James Rickards is a hedge fund manager in New York City and the author of Currency Wars: The Making of the Next Global Crisis from Portfolio/Penguin. Follow him on Twitter at @JamesGRickards.
With a presidential election just weeks away and the fiscal cliff not far behind, discussion of tax policy is in the air. Democrats favor allowing the Bush tax cuts to expire for high-income individuals, while preserving tax cuts for the middle class and making other reforms. Republicans favor an extension of the Bush tax cuts for all taxpayers while they work on a broader package of rates cuts and elimination of deductions designed to raise revenue by broadening the tax base. Actual legislation would be immensely more complicated and few of the important details have been completely spelled out by either party.
Regardless of who wins the election, tax legislation will be proposed almost immediately. Both parties agree that driving over the fiscal cliff in January without some effort to roll back the scheduled tax increases will be an economic disaster. New legislation may come in the lame duck session of Congress in November or it may come after January.
It is possible to pass tax legislation in mid-2013 that is retroactive to January. In this scenario, congressional leaders of both parties would say, "Trust us while we fix this, and please act like nothing's wrong in the meantime." This approach may work in the Beltway imagination, but it is unlikely to be without costs in the real world. Investors and entrepreneurs may be unwilling to rely on good intentions alone and may sell stocks aggressively in December to avoid the chance of much higher capital gains taxes beginning in January.
Yet, before plunging bravely into new tax legislation, Congress should consider some lessons from the recent past. Two examples stand out as illustrations of the law of unintended consequences.
During the 1980s, leveraged buyouts and hostile takeovers proliferated. In many of these deals, executives received multi-million dollar "golden parachute" compensation packages while workers were sacrificed to increase profits for the deal promoters. Congress responded in 1993 with a law that denied corporate tax deductions for executive compensation in excess of $1 million dollars per year. However, a loophole permitted the tax deduction if it could be shown that compensation in excess of $1 million dollars was performance related. This is a classic example of using the tax code to achieve social policies that have nothing to do with taxation.
It did not take tax lawyers and compensation consultants long to devise stock option plans that met the performance related standard and allowed companies to get around the million-dollar cap. Once the option genie was out of the bottle, executives found that they could manage corporate earnings to be lower during the option grant period so they could get cheaper options. Then when they got closer to retirement, earnings would magically surge so that huge gains would accrue to the executives. The result was massive manipulation of earnings and stock prices. Compensation levels became astronomically higher than they were in 1993. Congress meant to cap compensation and ended up causing it to explode.
In 1997, Congress set out on another feel-good mission by passing a law that allowed individuals to have tax-free income on the first $250,000 of gain on the sale of a primary residence. The tax-free amount was $500,000 for couples. This tax exemption could be used an unlimited number of times provided it was not used more than once every two years. The intended purpose was to provide tax relief to homeowners who had been in their homes for many years and had large gains due to inflation.
As with the executive compensation cap, this use of the tax code to pursue social policy also turned into a monster. The housing exclusion gave rise to a class of husband-and-wife flippers who bought houses using borrowed money, made some improvements, and then sold the houses for a tax-free gain as soon as the two-year waiting period expired. They would immediately buy another home and repeat the process. This continued for the 10 years from the passage of the law to the collapse of the housing bubble in 2007.
The flippers were not the only cause of the housing boom and collapse, but they contributed to the frenetic wave of leverage, turnover, and higher valuations that infected the housing market in those years. Congress passed a law intended to provide relief to long-term homeowners and succeeded in creating a class of short-term flippers who made the housing bubble bigger before it ended in catastrophe.
The lessons for tax policy are clear. The law of unintended consequences is alive and well. Congress will never be smarter than the individuals who set out to exploit loopholes and subvert the best of intentions. The only efficient tax code is one that is simple with low rates and almost no deductions or exemptions. The sole goal of tax policy should be to optimize needed revenues for the Treasury consistent with low rates and a minimum burden of compliance on the private sector.
Congress can pursue social policy to their hearts' content if the votes are there. But, don't do it through the tax code. Complexity in the code is strangling business, eroding respect for the law, and threatening to kill what little growth the economy has shown. Simplification is what the two parties should be discussing. Just don't hold your breath.