America's Biased Tax System is Stealing Our Opportunity

Commentary by Pete du Pont

Question: Why does the United States have the lowest savings rate of any major nation?

Answer: Not because we are guilty, pathological spenders or "me-generation" have-it-all-nowers. The reason Americans spend more and save less is that the tax laws penalize saving.

Income we spend now is taxed once, while income we save and invest is taxed four times.

To take an example, when we earn $100 at work we pay about 15% of it in federal income taxes. If we spend the remaining $85 the federal government does not tax it again; we are done with the IRS.

But suppose we save the $85 and put it in the bank. Now the government is going to tax the approximately $4.25 in "interest" the bank is going to pay us when it returns our $85 to us at the end of the year.

But that "interest" is really compensation for something we have given up: the immediate use of our $85 and the immediate satisfaction we would have enjoyed by spending it. It is like an insurance payment we receive after a fire or a car accident: compensation for something we have lost. The interest does not add to our assets as much as it makes us whole after a loss. So taxing interest is a penalty, it makes future consumption more costly than current consumption; the IRS is telling us it is better to spend now.

But it gets worse. If instead of saving the $85 in the bank we invest it in a company -- which allows the company to hire more people or make more products -- the IRS is going to tax its earnings twice. It will tax them once when the company earns a profit, and a second time when the company pays part of that profit to us as investors. So the IRS is telling us it really doesn't like us to invest in companies, for if we do it is going to double tax us. No wonder we Americans don't save and invest as much as people in other countries. The U.S. tax system is simply biased against savings and investment.

There are two ways to correct the bias against savings. One is to allow people to deduct money they save from their current taxable income, while taxing the saving and its return when spent in the future. This is essentially how Individual Retirement Accounts and other pension plans operate. The other is not to allow a deduction for saving, but permit any interest to accumulate tax-free. This is basically how municipal bonds are treated today.

Either one of these two methods, the IRA or the municipal bond model would create neutrality between spending and saving. It would eliminate the present tax bias against saving and in favor of current consumption.

As to the second bias, the bias against investment by double taxing it -- once at the company level when the company earns a profit, and again when those profits are paid out to the investors in a company in the form of dividends -- that can be corrected too.

By treating corporate shareholders as if they were sole proprietors or partners in the business, all the corporation's profits would pass through to them without a separate layer of taxation, regardless of whether dividends are paid or not. The shareholders would then pay tax on their respective individual share of corporate profits and losses.

But double taxing investments is not the end of the story -- the IRS adds a third layer by taxing the growth of our investment through the capital gains tax. But since "capital gains" merely reflect the present value of future profits, taxing a capital gain while also taxing the profits that create the gain is also a double tax.

Finally, if we should have the misfortune of dying while we hold the investment, the government will seize about half of our investment through estate taxes. In some ways this is the worst tax of all because it is a direct tax on capital itself. It does not even pretend to be a tax on gains or earnings, since assets that have lost value are taxed the same as those that have risen.

So there are four different layers of taxation on capital in the United States. First, we double tax saving by taxing interest and not allowing a deduction for saving. Second, we double tax saving again when it is invested in corporate equities. Then, when the prospect of higher future earnings causes our stocks to rise in value, we levy yet another layer of tax on the same original saving in the form of a capital gains tax. And, finally, if the saving outlives us, we whack it again with the estate tax.

Is it any wonder, then, that the U.S. has the lowest saving rate of any major country?