Obama Versus Romney

I began my career as an economics professor (actually, assistant professor) at the Claremont Graduate School (now Claremont Graduate University).  In 1980, I joined with three colleagues at the Claremont Men’s College (now Claremont McKenna College) who had started an economics advisory company called Claremont Economics Institute (CEI).  CEI provided financial forecasting and consulting to banks, savings and loan associations and money managers.  During the presidential campaign of 1980, CEI offered two economic scenarios based on the outcome of the election.  These were entitled, appropriately enough, the Carter Scenario and the Reagan Scenario.  Our most likely scenario was a Reagan victory.  The Reagan Scenario envisioned a recession in 1981 and 1982 as the Federal Reserve continued to squash inflation, major declines in inflation and subsequently in interest rates, and an economic boom starting in 1983.  This scenario unfolded more or less as laid out in the Reagan Scenario.

Today, we face a similarly profound election.  The current presidential election contrasts two very different points of view on economic policy.  Both sides agree that huge issues need to be addressed including education, energy, infrastructure, health care and entitlements.  But the two sides represent very different approaches to these problems.  President Obama appears to favor greater government investment and participation in the economy.  His policies call for a rising share of government spending in GDP.  Republican candidate Romney, on the other hand, supports a lesser role for government and greater reliance on private market competition to address the key issues. 

Whichever spending argument wins the day, it is time to rethink the tax code.  Both sides have tax proposals.  Romney wants to lower all personal tax rates by 20%, reduce the corporate income tax rate from 35% to 25%, eliminate the estate tax and eliminate dividend and capital gains taxes for people earning less than 200,000 per year.  Obama wants to raise personal tax rates for the top two income brackets back to Clinton era levels, lower the corporate income tax rate to 28%, raise the rate on long-term capital gains from 15% to 20%, and implement a new “Warren Buffett” tax (the WB tax).  The WB tax calls for all income in excess of $1,000,000 from whatever source to be taxed at 30%.  This is intended to make sure that Warren pays at least as high a tax rate as his secretary.

The WB tax issue is pretty interesting.  Warren himself is said to have complained that he pays a lower tax rate than his secretary.  The reason for this is obvious – most of Warren’s reported income is dividends or capital gains, both of which are taxed at 15%.  The rationale for lower tax rates on capital income is that this income has already been taxed at the corporate level.  In fact, as owner of 20% of Berkshire Hathaway (BRK), Warren’s share of BRK pre-tax profits in 2012 was approximately $3 billion, on which the company (and, effectively, Warren) paid tax of nearly $900 million.  Thus, Warren is actually paying 30% on the vast bulk of his total income.

The Romney plan has a negative public relations issue.  If all personal tax rates are lowered by 20% then everyone’s taxes will decline, but this decline will be much more meaningful for more wealthy people.  To take an extreme example, Tiger Woods is reputed to have ordinary income of about $100 million, so the benefit to him of the Romney plan would be about $7 million (top tax rate going from 35% to 28%).  Meanwhile, the benefit to the median income worker will be about $1,000.  

To address this public relations issue, and to increase the efficiency of the code, I suggest the following:  eliminate the corporate income tax, lower the top marginal individual rate to 30%, and treat dividends and capital gains as ordinary income.  Since most rich people, including Warren Buffett and Mitt Romney (and possibly Tiger Woods as well), derive much of their income from capital, the higher dividend and cap gains rates will cause them to pay higher individual taxes.  But the overall tax rate on capital will be much lower.  This will promote capital investment and, hence, job formation.

One potential problem with this suggestion concerns the issue of tax avoidance.  If the corporate income tax rate is much lower that the top personal rate, then there is incentive to re-characterize personal income as corporate income.  I’d leave assessment of the importance of this issue to tax experts.  If it is a relevant concern, this would argue for keeping the top marginal rate and the corporate rate the same, but presumably that top rate could be lower than 30%, maybe 25% or even 20%.  In this case, double taxation would not be eliminated but the overall tax rate on capital would at least be a little lower.

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