Wayne Perg is a synergic scientist and economist. He is has developed a new mechanism for financing a win-win world. The following article is written is reponse to President Bush’s so-called stimulus and growth program.

End the Double Taxation of Work Income

Wayne F. Perg, Ph.D.

Now that the Bush administration has established that double-taxation of income is unfair, that deficits don´t matter and that tax cuts will pay for themselves, it is time to end the double-taxation of work income.

Workers, both wage earners and the self-employed, pay income taxes on the OASDI (social security) taxes that are taken out of their paycheck (wage earners) or that they pay when they make their quarterly estimated tax payments (self-employed). This is not only unfair, it discourages work and, therefore, reduces employment and output. By reducing work, employment, and output, it reduces savings and investment, thus reducing growth.

The equitable way to eliminate this unfair double-taxation is to provide for a tax credit equal to what the income taxes would be on the OASDI taxes paid by workers and the self-employed, calculated at the highest statutory marginal income tax rate. This tax credit will end the double taxation of work income and assure every worker of receiving the same dollar income tax reduction for any given amount of OASDI tax paid, regardless of the worker´s marginal tax rate. Workers whose tax credit exceeds their income tax liability (the working poor) will receive a refund equal to the excess of the credit over income tax due.

In contrast to the elimination of the tax on dividends proposed by the Bush administration, this elimination of the double-taxation of work income will stimulate the economy short-term as well as increasing investment and growth. Elimination of the tax on dividends will not stimulate the economy short-term and it will most likely reduce investment and growth.

Business investment will rise only to the extent that elimination of the tax on dividends reduces the cost of financing investment. The cost of financing for a tax-free investment equal R_T time (1 – T), where R_T is the return on a taxable investment of equivalent risk and T is the lowest income tax rate paid by buyers of the tax-free investment.

Because most stocks are held by tax-free investors (e.g., pension funds), the lowest tax rate paid by buyers of tax-free stocks will be zero and the cost of financing with tax-free stocks will equal the cost of financing with stocks today (taxable stocks). Therefore, the elimination of tax on dividends cannot be expected to increase business investment and growth.

However, investment by businesses is not the complete story on investment and growth. Municipal (state and local) governments invest large amounts of money in public infrastructure (educational facilities, roads, airports, etc.) that is vital for economic growth. Eliminating the tax on dividends will reduce this vital infrastructure investment two ways – first by raising municipalities´ financing costs and second by reducing their tax revenues.

High net worth investors will transfer funds out of tax-free municipal bonds into stocks paying tax-free dividends. This will reduce the income tax rate paid by the marginal buyer of municipal bonds, thus driving up the interest rate on municipal bonds and increasing financing costs for state and local governments. Revenues will also be reduced for municipalities in states where state income taxes are based on federal taxable income.

In contrast, ending the double-taxation of wage income will be positive for the vital infrastructure investments of municipal governments. Increased work and income will produce increased tax revenues and the income tax rate of the marginal buyer of municipal bonds will be unchanged.

The above does not imply that elimination of the double-taxation of dividends should be abandoned. Granting corporations a deduction for the payment of dividends is a superior way to end the double taxation of dividends. In contrast to the Bush plan, it is simple and most of the benefits will go to investors whose stock investments are in pension funds, IRAs and 401k plans. Most importantly, it will reduce the cost of financing, thus stimulating increased investment by businesses and it will not negatively impact state and local government finances.

Growth will rise as a result of higher investment and increased efficiency of investment. The efficiency of investment will increase as mature, slow-growing firms are forced to pay out funds that can then be reallocated by the market to younger, faster-growing businesses.

By all means, let us end the double-taxation of income, but let us do it in a way that will increase growth and begin with the change that will produce the greatest stimulus now – ending the double-taxation of work income.