Explaining Southern California's economy

Fred Wilson lobbies for a flat tax, but why not just raise taxes on capital gains?

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The top of a form 1040 individual income tax return.

Fred Wilson, a venture capitalist at Union Square Ventures in New York, blogs daily at AVC and blogs well. His is the first post I read almost everyday, from a Google Reader that pipes in hundreds. I've written about his thinking before. There are times when he's great. And there are times when he drives me crazy.

On Sunday (he doesn't take the weekend off) the crazy was in evidence (in me, not Fred). After some speculation on where Mitt Romney's income comes from and why it's taxed at 15 percent, he goes on to discuss his own misgivings about getting a similar deal in his own business, due to the "carried interest" exception that allows him to treat income as capital gains. Then this:

...I am bothered by the unfairness of the situation. When I get a big distribution from our funds, I always ask my accountants how much of the distribution I should set aside for federal, state, and local taxes. The answer is usually something like 28% (the difference between 28% and 15% is the state and local taxes). And then I often think of my two brothers who probably pay 40-50% of their income each year in federal, state, and local taxes. It just seems so unfair.

And so lately I've been more and more attracted to the idea of a flat tax where everyone pays the same tax rate on income above a minimum amount. In this model, we would eliminate all tax deductions; for mortgages, charitable giving, for medical expenses, etc. There would be no difference in tax rates for ordinary income vs other forms of income (ie capital gains).

If we did that maybe everyone could pay a 15% tax rate like Mitt Romney and our family does. We would have a fair tax system.

Wilson has argued before that carried interest should be taxed as regular income. But what's baffling to me is that he restates that argument — then turns around and says that rather than raising capital gains to something resembling historic levels, more like 30 percent, we should just make everyone pay 15 percent on everything.

This would obviously change nothing in Wilson's, or for that matter Romney's, world. And it wouldn't be at all beneficial for people who aren't earning at the Wilson/Romney level, as I pointed out last year when several Republican presidential candidates rolled out flat-tax plans.

Fred acknowledges the key argument against the flat tax, but goes on to suggest that the current tax system isn't doing what it's supposed to do:

I've heard a number of arguments over the years against a flat tax. One is that a flat tax is regressive meaning that it penalizes lower income earners by taxing them at the same rate as higher earners. But I think we are all coming to realize that the current system may be even more regressive since most wealthy people find ways to pay lower tax rates.

This is where I get the crazy going. Reduced marginal tax rates at the top, coupled with the ability of the wealthy to either declare or shelter income as capital gains, taxed at a much-reduced 15 percent, does not make the system more regressive. It makes it inadequately progressive. Contrast this with what Wilson would be paying if capital gains were taxed properly (using his own math on state and local): 43 percent. He'd be right in line with what his brothers are paying on regular income.

And this is without making any major changes to the tax code at all. No increase in the top marginal tax rate — no tax hike on income for the wealthy! Rather, a simple Buffett-esque increase, to historic levels, of the tax on capital gains. You wouldn't even have to eliminate carried interest. You'd just have to tax it at the right level.

I think Wilson's heart is absolutely in the right place on this issue — carried interest is a big, fat tax break for the financier class — but I don't think a flat tax is the solution. In fact, I think we need exactly the opposite: a much more complex tax code.

Follow Matthew DeBord and the DeBord Report on Twitter.

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