“The power to tax involves the power to destroy; …the power to destroy may defeat and render useless the power to create…” So wrote John Marshall, first Chief Justice of the United States Supreme Court in the hallmark case Marbury vs. Madison.
Marshall’s statement is an axiom. It applies not only to the specific case the court was ruling on; it applies to all taxes. Taxation has exploded since Marshall’s day. Not just at the federal level, but at the state and local level too.
To see the endgame of how taxes destroy, look no further than Philadelphia. In the city of brotherly love, cola sales have plunged 32 percent thanks to a tax on soda sales that adds about a 50 percent total checkout price relative to the shelf price. The rationale behind the tax was to fund budget gaps by punishing those who enjoy sugary drinks. But the results speak for themselves. When consumers see what they’re paying with taxes, they’ll either do without or shop somewhere without the taxes.
As a result, both Coke and Pepsi are laying off employees at their local Philadelphia operations. That’s on top of a broad decline in consumer enjoyment of colas. The market’s already been sending them a warning signal, but governments are often great for speeding up that process.
This follows a broader pattern. And people are rational enough to make changes. In fact, many Americans migrate to places with lower taxes. Florida and Texas are fast-growing states, thanks to an exodus of taxpayers from high-fleecing states like California, New York, and New Jersey. It doesn’t hurt that these fast-growing states are growing fast because taxes are relatively lower to begin with.
Not all taxes are avoidable. There’s still the federal income tax, that looming monster of paperwork whose deadline hits as far away from Election Day on the calendar as possible. And, if you happen to die at some point with a few million in the bank, there’s a tax for that as well. Forget Benjamin Franklin’s joke about death and taxes. The only three certainties in life are death, taxes, and the death tax.
While America’s taxpayers—numbering barely half the country’s adult population—have just finished their annual contributions to the government, we now stand at the prospect of the biggest overhaul in the tax system since 1986.
Think about that. Back in 1986, there were no smartphones, no online banking, only a few home computers. Stocks were still quoted in fractions of eights. Our economy was far more grounded in the physical and tangible, not the incredible advances of the digital age. While that’s moved forward, our tax system hasn’t.
Enter President Trump. He’s placed some bold reform ideas on the table. Like most of his proposals, he’s using a strategy straight out of Art of the Deal: asking for far more than he’s likely to get, for the sake of getting as much as possible. For instance, he’s looking to cut tax rates on pass-through entities like LLC’s down to 15 percent. And he’s looking to cut the corporate tax rate as well. And eliminate the estate tax.
Those are just some of the proposals put forward last week to significantly overhaul, and greatly simplify, our tax system. It’s a system that definitely needs reform. But in the interest of not blowing up the budget too much—the proposals are expected to add another $2 trillion to the government’s $20 trillion debt—there are some simplifications to the tax code that may not sit well.
For instance, there’s concern over a change in the tax status of the 401(k) plan. As things stand right now, it’s a pretty good deal for middle class workers. They can invest in a plan with pre-tax earnings, and lower their tax base every year they’re contributing. The money that’s invested gets to grow tax-free until it’s time to take money out decades down the line. And unlike many other job perks, a 401(k) plan follows an employee when they leave their job (it’s typically turned into what’s called a rollover IRA).
But without that tax benefit, would as many Americans buy into such a plan? That’s doubtful. It’s one thing to avoid taxes now while getting to grow wealth. It’s another when you have to pay taxes as you go on your retirement accounts. This is one area where some clarity is needed.
Frankly, every tax proposal will face its challenges. Behind every carve-out, exemption, and so-called loophole is a group that’s benefitting from that rule change. Simplifying the tax code as part of a broader overhaul will bring out these special interest groups. That’s why the tax code got so complex and messy in the first place. It’s also a good argument for why simplification is needed.
Amidst the broad brush of the proposals, however, is a lack of specifics that will need to be hammered out later. And it’s hard to escape the proliferation of state and local taxes like Philadelphia’s soda tax.
What’s an investor to do in the meantime? With tax rates on capital gains and dividends unlikely to change under the current proposal, few changes are needed. Dividend tax rates, already as low as 15 percent, create a powerful incentive to invest and generate income that way rather than work for a living. And capital gains rates, both short-term and long-term, are competitive with such rates in other countries (unlike corporate tax rates).
While things might be up in the air for tax-deferred retirement accounts, until there’s a specific change, I wouldn’t sweat it. Any change there will likely be phased in, so don’t give up on the tax advantages of a 401(k), IRA, or Roth IRA for 2017.
Things may change, or they may not. Our current system of creeping small changes set by congressional statute each year is the equivalent of letting the weeds grow. It’s time to do some gardening. But those changes won’t be easy, and it may involve giving up some changes for a better whole. It’ll be an interesting process to watch unfold—and as the tax system changes we might want to think differently about how to invest as well. Until that happens though, don’t sweat any big changes yet.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.
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