We Need More Income Inequality, Says a Bain Alumnus

Edward Conard is a former colleague of Mitt Romney at Bain and a backer of Romney’s campaign. He takes issue with the outrage over the huge imbalance of wealth that has flowed to the top 1% of Americans. In a new book, “Unintended Consequences: Why Everything You’ve Been Told About the Economy Is Wrong”, he argues that our economy should be structured so that still more wealth would go to the top tiers.

He points to the innovative advances that have enriched our lives over recent decades — personal computers, smart phones, Internet search — it’s a long list — all brought about through the daring of risk-takers. People who have taken chances with their investments rather than sit on the sidelines — “art history majors” he calls them. The super-rich don’t spend their money on themselves, he says; they invest it in productive businesses that improve life for all. His premise is that if the rewards were made even greater, more of us would be drawn into taking those risks and we would see a renewal of growth.

That last is compelling, but it relies on his belief that all or most of the wealthy pump their earnings back into nascent businesses, stoking innovation, growth and job creation. In fact, most is plowed into the stock and bonds of well-established companies or into funds of such companies or into U.S. Treasuries, and a goodly portion finds its way into investments abroad. The Wall Street Journal reported that 60% of investors worth more than $30 million place a third of their total assets in other countries, and one in five invest half their assets offshore. A joint study from Cap Gemini and Merrill Lynch found that "The wealthy have, on average, 43% of their holdings in low-risk assets...29% bonds and a thumping 14% in cash. So much for the idea that the more you have, the more risk you can take".

Dividends and interest go overwhelmingly to the top 2% of taxpayers — that stratum of supposed risk-takers that Conard wants Americans to join. Money that earns dividends and interest is unlikely to be invested in the sort of striving, entrepreneurial businesses that Conard wants us to back; only the most mature companies pay dividends.

Conard’s book isn’t out yet as this is written, so we are unaware of whether he focuses as well on the utterly irrational tax code. If he wants to entice Americans to take risks and join the 400, he should start with a complete overhaul of tax structure as it applies to dividends, interest and capital gains.

Republicans, especially, argue for lower corporate tax rates to make American industry more competitive in the world. Wouldn’t you think that they long ago would have pressed for the dividends corporations pay to be an expense that reduces their taxable income? Much like payroll to employees, this "pay" to a company's owners would be singly taxed only on the individual tax returns of dividend recipients. The double taxing of dividends is a perennial topic for complaint, yet nothing is ever done.

That dividends are taxed at the 15% rate (let’s ignore “qualified”) while interest income is taxed at ordinary income rates makes no sense? Why is one form of investment (stocks) favored over the other (bonds, loans, etc.)?

If Conard wants to prod us to take risks, he should argue that dividends as well as interest should be taxed as ordinary income to steer us away from investing in established businesses. Which brings us to question of why all capital gains should qualify for the 15% rate.

What we should have said is: 15% on capital gains from the sale of a security held over one year. What’s the point of that differentiation? Long-term holding may stem volatility? Seriously? With 65% of all equities now traded in multi-millions of nanosecond algorithmic transactions every day? Can it still be the hoary shibboleth that one should be rewarded for staying loyal to a company? Nonsense. Virtually 100% of stock trades have no connection to the underlying companies. Virtually all trades of securities are between individual investors, funds, corporate portfolios, pension funds, etc. Save for the infinitesimal sliver of newly issued stock and bonds (only 125 IPOs last year), the money doesn’t go to those enterprising ventures that Conard wants us to support. The risk-taking is only that someone may not take a position off your hands for as much as you paid.

Yet for all this swapping back and forth amongst ourselves that does no good for the companies themselves (at this point we will hear bleats about “liquidity” and "capital formation"), investors are accorded a special tax rate of 15% should we sell at a profit. Successive administrations and Congress have rewarded their wealthy campaign donors with a tax policy tilted to help those who make the most money make still more. The apparent philosophy is that actual labor is what should be burdened at rates of up to 35%. Even Ronald Reagan agreed that such capital gains should be taxed as ordinary income.

Incidentally, if this form of capital gains is to be taxed as ordinary income, the quid pro quo calls for doing away with the government’s confiscatory practice of taxing profits in full while only allowing a deduction of $3,000 if a year’s net trades produce a loss — and only $3,000 a year thereafter for as long as the carry-forward produces a net loss. That amount isn’t even indexed to inflation. Incredibly, it hasn’t changed since 1978. Fully taxed profits should be matched with fully deductible losses.

To encourage risk-taking, an intelligent re-write of the tax code would differentiate between buying already issued securities traded independent of their companies, and investing in the new issues that fund those companies directly. It is these risk-takers who should be rewarded with low capital gains tax rates. Or even no capital gains tax for those with incomes of $250,000 or less as Mitt Romney has proposed — except that he means all capital gains, not restricted to those that arise from direct investment in companies.

Sorting out the two categories shouldn’t be difficult, now that the IRS requires brokerages and funds to keep track of both ends of a trade and report gains and losses. Their computers could permanently tag stock bought as part of a direct offering and, once sold, report such trades as a separate tax class.

But a fix is needed. If the best customers of an investment bank get the IPO allocations, only to buy and flip a stock, there is no justification that they should get this special tax treatment. One solution would be to restrict re-sale for a set period.

This still doesn’t fix how IPOs are rigged. Here, venality is in flagrant display, with the lead investment bank swindling the issuing company by setting a low per share price that is sure to zoom at the offering so as to lavish hugely undeserved profits on those best customers. They pocket money that should have gone to the issuing company itself. A well-remembered example was Netscape; priced at $28 a share, it zoomed to $75 as the buyers unloaded, pocketing the difference instead of Netscape. As a lonely antidote, we can savor the Facebook offering, watching investors howl — even sue — because there was no run-up in the stock’s price for the freeloaders. Facebook got the full amount of the posted offering. Unheard of.

Still another fix: If you do buy and hold, inflation will chew away at any gain — or reduce your true loss — because capital gains and losses are figured on the nominal dollars of the buy and sell. The dirty secret that the government (which, after all, is charged with controlling inflation) never mentions is that, given enough time and inflation, you could literally find yourself paying taxes on losses.

Again because brokerages and funds are now retaining cost bases, they could easily factor in the annual rate of inflation across the years that we hold an asset so that one's cost basis is stated in current dollars.

There are still many other changes needed for a full restructuring and several thorny categories of income yet to be considered — how to treat the different types of “carried interest”, whether founders' shares should be taxed as pay, what adjustments would be needed for stock options, etc. But short of tax reform structured so as to favor only the risk-taking that leads to new jobs and growth, the core of Mr. Conard's thesis is hollow.

But as all of this depends on Congress, why continue? Instead of fixing the mess, the years go by with our representatives merely talking about tax reform while doing nothing.

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