it treated gambling winnings as ordinary business income. Our federal government has a solution to that problem: It’s inconsistent. Uncle Sam wants to share in all your winnings, but wants you to take the full hit on your losses (net of gains).

If this doesn’t seem self-evidently absurd to you, imagine sitting in a bar and flipping a coin for $100. Even though no income or wealth is being created and even though no product is being produced, the IRS position is that the winner of the coin flip owes a tax and the loser gets no deduction!

How should the tax system function? Let’s begin by recognizing that the roll of the dice and the spin of the roulette wheel do not create any real income. They just result in money being shifted around. In the official accounts of our country’s national income, there is no line item labeled “gambling winnings.” Gains and losses from gambling are not part of our gross domestic product (GDP). In fact the only thing that happens in a casino that counts as part of our national income is the net income of the casino itself.

Taxing gambling winnings is like taxing rollercoaster rides or movie tickets or any other form of entertainment. You may think we should do it, but that is totally unrelated to why we have an income tax system.

This same principle applies to the stock market. When the market is open, stock prices are changing every second. Every time they change, there are winners and losers. Yet none of this reflects real production or income associated with real output. There is no line item in our GDP accounting or in per capita income statistics for “stock market gains and losses.”

I know what you are thinking. If we don’t tax gains from stock market trades, won’t we be allowing a lot of income to go untaxed? The surprising answer to that question is “no.” The only reason stock prices rise or fall is because of changes in expectations about the future earnings of corporations. But eventually the future will arrive. All the corporations will pay taxes (and therefore all the stockholders at that time will become less wealthy) when corporate earnings are actually realized.

In the meantime, when we tax stock market trades all we are doing is taxing changes in expectations. This makes no more sense than taxing changing expectations about the next election or who will win the Super Bowl.

Moreover, as in the case of gambling, if the tax law were consistent, the Treasury would actually lose money on the taxation of stock transactions. Over time, the market does tend to rise and gains will exceed losses. But since individual traders have discretion about when to buy and sell, they will time their trades so that aggregate losses will tend to cancel out aggregate gains on the income tax returns of traders as a whole.

The only reason the government gains from taxing stock trades is because it is inconsistent. As in the case of gambling, the taxation of gains is unlimited while the deductibility of losses is very restrictive.

These same principles apply to almost all capital gains. The term “capital gain” cannot be found anywhere in our national income accounts. It is not part of national income or per capita income or any other national income statistic. In general, a capital gain or loss usually reflects a change in the market’s expectation about the future. These expectations may be right or wrong. But there is no reason to tax them. Eventually the future will arrive and all income will be taxed when it is realized.

Now at this point, I really know what you are thinking. Goodman, are you saying Warren Buffett shouldn’t be taxed at all? Not on your life. Warren Buffett should be taxed. And he should be taxed more than his secretary is taxed. But he should be taxed in a way that makes sense.

As I wrote in a previous editorial, when Warren Buffett is consuming, he’s benefiting himself. When he’s saving and investing, he’s benefiting you and me. Every time Buffett forgoes personal consumption (a pricey dinner, a larger house, a huge yacht) and puts his money in the capital market instead, he’s doing an enormous favor for everyone else. A larger capital stock means higher productivity and that means everyone can have more income for the same amount of work.

So it’s in our self-interest to have very low taxes on Buffett’s capital. In fact, capital taxes should be zero. That means no capital gains tax, no tax on dividends and profits — so long as the income is recycled back into the capital market. We should instead tax Buffett’s consumption. Tax him on what he takes out of the system, not what he puts into it. Tax him when he is benefiting himself, not when he is benefiting you and me.

What kind of tax system would get the incentives right? Any tax system that taxes consumption, but not investment.

A flat tax, a national sales tax or a value-added tax — at least in their pure forms — would all accomplish the right goal. And contrary to a lot of loose rhetoric, the changeover to a consumption tax is actually “progressive.” It would leave after-tax income more equal than it is today!


John C. Goodman

John C. Goodman is Senior Fellow at The Independent Institute and author of the widely acclaimed book, Priceless: Curing the Healthcare Crisis. The Wall Street Journal and National Journal, among other media, have called him the "Father of Health Savings Accounts."