by Norman G. Kurland
© 1977 by Tax Executives Institute, Inc. Reprinted with permission from The Tax Executive, (April, July 1977) 187-199, 386-402, with author’s 1993 revisions.
“Our tax system is a national disgrace.”
(President Jimmy Carter, during his 1976 Presidential Campaign)
“The Congress in a series of laws has made clear its interest in encouraging employee share ownership plans as a bold and innovative method of strengthening the free enterprise system which will solve the dual problems of securing capital funds for necessary capital growth and of bringing about share ownership by all corporate employees.”
(Section 2701, U.S. Tax Reform Act of 1976)
“To begin to diffuse the ownership of capital and to provide an opportunity for citizens of moderate income to become owners of capital rather than relying solely on their labor as a source of income and security, the Committee recommends the adoption of a national policy to foster the goal of broadened ownershipWhatever the means used, a basic objective should be to distribute newly created capital broadly among the population. Such a policy would redress a major imbalance in our society and has the potential for strengthening future business growth.”
(1976 Annual Report of the Joint Economic Committee of the U.S. Congress)
The monumental task of reforming the U. S. tax system requires willingness to go back to the beginning, to reexamine fundamental principles and ideals from which this unique nation was born, and to question any assumptions in current economic and tax philosophy that may be inconsistent with those fundamentals. The forthcoming debate will certainly center around issues of justice, equality, tax expenditures or subsidies and loopholes, terms bound to produce confusion and divisions among Americans if their thinking remains shackled along present ideological lines.
This article will suggest a philosophical framework that offers new definitions for these vague expressions and an alternate perspective for understanding basic issues of tax reform. It attempts to shed more light on the philosophy behind the creeping movement on Capitol Hill to foster a new national goal of broadened capital ownership. And it attempts to explain the broader context surrounding employee share ownership plans (ESOPs) and how the ESOP fits into a more comprehensive national ownership strategy, within which a totally new approach to taxation is a prerequisite. Finally, this article offers new guideline suggestions to unite opposing forces on some of the most controversial issues facing tax reformers. At the very least, the writer hopes to provoke thinking people, persons who recognize their responsibility for making today the decisions that will determine the way of life twenty or thirty years from now, to think again.
Since the goal of equality has a certain universal moral ring to it, as we boldly approach the tax system as an instrument for achieving greater equality for Americans, we should be reminded of de Tocqueville’s final warning to us after observing American democracy in action:
The nations of our time cannot prevent the conditions of men from becoming equal, but it depends upon themselves whether the principle of equality is to lead them to servitude or freedom, to knowledge or barbarism, to prosperity or wretchedness.
(Alexis de Tocqueville, Democracy in America, 1840).
Let us start with a simple thesis. Political democracy cannot preserve the institutions of a free society unless everyone can participate on an equal basis. An economically free and classless society – another way of describing economic democracy – is therefore both a goal and a means for supporting political democracy. Where opportunities to accumulate wealth are grossly unequal, great inequalities in the distribution of wealth are readily seen as flagrant contradictions to the goal of a free, just and economically classless society. Therefore, attacking the problem of inequality of wealth is a legitimate concern of a democratic government. How to build an economically free and just social order, however, forces us to think about what we mean by economic justice.
A thorough search through the literature of Western civilization for a pathway to a just economic order, will eventually lead the serious scholar to two seminal philosophical works, each diametrically opposed to the other, not in their quest for an economically free and classless society, but rather in the moral and political principles and the institutional framework each considered necessary for achieving economic democracy.
That the first one, written in 1848, has had a profound and growing influence on tax philosophy and tax reforms around the world, is hardly debatable. In the second chapter of The Communist Manifesto, Karl Marx and Friedrich Engels presented a list of ten measures “which appear economically insufficient and untenable, but which in the course of the [communist] movement, outstrip themselves, necessitate further inroads upon the old social order, and are unavoidable as means of revolutionizing the mode of production.” Marx and Engels described these ten measures as “despotic inroads on the rights of property” which the propertyless masses will use to “wrest, by degrees, all capital from the bourgeoisie [and] to centralize all instruments of production in the hands of the State.” Besides calling for abolition of property in land, the extension of factories and instruments of production owned by the State, and the centralization of the means of communication and transport in the hands of the State, among other things, the second and third items on the list were:
(2) A heavy progressive or graduated income tax.
(3) Abolition of all rights of inheritance.
If Marx and Engels have correctly predicted that the ultimate conclusion of their pathway to economic justice is a society where everyone is equally propertyless, equally liable to labor for a single employer, the State, and equally dependent for their subsistence on wealth redistributed by the State (“the dictatorship of the proletariat”), do the roots of America offer a better road to a free and classless economic order?
Directly challenging Marx and Engels, Louis O. Kelso and the eminent American philosopher Mortimer J. Adler reasoned in The Capitalist Manifesto (1958) that, while concentrated capital ownership was manifestly unjust and destructive of a free and democratic order, a higher order of economic justice should be built upon the proposition that everyone, as a fundamental human right, must have equal opportunity to become an owner of capital. Property as an institution was not the fundamental flaw of nineteenth century capitalism, as Marx and Engels asserted. And the redistribution of income is not necessarily just and orderly. Rather, countered Kelso and Adler, an industrial society could achieve a more just and orderly distribution of wealth by preserving the institution of private property and redistributing future ownership opportunities. Thus, as new and more advanced technology is added, more and more and gradually all persons would gain direct property stakes in productive resources. Following the wisdom of America’s founding fathers and some of history’s greatest political philosophers since Aristotle, Kelso and Adler made a logical and socially compelling case (to which no article as brief as this can do justice) that the institution of property is a prerequisite for preserving a free society and the foundation upon which all other human rights must be grounded.
Since, in the words of Daniel Webster, “power naturally and inevitably follows the ownership of property,” a society where all power is supposed to rest in its citizens, must necessarily develop means to keep property broadly diffused.
The worldwide moral appeal of this fundamental right is recognized by Article 17 of the UN’s Universal Declaration of Human Rights, which reads: “Everyone has the right to own property, alone as well as in association with others.”
Moreover, argued Kelso and Adler, welfare and charity, while justified as humane, short-term expedients for coping with severe cases of economic deprivation, offer no lasting politically realistic solutions to economically unjust situations. As expedients, however, they can be carried on simultaneously with a comprehensive long-range program for restructuring the future ownership patterns of a society.
The Kelso-Adler version of a just society rests upon three basic principles of economic justice
The Participation or Input Principle (Equal Opportunity to be Productive)
Since everyone has the right to life, everyone must be provided, as a fundamental human right, the right to produce a self-sufficient income. In other words, one can legitimately participate as a producer of marketable goods and services, either as a worker or as an owner of capital instruments, or both. In terms of a high technology society, Kelso and Adler would redefine the term equality of economic opportunity to require government to lift all barriers and take affirmative action to promote more equal access to the future ownership opportunities. Where new capital formation is added through such a uniquely “social good” as expanded bank credit, for example, this means that everyone should be provided equal access to society’s capital credit system.
The Distribution or Outtake Principle (Private Property)
Reward should be based, not on one’s clout or on charity, but on the value of one’s input to production, whether through one’s human efforts or through one’s ownership of productive capital, or both. If a person wants to consume more, it follows that he must produce more; otherwise he must become dependent on the wealth produced by someone else’s labor or someone else’s property. However, just as the denial of one’s entitlement to the fruits of his hands or mind is a denial of his property rights in his own body, taking away anyone’s property income is a direct erosion of his property rights in the means of production.
Under the private property principle of wealth distribution, how would prices, wages and profits be determined? Following Aristotle, Kelso and Adler would allow the free and competitive marketplace to determine what is a just wage, a just price, and a just profit. Neither coercion on the buyer or on the seller of any goods or services would be allowed. In the freely competitive marketplace, the laws of supply and demand, not special privilege or superior clout, control economic values. In this democracy of the marketplace, consumer sovereignty reigns and everyone’s vote counts.
The Feedback or Limitation Principle (Anti-Monopoly)
Where a few own too much of the means of production and most of society owns too little property or none at all, justice is automatically denied. No one is born with property in the means of production. In a free society everyone is born with property in their own bodies. The ownership of capital is wholly determined by society’s institutions, which in turn are products of society’s laws. Hence, no monopoly can exist without the approval or tolerance of government. Since most technological gains are produced by improved tools (i.e., machines, techniques, structures, organizations), an economy is inherently unjust if government permits a monopoly over the ownership of its instruments of production. Such a monopoly is a systematic denial of equal economic opportunity because it denies others the right to produce enough to support themselves by owning the tools that produce wealth. Since tools continue to produce more with less and less human efforts, concentrated capital ownership, if left uncorrected, leads inevitably to redistribution and the eventual breakdown of the other two principles of economic justice. By allowing a few to produce radically more than they and their families can consume, others are forced into conditions of dependency. One man’s surplus is another man’s poverty.
If Kelso and Adler’s version of economic justice is more sound than that of Marx and Engels, then we can well understand why tax reform during the last sixty years has failed so miserably. What becomes almost self-evident is that tax reformers in general have put the cart before the horse. By discouraging new capital formation through discriminatory taxes on property and property incomes and emphasizing redistributive goals of taxation instead of encouraging broadened ownership opportunities, tax reformers have elevated the tax system and government stimulated demand to a position higher than the nation’s wealth production system, upon which all tax revenues and everyone’s ultimate standard of living depends.
A sound tax policy cannot be constructed upon confused or unsound political or economic principles. The Kelso-Adler concept of economic justice offers a solid foundation upon which business, labor, and government can forge a new consensus and new common strategy to enable our Nation to cope more realistically with today’s industrial world, with our capital and other shortages, and with the challenges we can expect from accelerating technological change.
Sound tax policy is based upon a reassertion that once made America the last best hope of mankind. It would recognize that government does not produce wealth and that every subsidy must originate with those individuals whose productive toil and productive capital actually produce society’s marketable goods and services, including those diverted through taxation. It would also recognize that wealth is produced most efficiently within competing privately owned enterprises vying to satisfy private consumer demand, with every buyer voting with his own dollars to reflect his choices among available goods and services.
Government, through its taxing and spending powers, has the power to redistribute wealth, in addition to carrying on its originally conceived and more normal functions of enforcing contracts, protecting property, suppressing violence and otherwise maintaining a just and peaceful society. And to the extent it can create legal tools like the business corporations to meet the needs of society, it can regulate them. On the other hand, when business corporations, voluntary associations, or any other specialized social inventions become socially dysfunctional and create, rather than solve, problems for society, government is the instrument through which we overcome the problem, directly or through a restructuring of our institutions and laws. It is not in the nature of government to leave social vacuums unfilled.
As a result of defects in our economic institutions, wealth patterns in America have become grossly distorted and plutocratic. The gap between the very rich and the very poor continues to widen. Class divisions between propertied and non-propertied Americans produce a never-ending political battle. This is reflected in the 1976 Annual Report of the Joint Economic Committee, which found that the richest 1% of Americans own over 50% of all individually owned corporate equity and receive about 46% of all corporate dividends, and that concentrated ownership patterns will only worsen in the years ahead because of traditional methods used by U.S. corporations for financing their new capital formation.
Today, as a result of the maldistribution of ownership and income, we have reached a point where government itself is suffering from an acute case of functional overload. Public redistribution and efforts to control the economy have placed responsibilities on government that are contrary to its very nature. The mere shifting of centralized governmental activities to state and local levels totally ignores this problem. Reorganization of the federal bureaucracy is similarly futile.
The State – civilization’s most important social invention – can no longer effectively carry on the highly specialized and limited functions for which it was originally designed. The State, in the view of many, is mankind’s only legitimate monopoly, our social contrivance for monopolizing coercion and violence. As such, however, it is a highly dangerous and unnatural tool when it tries to assume powers best left to private individuals and their associations, especially where market disciplines are present to govern economic decision-making.
Next to the State itself, the modern corporation is our most important social tool. It is an excellent vehicle for absorbing technology, harnessing together talent and capital, and marketing on a global basis. Since industrial capital produces an increasing share of society’s wealth, a sound and just governmental policy would remove roadblocks to broader participation in corporate equity ownership for all households, so that the need for governmental intervention and income redistribution would gradually and systematically be reduced to tolerable levels. The corporation is, after all, a mere creature of the law and to the extent it does not serve the ends of justice, our system of justice is necessarily deficient.
Encouraging growth of the corporation while broadening the base of its future shareholder constituency means that the necessary costs of government can then be shared by a constantly growing base of citizens with private incomes distributed directly in the form of paychecks and dividend checks from our corporate sector as a whole.
From a political standpoint, a corporate shareholder constituency consisting of a more representative base of American households would also automatically make management of our largest and most powerful corporations less vulnerable to self-proclaimed consumer advocates and overregulation by government. As it becomes more directly people-connected and people-empowering, the corporation will become more popular as an instrument of society. Corporate profit would soon lose its social and political attackers as companies provided second incomes to the broadest possible consumer base. Making its future growth opportunities accessible to every citizen would enable the corporation, in my opinion, to make a quantum advance in its own evolutionary development as a major component of a democratic society. (In terms of its presently narrow constituency base and its efficiency as a direct distributor of mass buying power, the mass production corporation is still remarkably primitive, about comparable in historical terms to the democratic form of government over a thousand years ago.)
The new approach recommended in this article would reconstruct the economic system, along the lines of the four pillars illustrated in the following figure.
Congress has acted five times since late December 1973 to promote the ESOP. What has surfaced thus far is only the tip of the proverbial iceberg. Below that surface lies the revolutionary private property philosophy and comprehensive ownership strategy first articulated by Kelso and Adler. Too scholarly in its tone to inspire a new political movement and too revolutionary in its ideas to gain the support of economists and academics wedded to orthodox ideologies and the economic status quo, this blueprint for an advanced socioeconomic order seldom is associated with the history of ESOP, although both were inspired by the same person, San Francisco lawyer and investment banker Louis O. Kelso.
When this writer first became associated with Kelso in 1965, to most politicians, businessmen, and labor leaders, ESOP sounded like the author of ancient parables and Kelso was a famous winning race horse. By 1972 several dozen ESOPs were established. Since Congress legitimated the ESOP in 1974, an estimated 200 or more classical ESOPs have been launched. The mass media and professional journals have begun to take serious notice of the ESOP and since 1974 articles on the ESOP have appeared in Time, Newsweek, Fortune, Business Week, The Wall Street Journal, The American Bar Association Journal, Harvard Business Review, The Tax Executive, Barron’s and even The Village Voice. Many criticisms have surfaced regarding the ESOP, some valid and constructive, some simply nit-picking and totally negative, some based upon fear and ignorance. Few recognized that the ESOP, even in its primitive form, is only a small part, a single instrumentality, of a much bigger picture. The most comprehensive compilation of the pros and cons of ESOP were covered in two days of congressional hearings in late December 1975 before the Joint Economic Committee. Without attempting to address these problems here, let us examine the nature and purpose of this controversial tool.
Here is how the Senate Finance Committee, chaired by the ESOP’s most ardent champion on Capital Hill, Senator Russell B. Long, describes the ESOP:
Employee share ownership plans make it possible for workers in the private sector of our economy to share in the ownership of corporate capital without redistributing the property or profits from existing assets belonging to existing owners. Since its first application as a financing tool in 1957, [ESOPs] have been implemented by a growing number of successful U.S. corporations. Through the vehicle of a specially designed tax-exempt trust, this method of finance offers corporations certain tax incentives and cost-reductions not available under conventional methods of finance. The [ESOP] also allows workers to accumulate significant holdings of capital in a tax-free manner during their working careers, while being taxed only on second incomes received in the form of dividend checks or on their assets when removed from their trust accounts
[Sen. Report 93-1298, Trade Reform Act of 1974 (Nov. 26, 1974) 158-9].
From this description it seems clear that the classical ESOP is not a mere share bonus plan, although its legal basis can be traced to the same provisions of the U. S. tax laws which deal with share bonus plans, profit sharing plans, pension plans, thrift plans and other IRS-qualified employee benefit plans. Like the share bonus plans and the relatively few profit sharing plans that invest heavily in company shares, it is not basically a retirement vehicle, but is designed to link all employees of a company to the full status of shareholders, up to 100% of the company’s equity ownership.
The ESOP is an ownership creating tool, plus. Unlike profit-sharing and conventional share bonus plans, the ESOP, if properly designed, adheres rigidly to protecting the private property rights of other shareholders, as mandated by Kelso-Adler principles of economic justice. It does not share their profits with nonowners. It does not dilute their ownership rights by simply issuing new shares without a corresponding increase in productive capacity or in disposable cash available to the corporation for corporate investment purposes. It merely makes capital growth and growth profits accessible to new ownership. Unlike thrift plans, share purchase plans and share option plans, the ESOP is a credit device and requires no cash outlay whatsoever from those to whom new equity opportunities are to be extended. Instead, it makes the magic of nonrecourse corporate financing work for new owners, based on credit designed to be amortized with expanded future corporate profits. It should not be adopted by a management unwilling to be accountable to its employees in their newly acquired status as shareholders. And the ESOP should not be adopted for financing growth, unless the expansion capital is expected to pay for itself. Then, as long as a baseline after-tax cash flow per share held by present shareholders is maintained in the future, all projected increases in after-tax cash flow can legitimately be applied for building ownership of newly issued equity into employees, without violating the property rights of existing shareholders.
Here’s how the classical ESOP works for financing corporate growth:
Suppose a $10 million company with 10 owners and 100 workers needs to double its plant capacity and having paid out dividends in the past, finds itself with little or no retained earnings. With solid contracts on hand to justify the expansion program, the company turns to a syndicate of lenders who are willing to lend the necessary ten million dollars for the second plant, repayable with future after-tax dollars. Management hears about the ESOP and sets one up to cover all 200 employees (including the new 100 employees to be hired when the second plant becomes operational). The ESOP borrows the $10 million, the company gets its cash by selling $10 million in new shares to the ESOP at the current market value, the company guarantees the ESOP’s credit by agreeing to pay out of projected future profits enough cash to the ESOP to service the ESOP’s debt. If the shares are not pledged as collateral, they are held in an unallocated account. As installments of the ESOP’s debt are paid, blocks of shares, once paid for, are divided up according to payroll and placed in each of 200 individual trust accounts. At the end of the financing period on this single transaction, therefore, the average employee will have gained $50,000 in new equity and the right to future dividend checks to supplement his payroll and retirement checks. The original 10 owners will not have lost any of their original equity or dividend rights from their $10 million investment. Even better, the company, through the unique privileges Congress has extended to ESOP financing, is permitted to service the debt for its expansion capital with pre-tax, rather than post-tax corporate dollars, a tax advantage that increases the company’s cash flow by roughly 50¢ on every dollar borrowed by the ESOP. This is so because Congress has specially recognized the ESOP, both as a socially improved technique of corporate finance and as a new form of employee benefit. The ESOP must be approved by the Internal Revenue Service (IRS) and is policed by the IRS and the Department of Labor. Up to 15% of covered payroll, the cash for servicing the ESOP’s share acquisition debt is treated as a tax-deductible contribution. Although dividends may currently be used to accelerate repayment of the ESOP’s debt, under present tax laws share dividends are discouraged. In the future, Congress may allow corporations to take tax deductions for dividends paid out, perhaps initially only for ESOP acquired shares. (See proposals below.) Then ESOP financing would be designed to be repayable primarily with projected pre-tax dividend payouts rather than employee benefit dollars, which under today’s accounting procedures create an illusion of reducing corporate net earnings.
The Investment Tax Credit ESOP
In contrast to the classical ESOP, the investment tax credit ESOP can be justifiably labeled as a giveaway, not from present shareholders but from the federal treasury. Nevertheless, unlike other tax subsidies, this bonus to companies adopting an ESOP contain the seeds of the quiet and creative revolution launched by Kelso and Adler. It points to a new direction for business, labor and government and to a gradual overhaul of the tax system itself, along lines suggested in this paper.
Tax Philosophy Behind the Classical ESOP
As noted earlier, the classical ESOP involves no giveaway from present owners. And, unlike the normal 10% investment tax credit, tax deductible payments to a classical ESOP are wholly distinguishable from tax subsidies and should no more be considered a taxpayer gift than that which permits corporations to deduct wages and salaries from gross earnings. While many tax deductions are hardly distinct from direct government expenditures, and thus can appropriately be labeled subsidies or “tax expenditures” under today’s unjust tax system, this is not the case for deduction of debt service contributions to an ESOP. Rather, from a standpoint of the philosophy of economic justice upon which the ESOP is based, the double tax penalty on corporate profits is a direct violation of the private property rights of a corporate equity owner. The corporation income tax is therefore inherently an unjust tax under any social system which is based upon the institution of private property. If all corporate net earnings were deductible to the corporation to the extent they were paid out directly to the equity owners as dividends and taxable as personal incomes, the double tax problem would vanish. (See proposal below.) It is in this light that the nature of the ESOP can be properly understood.
Behind the ESOP is a philosophy of taxation and a carefully conceived strategy to remove gradually the tax system’s present bias against property and property accumulations, on the one hand, and, at some point, to reduce the government’s use of the tax system as an income redistribution mechanism, on the other. The 48% corporate income tax involves pure redistribution. Instead of treating all incomes the same, whether they are derived from capital or labor, the tax on corporate profits dilutes by half the property incomes (and thus the property rights) of present shareholders. Then when that income becomes available to owners in the form of dividends or capital gains, the government takes a second and third bite out of the remainder. Where the corporation tax is a direct frontal attack on the institution of private property, the ESOP offers a powerful means for counterattacking in a manner that will simultaneously serve other desirable social goals: it can help overcome shortages in private sector capital formation; it fosters more equity financing; it can help foster more private sector jobs in the fabricating and operations of newly added plant and equipment; it can help expand the federal revenue base from expanded private payrolls and dividend rolls; and it can help create a broader base of shareholder constituents to help corporations surmount unreasonable and unwarranted political attacks. In contrast to true tax subsidies, the ESOP is a solution, not an excuse for perpetuating or ignoring structural flaws in our major economic institutions.
The reader who is interested in gaining a more detailed understanding of the specific reforms needed to implement the Third Way should turn to Section VI of this book, describing “Basic Economic Democratization Vehicles.” Chapter 8 describes the Employee Share Ownership Plan (ESOP) and Chapter 9 describes the Consumer Share Ownership Plan (CSOP), the Individual Share Ownership Plan (ISOP), and the Community Investment Corporation (CIC). Sound tax policy should be structured to encourage the use of these vehicles for expanding or transferring the ownership constituencies of enterprises. Then turn to Appendices A and C to see the specific tax reforms needed. For the monetary and other non-tax economic reforms to promote the Third Way, the reader should turn to Chapters 5 and 6 and Appendices A, B and D.
On the Purpose of Taxation
If tax reformers become persuaded that redistributive taxation is morally wrong and contrary to the basic values and objectives of a free and democratic society, that redistribution keeps the rich rich and shackles the average taxpayer to wage serfdom, that redistribution leads to unnecessary shortages and bureaucratic waste, that it perpetuates mass propertylessness, then it may be possible to make a new beginning in rebuilding today’s overly complex, inherently unjust tax system. Until someone offers a more definitive overview of what constitutes tax justice, let us take advantage of the guiding principles and general strategy conceived by Kelso and Adler, at least to analyze some of the central issues all tax reformers must face. Any new beginning must start with the simple question, “Why do we have a tax system?” If we reject Marx and accept Kelso, the answer is also simple: to yield the revenue to pay the costs of a limited government, without damaging the incentives to the maximum production of wealth and the broadest distribution of capital ownership. From this point, a whole new set of conclusions follow:
The bias in the present tax laws against property accumulations and property incomes should be removed. The bias in favor of redistribution, as a practical matter, must be more gradually phased out, as redistribution of income is supplanted with an effective program of redistributing future ownership opportunities. The tax system and federal laws generally should be restructured to encourage the creation, accumulation and the maintenance of property, its widespread distribution among all households, and the maximum generation of new wealth and improved technology within the free enterprise system.
Government should announce a target goal for the economy of a minimum floor of capital self-sufficiency for every household to achieve within the next thirty years. A national ownership plan, including new tax laws, would be launched to reach that goal, similar to the manner in which government assisted Americans in the building of our agricultural base through the Homestead Act of 1862. Although the 160 acre ceiling made sense in distributing shares of our necessarily finite land frontier, the amounts that could be accumulated under the proposed “Capital Homestead Act” program is limited only by our talent, our know-how, our technological potential, and our ability to mobilize all our resources in building a new and more productive industrial frontier during the next several decades. Hence, in today’s world, a target floor is more appropriate than a ceiling as the focus of government initiatives under a national ownership program. Where most government initiatives in the last century have tended to centralize economic power, these initiatives would aim at widely diffusing economic power, while keeping it in the hands of individual citizens.
An effective tax system would offer incentives for the enterprise system itself, as the principal source of wealth production, to become a more direct and efficient distributor of mass purchasing power for all consumers in the economy.
As the need for income redistribution and governmental intervention within the private sector lessens to an irreducible minimum, the functions and costs of government should drop progressively, eventually to the tolerable levels projected by the founding fathers. Instead of constricting private initiatives and production, as under today’s tax laws, government under a soundly conceived national ownership strategy, would become the catalyst for stimulating expanded production of a more competitive free enterprise system.
Since government, by its nature and highly specialized social functions, is a monopoly, it is not inherently an efficient producer of wealth, as the followers of Marx are beginning to discover. And, with a few rather unfortunate exceptions, government in the United States does not engage directly in the production of real wealth. Although some redistribution advocates seem to assume that all wealth is produced by government, taxpayers know otherwise. Since the wealth necessary to cover the costs of government are products of private labor and private capital, taxes should be viewed as charges to consumers for essential services not available through the private sector. Unlike other services, however, the buyer of public services is compelled to buy and the government will remain the sole seller, at least until these same services can be satisfactorily provided through the competitive enterprise system. This seemingly minor change in emphasis could open up some new ideas for privatizing (democratizing) government services and new opportunities for creative businessmen.
Direct or Indirect Taxation
Any tax blunts incentives, but a direct income tax on individuals is the least damaging, and, at the same time, places before the electorate the cost of government. User fees for government services, like camping fees and grazing fees, are also legitimate direct taxes. But sales taxes, value added taxes, payroll taxes, most excise taxes, and other indirect taxes are not just or economically sound methods for covering government spending, since they mask the spending patterns of public servants and elected officials from close taxpayer scrutiny and direct accountability. Indirect taxes (including Social Security and unemployment taxes) also add to the costs of goods, thus shifting taxes to the consumer, reducing the competitiveness of U. S. enterprises and also our growth within the global marketplace. Taxes on property discourage new construction, improvements, and maintenance. But taxes on corporations are the most counterproductive of all forms of indirect taxes. The corporation income tax damages the corporation, an invention of man that is indispensable to the maximum production of wealth. To the extent return on investment is reduced, growth is stifled and the investment will go elsewhere.
But there is a more serious adverse and unjust effect of present corporation income tax laws flowing from the wide array of incentives the tax system now offers to the financing of industrial growth without the issuance of new equity instruments. The nondeductibility of dividends encourage the use of retained earnings or conventional borrowings for financial growth. (This is reinforced by tax subsidies, investment tax credits, tax exclusions and other loopholes to encourage investments in ways which make the rich richer.) By perpetuating exclusionary patterns of corporate finance, the corporation tax minimizes opportunities for all households to share in the growth opportunities of the economy.
Rates of Taxation
A growing number of tax scholars have argued that the case for progressive or graduated rates of taxation is uneasy at best. If redistribution of income (in contrast to a redistribution of future ownership opportunities) is a form of direct discrimination against property, a progressive income tax is inherently an unjust tax, assuming one accepts the Kelso-Adler, rather than the Marx-Engels, version of economic justice.
But what about the poor? No more effective aid can be provided the poor than allowing them to share in the new job and ownership opportunities within a healthy and growing private economy. The problem of those still too poor to share in the cost of government can be handled through tax exemptions or tax credits, and perhaps even the kind of negative income tax advocated by Nobel prize winner Milton Friedman.
Yet responsible citizenship is best served when everyone pays some direct tax. In an economy productive enough to provide a high standard of living for all households, which would be the long-range goal of economic decision makers, the cost of government would be minimal. Since government benefits should be equally accessible to each member of society, absolute justice would demand an equal per capita charge on all individuals, without regard to their income levels. But this, of course, is impractical at this stage of our economic history.
A more realistic and just tax today would be a flat or proportionate rate imposed on all direct earned and unearned incomes above a poverty-level income for all taxpayers. A single tax rate would be administratively more efficient than a progressive or graduated tax. Ideally, the flat tax on individuals would cover all government expenditures each year, including welfare, defense, interest on the Federal debt, social security obligations, unemployment and all other current spending not covered by user fees. It could also cover the cost of health insurance premiums under universal minimum coverage, including subsidies for the poor. This will allow for the gradual or immediate elimination of regressive payroll taxes on workers and companies, making the economy more competitive. And it would help make government vastly more accountable to the electorate. If tied into a vigorous national growth and expanded ownership strategy, one could easily imagine future candidates for public office actually competing for votes on the basis of who could offer the best government services at the lowest flat rate. Each year’s single direct tax rate could be adjusted up or down to provide sufficient revenues to avoid budget deficits.
Under a progressive or graduated tax, on the other hand, political irresponsibility and waste is more easily tolerated. Many voters believe that the heaviest costs are borne by a tiny fraction of high-income individuals or by fat cat corporations, or they fail to appreciate the dangers of printing press money where there are sizable budget deficits. A flat tax would help raise the levels of economic sophistication of the taxpayers. Another shortcoming of a progressive or graduated tax is that tax evasion and the search for tax loopholes by wealthy taxpayers increase as tax rates increase. And when inflation forces workers into higher tax brackets, pressures for additional pay increases add more fuel to the inflationary fires.
Resources tend to be misallocated under a progressive or graduated tax. Economic decisions become increasingly made, not on their economic merit, but on tax considerations. Thus, high tax brackets stifle growth and incentives to innovate and increase production, making all of society the poorer and less competitive.
Earned or Unearned Income
Under the Kelso-Adler theory of economic justice, the earnings from one’s property in the means of production are morally indistinguishable from the earnings produced by one’s skill or brain power. Since they are both rewards directly related to production, they should be taxed alike. And discrimination against property discourages investment and reduces society’s overall productive capacity.
Karl Marx considered profits as income stolen from labor. Our tax laws that discriminate against property incomes reflect the same bias. But if capital is recognized as a producer of wealth, then capital incomes (whether distributed or undistributed) are legitimately earned by those who share property rights in that capital, the same as those paid for their skills and ingenuity. The most serious problem with laws that discriminate against property incomes is that they hurt the poor more than they do the rich. Access to the full, undiluted stream of earnings from capital is a prerequisite for the financing on credit of broadened ownership opportunities and for more widespread distribution of second incomes among today’s non-owning citizens, including civil servants, many professionals, teachers, the military and the unemployable.
The only form of income that can properly be classified as unearned is that which is truly gratuitous and wholly unrelated to the production of marketable goods and services. Examples of unearned income, which should be included for direct taxation (once poverty-level incomes are exceeded) at the same rate as earned incomes, are: welfare checks, unemployment checks, social security checks, food stamps, gifts and bequests, unclaimed valuable findings, gambling gains, and other gains not immediately converted into tax-free or tax-deferred individual capital accumulations, as described below.
Individual Capital Accumulations
As discussed previously, building capital self-sufficiency into every American household cannot take place overnight. But once we establish a specific minimal level or floor for individual asset accumulations as a ten- or twenty-year goal to strive toward, it allows everyone to focus on the importance of property and the need to remove all institutional barriers to the broader distribution of ownership opportunities as expeditiously as possible. The floor of capital accumulations per household should represent the industrial equivalent of the 160 acres of frontier land that the federal government made available to its propertyless citizens under the Homestead Act of 1862. Thus the tax laws should be reconstructed to encourage the tax-free (or at least tax-deferred) accumulation of a “capital homestead” for all Americans over their working careers, consisting of a growing number of equity shares in the economy’s expanding industrial frontier.
A tax-qualified ISOP could be set up in the name of each individual, from birth, at a local bank to serve as his or her tax-free accumulator of capital. Shares acquired through ESOPs and CSOPs could be rolled over into one’s ISOP account tax-free, as well as income-producing property acquired through tax-free gifts and bequests. Each individual’s total acquisitions would continue to accumulate in a tax-free manner until the federally established capital sufficiency floor was reached. Thereafter, future accumulations would lose these tax privileges and become taxed at the current flat rate, thus discouraging grossly excessive, monopolistic accumulations of capital in the future. Upon death or when all or part of the assets are sold to increase consumption incomes, such tax-deferred assets would be taxed at the flat rate then prevailing. Fairness in the distribution of future ownership opportunities would mainly be controlled through the traditional IRS tax-qualification controls over discriminatory allocations and, more importantly, through the Federal Reserve Board’s control over credit extended by commercial bank lenders to ESOPs, CSOPs, and ISOPs to foster growth of the private sector economy.
Under H.R. 462, the proposed Accelerated Capital Formation Act introduced in 1975 by Ways and Means Committee member Bill Frenzel, this tax-free floor was set at $500,000. Whatever the target amount, it should be set at a level that both fosters initiative and a desire for income independence for its owner, and it could be adjusted to rise with cost-of-living increases. To encourage the continued accumulation and retention of income-producing investments, and to discourage squandering, all tax-qualified accumulation trusts would be required to pay out all property incomes on a regular basis as second incomes to the owners, subject to direct personal income taxes.
The rationale behind permitting tax-free accumulations below excessively large wealth concentrations follows the principle that new capital formation and widespread capital accumulations should be encouraged, both for promoting economic democracy and for raising the standard of living for all citizens. Taxes on property slows down the capital creation and accumulation process. On the other hand, a direct tax on the incomes from already accumulated capital assets is simpler to understand, less harmful to investment and the care of property, and easier for tax authorities to administer.
Offsetting Revenue Losses from Reduced Corporate Tax Revenues and from the Channeling of Personal Income Into Tax-Exempt Homestead Accumulations
Presently the federal corporate income tax accounts only for 14% of total federal revenues. It would shrink in relative size only gradually under even the most optimistic rate of implementing a national ownership strategy. The question is whether the benefits to be derived, from the standpoint of American business, labor, the voting public, and even the Treasury itself, is a worthy trade-off for this shrinkage of corporate tax revenues. To weigh the trade-off, one must focus on the big picture. The overall dynamics that should be expected in the proposed comprehensive national ownership strategy are two-fold: (1) to increase private production, private taxable job incomes, and private taxable property incomes; and (2) to reduce federal budgets for unemployment, job subsidies and welfare. Hence, the overall tax burden, as now-wasted manpower and other resources are absorbed within a faster growing private sector, should gradually be reduced. To argue that the trade-off is not worth it, considering today’s high unemployment rates and continuing high rates of inflation, would seem preposterous.
Government Debt and Government Deficits
Since tax policy affects the size of the government’s debt and government deficits in general, a few comments on the wisdom of debt and deficit spending policies are in order.
Under the influence of Keynesian economic concepts, the objective of many tax decisions in the past forty years was to cure inflation and unemployment. Keynes assumed the continuance of historic patterns of extreme maldistribution of capital ownership, and sought merely to fine-tune that malstructured economy through the bureaucratic manipulation of government tax, spending, interest, and money-creation machinery. Structural reforms to our corporate ownership patterns were not part of Keynes’ approach to the problems of unemployment and inflation.
In the Kelso-Adler strategy, however, the structural void left by Keynes is met head-on. Kelso and Adler would attack inflation and unemployment at the roots. The main thrust of their approach is to super-stimulate expanded rates of private sector capital investment, financed so as to broaden the base of equity owners in society.
The credit financing of corporate expansion must meet rigid standards of feasibility and must be repaid as a self-liquidating investment. New dollars flow directly into new productive capacity. In sharp contrast, government debt seldom, if ever, finances any production increases. Rather, it goes into nonproductive spending, war, and even into wastes of human talent and natural resources. Government debt is therefore inherently inflationary. Even worse, when government spending is not matched with current tax revenues, the inflationary impact worsens. Funds must either be borrowed (thus diverting those same funds from productive investment in the private sector) or simply issued as printing press money.
Today the Federal debt already exceeds one half trillion dollars or 35.5% of the GNP. Annual interest charges on this debt – one of the highest expenses in the entire budget – amounted to $34.6 billion in 1976 and are rising. President Carter envisions a $68 billion deficit for the current fiscal year (widened from President Ford’s $57.2 billion) and projects at least a $57.7 billion budget deficit for fiscal 1978.
From a standpoint of economic justice, government deficits make no sense at all. They cause inflation and are therefore a pernicious form of hidden tax on the public, most painful to the poorest members of society. A just tax system would work toward the elimination of future inflationary budget deficits and to curb further increases in the already bloated government debt. Better yet, a concerted effort should be made to begin to repay this debt.
Under a national ownership strategy, inheritance policy should be restructured to discourage excessive concentrations of wealth and, in order to promote individual initiative and capital self-sufficiency, to encourage the broadest possible distribution of income-producing assets. Gift and estate taxes therefore should not be imposed on the donor or his estate (including that accumulated within proposed “capital homestead” vehicles). Rather, taxation should be based on the size of the recipient’s total accumulations after receiving the gift or bequest. If the value of the recipient’s asset accumulations remain below the floor mentioned above, no tax would be imposed on the newly acquired assets. Above that floor, a reasonable asset transfer tax (or a flat rate tax on “excess” capital homestead accumulations) would be paid.
Asset Transfer Tax
Above the targeted homestead accumulation floor, an asset transfer tax or the flat rate tax would be imposed on each new owner to discourage future excess concentrations of wealth and economic power when assets transfer from one generation to the next. This would replace the existing estate and gift tax systems. The asset transfer tax and flat rate tax could be avoided by distributing excess accumulations to others, including family members, friends, and employees, as long as their personal accumulations remain below the floor.
Integration of Personal and Corporate Income Taxes
The double tax penalty now imposed on corporate profits is becoming widely accepted as an unjust form of tax discrimination that should be eliminated. Some reformers are proposing to mitigate this problem through a highly complicated and arbitrary compromise that not only avoids the problem but worsens it. Instead of eliminating the double tax directly at the corporate level, they would permit a partial deduction for dividend payouts to the corporation and a redistribution oriented partial tax credit for shareholders. Hence, it neither restores private property in corporate equity nor does it promote expanded distribution of equity issuances. It merely makes the top 1% who own the majority of directly-owned outstanding corporate shares even richer.
The Kelso-Adler theory of tax justice would attack this problem directly with elegant simplicity. It would recognize that property and profits are inseparable and therefore all corporate net earnings, whether distributed or retained by the corporation, would be treated as earned by its owners and therefore should be taxable at the personal level, on the same basis as any other direct income. Under this alternative, the corporation would be treated for tax purposes like a partnership, with its business expenses (including depreciation and research and development) attributed and deductible at the enterprise level and all capital incomes attributed individually according to each owner’s proprietary stake in the business. To encourage more equity financing of corporate growth, higher dividend payouts must be encouraged and alternative low-cost sources for financing must be made available to expanding and viable new enterprises.
Dividend Deductions at the Corporate Level
Corporations should be allowed a dollar-for-dollar tax deduction for any dividends they distribute either (1) directly to their shareholders (including beneficial owners, such as employees under tax-qualified ESOPs, profits sharing plans, pension plans, etc.) to the extent such earnings become currently taxable at the individual level or (2) to repay share acquisition indebtedness on any new equity issuances through tax-qualified financing mechanisms that further the goals of a national planned ownership program.
Capital Gains Taxation
How to tax capital gains is a continuing source of much of the complexity and confusion that now plague our tax laws. How would a property-oriented theory of tax justice handle this problem?
First, it would restructure the tax laws to encourage investment and discourage speculation. It would add disincentives to gambling in high-risk securities and the commodities market, at least for non-wealthy individuals. Tax laws would be designed to facilitate the acquisition, accumulation and retention by today’s capital-deficient Americans of long term investments, held mainly for their potential of yielding high, steady, and relatively secure second incomes to supplement their paychecks and retirement checks in the future.
To the extent capital gains income results from short term purchases and sales of commodities and securities, as under present law it should be treated like any other kind of direct personal income. Such capital gains are no different than the purchase and sale of any other goods for a profit, or for that matter, gambling gains.
Capital gains from long term holdings deserve different treatment, however, under a national strategy to broaden the base of capital ownership. As recommended above, to the extent that investments are accumulated within a tax-qualified vehicle, the gains should be permitted to increase tax-free or tax-deferred, until the individual affected reaches a targeted floor of capital self-sufficiency. Above that level capital gains would be subject to normal taxation after indexing for inflation.
If all of the proposals recommended in this article were adopted, the capital gains problem would gradually disappear. Much of the appreciation in the values of corporate common shares can be traced to the retention by management of earnings for meeting their capital requirements. As dividend payouts increase (encouraged by tax-deductibility of dividends at the corporate level) and as new sources of equity financing become readily available through the discount mechanism of the Federal Reserve System, the value of individual shares would tend to stabilize over time and be based on current and projected dividend yields per share. Hence, long term capital gains would be less a source of future government revenues.
To some extent, long term capital gains result, not from the increased productive value of the underlying assets, but from a gradual debasement of the American currency. Only inflation-inducing government economic policies can be blamed for these increases in profits and capital values. Hence, except where prices increase from natural shortages, government should assume total responsibility for inflationary increases in the value of investments. Therefore capital gains taxation should always be inflation indexed to see if any gains in value actually exist.
State and Local Tax Systems
Today, a heavy portion of local revenues come from the taxation of property, thus discouraging investment and improvement of industry and residential property in their areas. Sales taxes also increase price levels, encourage tax evasion by local merchants, discourage trade, and generally can cause one area to become less attractive than another. Since high production, high incomes, and a higher quality of life rests on the quality of the structures, industrial equipment and facilities, and technology available to the residents of an area, it should be obvious that taxes on local property are counter productive and should be gradually supplanted with a universal system of state and local taxation based upon the direct incomes of its residents from whatever sources. Thus federal tax policy should create additional incentives for state and local taxing authorities to gradually shift to direct flat rate income taxes at the individual level, for the same reasons outlined above. To simplify tax collections, the state and local rates could be set at a percentage of the federal tax imposed on residents of the area. Another advantage of this approach is that all areas of the country would become tax-neutral for investment purposes, thus increasing the nation’s overall efficiency in the allocation of our manpower and other resources.
Although corporate income tax returns would still be important for disclosure purposes and for corporations unwilling to pay out their earnings fully to their shareholders, most of the tax revenues would flow from the expanded personal tax base. The personal income tax return and the tax system itself would, as result, be enormously simplified and easier to understand. A simple one-page personal income tax return would be well-received by the American taxpayer.
Most personal deductions and tax credits could be eliminated under a flat-rate tax system, restoring the neutrality of the tax system over people’s consumption choices. Personal exemptions, however, could be raised to the poverty level, so that the poorest families only would pay no taxes, including payroll taxes. But by filling in a simple annual income tax return, a poor family could qualify for a negative or reverse income tax (or refund) as proposed by the conservative economist Milton Friedman.
A Quadrennial Census of Wealth
Through assets accumulated with ESOPs, CSOPs and ISOPs, within one generation, the nation would gain a useful profile of total property accumulations and its wealth distribution patterns. It would also be a way of meeting the recommendation of the Joint Economic Committee in its 1976 Annual Report calling for:
a quadrennial report on the ownership of wealth in this country which would assist in evaluating how successfully the base of wealth was being broadened over time (p. 100).
The main purpose of this article is not to offer definitive answers but to suggest some new questions that tax professionals might pose in evaluating tax reform proposals in the future. It is not intended to leave the reader feeling comfortable, because the history of tax reform leaves little room for optimism about the future of the privately owned corporation and the free enterprise system in general. But, it might aid the socially minded business statesman to gain some deeper philosophical insights into the history and trends of tax reform over the last century. Whether Karl Marx’ tax strategy will succeed in finally destroying the privately owned corporation and converting it into one owned and controlled by a dictatorship of the proletariat, remains an open question.
Some in the business world seem unconcerned as to who signs their salary check. They seem to have thrown in the towel to Marx. Others seem prepared to take a new stand against further erosion of our private property system. It is the latter to whom this discussion is primarily addressed.
The author rejects the piecemeal and narrowly partisan approach to tax reform. This is a call for a new tax philosophy that will transcend the interests of special power blocs and interest groups. The tax system affects each of us, and will certainly affect the kind of society we will bequeath to future generations of Americans. Armed with a set of principles that are totally consistent with the revolutionary philosophy that fathered our nation, each of us can better judge tax reform proposals as they are presented to the American people.
When proposals are delivered to Congress, we need to judge whether those proposals will move us toward tax justice or toward further tax injustice, whether they support property or are further despotic inroads on the rights to property, whether Karl Marx has won another victory or whether we have turned in a genuinely new direction.
Senator Russell Long, when in 1973 he urged his Senate colleagues to consider converting the failing northeast rail system (Conrail) into a 100% employee owned private corporation, said:
[T]here are but three political-economic roads from which we can choose.
We could take the first course and further exacerbate the already intensely concentrated ownership of productive capital in the American economy.
Or we could join the rest of the world by taking the second path, that of nationalization.
Or we can take the third road, establishing policies to diffuse capital ownership broadly, so that many individuals, particularly productive workers, can participate as owners of industrial capital.
[T]he choice is ours. There is no way to avoid this decision. Non-action is a political decision in favor of continued, and indeed increased, concentrated ownership of productive capital.