Wednesday, February 08, 2012

Its Taxing Explaining this....



Its taxing explaining this sometimes!


An Op-ed featured in The New York Times today, written by a tax lawyer called David Miller titled “The Zuckerberg Tax”.  (http://www.nytimes.com/2012/02/08/opinion/the-zuckerberg-tax.html?nl=todaysheadlines&emc=thab1)

Briefly, his argument is:

The US tax system is based on the concept of “realization.” Individuals are not taxed until they actually sell property and realize their gains. But this system makes less sense for the publicly traded stocks of the superwealthy. The fix is called mark-to-market taxation.  

To illustrate:

If I own 100 shares in which I invested Rs 20 each (Rs 2000 in total) and the current market price at the end of the tax year is Rs 50 each, then I pay tax on the increased value (Rs 50-20) or on the Rs 3000 of additional wealth I now own. I pay this even if I don’t actually sell the share, my bank account is still zero. Alternatively, if the share price falls from Rs 20 to Rs 5, then I get a tax refund on lost wealth of Rs 15 x 100 or Rs 1500.

This tax is to apply to the super-rich (some income cut-off over which it applies) and is therefore, equitable in his view.  To support the view he presents the argument that as a holder of stocks that are valued at say US $ 1 billion, I don’t have to pay taxes, but I can borrow against this and buy a luxury yatch (this is what Larry Ellison of Oracle apparently did). It isn’t fair that the rich guys don’t pay taxes on their wealth.

Prima facie, this is a strong argument that sounds quite fair. Why should rich guys avoid taxes and buy a yatch, while I’m struggling on mortgage payments? 

Except, let’s chase this down a bit:

     1.  The Rs 2000 that I invested in the shares above represents money I’ve earned and paid taxes on to start with. This portion is not taxable again according to Mr Miller’s plan.

    2. The Rs 2000 I invested contributes to an enterprise that’s, let’s say, earning Rs 3500 as net profit (after tax) every year. This contributes to the increased value of Rs 5000 of the stock I now hold.  So in effect, the value reflected in my share price, is because of the net profit of the enterprise is already taxed.

       3.   So the accounts of the firm I’ve invested in could look like this:

A
Sales Turnover
Rs 25,000
B
Various Expenses /costs
Rs 15,000
C
Salaries to employees
Rs 5,000
D
Taxes on Profits
Rs 1,500
E
Net profit after taxes
Rs 3,500
F
Total investment in equity of the firm
Rs 20,000
G
Taxes paid on salaries c. above @30%
Rs 1,500
H
Taxes paid by suppliers of various costs b. above @ 10%
Rs 1,500


The total tax generated by equity investment (and others’) is now Rs 4500 on an investment of Rs 20,000, (which is tax paid money) or 22.5 %. This tax money would not be there if the investment and enterprise wasn’t running. As a Rs 2,000 investor, I’ve created taxes for govt of Rs 450 per year plus have created earnings for several people and, therefore, families.

As the stocks I hold are not sold yet, the value of Rs 5000 cited earlier, is not cash in the bank. Let’s assume like Mr Ellison, I borrow Rs 3000 from a bank to buy an LED home theatre system.  I have to repay the Rs 3000 from money that has to be realized in cash to the bank. All money that I realize in cash is taxable in the system of “realized” income referred to by Mr. Miller. So I have to earn Rs 3000 after taxes or about Rs 4200 approximately in total to pay the Rs 3000 plus some more earnings to pay the interest. This is not, as Mr Miller suggests, a tax free ride.

Let’s contrast the Investment of Rs 2000 I’ve made, with an investment of Rs 2000 I’ve made in say, gold or a house. Both assets are essentially non-earning assets – they do not for the most part create jobs (you can say a house still does, but gold does not),  houseowners borrow against appreciated value (roughly what happened in 2007) just like Mr Ellison did and could end up buying their own yatch. (Now try telling me that a person in a US $ 0.5 million house is poor.) More importantly, would I as a member of society, rather have rich guys putting their money in things that create jobs or buying gold. This is the fulcrum on which taxation policy tries to be progressive or knee-jerk political. 

Realized income in your hand is what you can spend. Notional values can’t be spent – you can only borrow and you have to repay the borrowing with realized income that is taxed. The distinction between productive capital (ie investments that create more jobs and earnings), unproductive capital (gold, cash that sits in your locker) and earning (what cash you put in the bank and is yours to spend) has a sound economic reason and therefore, accounting reason.  If you can put your saved income, that is tax paid, into assets that benefit society through more jobs etc, that create more taxes as a by-product for govt. there seems no reason to tax you on just ownership. This provides an incentive for people to save and invest in assets of the kind society wants, ie, job creating.

Perhaps the view in these times of greater economic hardship in some countries is that the rich must do more for society. Why not incentivize them to invest their wealth in the country’s long term good? This they can do by investing in government bonds that the govt used to borrow funds to run its various programmes including health and education.  Rather than ask the holders of notional value to pay taxes in cash, that they may not have, incentivize them to invest in funds that have a longer-term socio-economic purpose. This last thing, in fact, is what many governments do, including the Indian government. Tax free bonds say in infrastructure is a means of channelling savings into more long term needs of the economy. So Bill and Melinda Gates have to sell their stock, and pay taxes, to provide funds for the development activity their Foundation supports around the world.  The government may in their wisdom, exempt them from some taxes, as all that tax saved is going towards things that the government would have done anyway. This is not a case of the rich guys avoiding tax, as its made out to be.

Taxation is not an extortion racket run by the government. This is the case with dictatorships and the monarchies of old, where sovereign right means that the King allowed you to earn, collected taxes from you that he blew on anything he felt like – including building the Taj Mahal for his dead wife.

Taxation is a means to channel funds to where a society needs it because otherwise there’d be no money for it. Taxation is a not a weapon to ensure that everyone has equal income. In a competitive environment, the latter approach will just result in people taking their wealth to another country – Bjorn Borg lived in Monte Carlo right through his high-earning years between 1976 and 1981. Then you’re worse off because of this. Borg's shelling out taxes for poor Monaco (per capita income reported in excess of US $ 100,000), watching F1 and sipping champagne with Princess Grace. 

Marked-to-market taxation, in my view, is a throw-back to the socialist way of ensuring that no-one gets rich and discouraging investments in things that create value. Taxation policy that takes a reasonable share of what people earn, ie, profit / income – is progressive in that you’re taking from what’s there. Taxes that are collected before earnings are realized in cash, are regressive – they not only create higher costs for usage but might render a job-creation activity unviable.  High telecom licence fees, that I wrote about in an earlier post, is a good example of the latter.

The reasonable share must be used for public benefit – not paying fat salaries for uproductive things! That’s what the debate on fiscal responsibility, budget deficits, austerity etc is about. But more on that another time.

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