How to Make Our Tax Code Much More Progressive and Business Friendly Simultaneously

More Specific Rules for My Investment Income and C Corporation Tax Reforms

Below are the more specific and detailed IRS and other rules that I have proposed for my, Investment Income, US Employer/ Manufacturer Tax Rate Carve Out, tax reform, as well as my C Corporation, and possibly large Qualified Business Income Deductee, Higher US Employee Compensation Tax Incentive, tax reform. These rules work well with an accompanying video that I have up on my very new Youtube channel, “Tom Pallow’s Economics of Quality”. I will start with the first tax reform.

Before I go into these proposed rules, let me first explain the many and enormous economic benefits that would result from this tax reform and tax rate carve out.

There are Four Special Financial Investments wherein the income earned from those investments will receive a much lower tax rate when compared to the tax rate for gains derived from all other financial investments. In fact, this difference in tax rate between the carve out rate and the general tax rate could be the widest among modern tax carve outs. This is because the reform would be so hard to game, the math of the carve out is so positive, and the reform would spur so much domestic economic growth!

The Four Special Financial Investments are: One, Corporate Bonds that are bought only at first issue that are used by a US corporation or US corporate subsidiary of a foreign business. Second, US corporate or private entity stock that is publicly traded and bought only at first issue, or IPO or following issue involving real business equity. Third, US venture capital investments through established banks and venture capital firms. Fourth, the financial underwriting of any of the above investments. Of course, all FSFIs will first need to achieve US wage and/or US business capital expense requirements in order to acquire the lower carve out tax rate, and I will explain more soon.

The economic benefits of carving out for tax purposes these four investments are many!

To start, by incentivizing more investments in these four financial vehicles via a lower tax rate on capital gains derived from them, the cost of capital for businesses expanding in the US will be substantially reduced, while simultaneously creating the ability to raise massive amounts of new federal tax revenues by raising capital gains tax rates on capital gains derived from all other investments but the FSFIs.

The FSFIs are the financial vehicles that are used by businesses to raise business capital in the financial markets to expand. Large corporations will generally borrow from banks or float new corporate  bonds in order to raise capital. More medium sized businesses will often go from being private businesses to publicly traded corporations and in that process issue an Initial Public Offering of stock. Still smaller businesses will look for Venture Capitalists to fund expansion. Then banks and even individual people will underwrite the above three types of financial investments as these financial vehicles are first being created and packaged to be sold to ordinary investors for the first time.

The FSFIs are, in the end, the real economic purpose of the business side, as opposed to the investment side, of the stock and bond portions of the investment markets. The, almost always over 90 %, of investment market income gains that are derived from financial vehicles that are NOT any of the FSFIs, these none FSFIs are what are now sometimes called the, derivatives market, but were in the past commonly called the, secondary market, or even before, paper trades. They are stocks, bonds, and other financial investments that have already, as is referred to today as, “been underwritten and packaged”, and importantly for this reform, also have been “sold at least” once already. Or in other words, these are financial investment vehicles that have been “sold a second time or more.”

Therefore, by pinpointing when capital gains taxes can be lowest, that is with the FSFIs that have not been sold a second time or more and have met US wage and businesses capital expense requirements, by pinpointing lowest tax rates here at the point of US business capital formation, we will insure a much lower cost of capital for businesses expanding in the US by increasing the incentive for Americans to invest in qualifying FSFIs.

Qualifying FSFIs also make the perfect tax rate carve out definition point wherein capital gains and dividends that do not come from qualifying FSFIs could have tax rates increased on, and this would have the effect of both increasing federal government tax revenues while simultaneously increasing the tax incentive to invest in qualifying FSFIs, therefore further biding down the cost of business capital for businesses expanding in the US!

Here are some footnotes I have often used for this reform:

1. “Recent Changes in US Family Finances”, Federal Reserve Bulletin

2. Jay R Ritter, University of Florida, “Initial Public Offerings.”

These studies together show that the FSFIs over about a 30 year period, only in four quarters produced over 10 %, and never over 20 % of total financial market income gains, and that the average was around 6 %.

However, sources for both footnotes 1 and 2 do little to nothing to distinguish between foreign and US investments while also not having any of the domestic wage or business capital expense requirements in order to achieve the lower tax rate. So the percentage of investment income gains that come from qualifying FSFIs will be significantly less than 6 %, and my estimates would be that with the proper US wage and capital expense requirements, the cost of this tax carve out would always be under about 5% of the current federal investment income tax revenue total. Of course, that is the total cost of the tax carve out, without calculating and adding in any of the new federal tax revenues that would accrue  due to the amazing new levels of economic growth that would occur due to the incentives in this tax reform. .

The first footnote source is a very large survey that has been taken since the 1960s by the US government, and the second source I used to get the venture capital calculations.

So this reform would be, statically scored, extremely inexpensive, while economically doing so much. It would direct more business investment into the US by corporations, venture capitalists, and the investing community, thus increasing US wage and economic growth. It would reduce the cost of capital for businesses expanding in the US, thus improving US business competitiveness and growth.

Also, this tax reform would likely reduce the probability and adverse economic effects of financial market crashes by moving more financial market investments into tangible domestic wage and business capital expenses that have much higher domestic economic multiplier effects than do derivative trades and secondary market trades.

The reform would also reward gains from investments that require more research into an actual business, industry, and economy, instead of derivative and secondary market trading wherein the investing research tends to focus on fluctuations in financial market movements.

This reform could also very easily fix the Carried Interest issue by differentiating with income taxes on hedge funds between hedge  fund income from gains via qualified FSFIs and all other hedge fund income. This could be done in a, statically scored, “revenue neutral” way, and it would raise huge amounts of new federal revenues while increasing US economic growth. It would also discourage hedge funds and others from buying US businesses and moving them abroad.

In a bit I will also explain how small investors will also be able to invest in qualifying FSFIs.

But first, how can this investment income tax reform actually work without being gamed?

To start, fortunately for this reform, it concerns the US financial markets, which are one of the most regulated markets in the world. Importantly, I can not think of any information or data that will be needed to be collected by businesses and the IRS for this reform to work that is today not already required to be collected by some business or  government agency.

Let me start with the US wage and business capital expense requirement rules.

Generally stated, the US wage and Cap X requirements will vary depending on the legal structure of the business, the type of investment infusing capital into the business, and whether or not the business has direct investments outside the US.

The Wage and Capital Expense Requirements are expressed as a percentage of the Total Infusion of New Capital that are acquired by the business due to one of the FSFIs, minus any legal costs but within limits, to the business to acquire that new capital.

At the lowest level, a private business that is selling some or all ownership through venture capital and has no direct business investments in a foreign country, would only need to spend 60 % of its Total Infusion of New Capital as Qualifying Wage and Capital Expenses. 60 % would also be the percentage required for private businesses that sell ownership publicly and issue IPOs while not directly investing in a foreign country.

However, 80 % of the TINC would need to be spent on Qualifying Wage and Capital Expenses if: the FSFI that created the TINC is the flotation of any bond by any type of business entity, or if any business that created the TINC has any direct investments outside of the US.

The requirements of 60 % and 80 % were not set this way as an incentive for more US investment, although this tax reform as a whole seeks that goal, 60 % and 80 % are set this way so that they are low enough for the investment markets and economy to best function while not letting the tax law be gamed. We can talk more deeply about this area if you’d like.

Regarding hedge funds and fixing the carried interest issue by, when taxing hedge funds, carving out for a lower tax gains derived from qualifying FSFIs while raising taxes for hedge fund income from none qualifying FSFIs gains, for these investments, 90 % of the TINC would need to be spent on Qualifying Wage and Capital Expenses

Regarding the question of what are Qualifying Wage and Capital Expenses, wherein 60 % or 80 % or 90 % of the Total Infusion of New Capital of one of the Four Special Financial Investments needs to be spent in order so that income gains from this Four Special Financial Investment might receive the lower carve out capital gains tax rate?

First off, there will always need to be some US wage expense requirements that accompany any US business capital expense requirements for businesses to help their investors achieve the lower carve out tax rate. That is, if the lower carve out tax rate could be achieved through only business capital expenses and not any US wage expenses, then the law would be open to extreme abuse and gaming.

However, and often with manufacturers, bonds and stocks are issued and parts of ownerships are sold in order to raise funds for specific capital goods investments in order to remain globally competitive and keep employing in the US. That said, and only as my opinion due to economic and social benefit and not due to need that without this tax reform would be gamed, but  as a rule, the lower the total wage component of this requirement, the higher should be the average wage in this wage component. How “average wage” is measured I will explain with my second two tax reforms.

The good news with this tax reform is that we could use the same definitions for wages and capital expenses as is used with the Qualified Business Income Deduction of the TCJA of 2017.

In the past I set the minimum percentage of domestic wage expenses needed to quantify at around 10 % or even 5 %. This is because most manufacturing and even retailing is heavily capital intensive and not labor intensive.

And while it would complicate things a bit, and I will explain later with the other two tax reforms how it most easily could be done, I believe that as the US wage requirement is reduced as part of what is required, a higher US employee compensation average should also be needed to acquire the lower investment income tax rate.

The IRS will also need to document the exact date of TINC as well as the completion date of Required Wage and Capital Expenses. This is because income gains from the Four Special Financial Investments can only receive the lower carve out tax rate if the Four Special Financial Investment is first “bought” at “date” of TINC and first sold on or after the “date” of the business spending the RWCE. In my opinion this is the fairest and most economically beneficial method here, as opposed to also attaching specific time periods after date of TINC as well to quantify for the lower carve out tax rate.

Fortunately, our financial markets, especially concerning the FSFIs, are one of the most highly regulated markets in the world. The IRS and proper government agencies could have a policy wherein businesses with stellar records of compliance set their announcement dates of own TINCs and dates of reaching RWCE. Other businesses that have less than stellar legal records with the IRS and others would need to pay for IRS and other audits to be completed before certification of RWCE dates and even as possible TINC dates are publicly announced. Again, I always welcome questions.

The most obvious questions from here are, when is an investment considered “bought” on the date of TINC? Also, when is an investment considered “first sold” at or after date of RWCE and therefore no longer considered a FSFI?

The primary goals of laws and regulations here would be to accurately document and possibly certify that the information regarding ” sellers and buyers” of FSFIs at date of TINC, and sellers of FSFIs at date of RWCE, and all of these purchase prices involved are indeed accurate, while opening up investing in the FSFIs to as many people as possible and not just the wealthiest investors who have special access.

With these goals in mind, a FSFI would be considered “Bought at Date of TINC” if: It has not been bought by more than two financial or trading institutions or more than one private investor, or if it is more than three working bank days from the date of TINC. The federal government and regulators would also need to force large trading institutions into finding further ways for small investors to be able to buy FSFIs.

And, an investment that is considered “First Sold on or after Date of RWCE can only be sold once, be it sold to any financial institution or private investor.

Also to clarify, the FSFIs must be bought at TINC and can not be sold in any way until Date of RWCE.

So this is essentially the basics of this tax reform, but I am always open to every type of question. .

On to my second tax reform which is a tax incentive for C Corporations, and possibly large Qualified Business Income Deductees, to compensate their US employees at ever higher rates. A more specific example could be allowing America’s highest employee compensating C Corporations to have a top tax rate of 15%, while the worst employee compensating C Corporations would have a top tax rate of 35%, with an average tax rate of about 25%, and corresponding tax rates inbetween.

These two tax reform’s political opponents will argue that businesses must pay market rates for their employees, so rewarding businesses that compensate their US employees at above average rates with lower income tax rates will have no positive effects because businesses must pay their employees more regardless of their income tax rates.

While this may be true for long established business sectors that see little innovation, most of the economy is much more dynamic and ever changing than that, with new business models being implemented in new and old business sectors all of the time. With this tax reform, all entrepreneurs will always have a strong financial incentive to come up with business models that pay their US employees above average, and the more above the average the greater the tax incentive reward.  It is at this crucial stage, of the inception of new business models by US entrepreneurs, that a tax incentive to employ Americans at higher than average rates of compensation will be greatly appreciated by the American worker!

The one thing that all economists believe is that financial incentives work, at least to some degree. At least as importantly, the political, economic, and social value that will come from institutionally incentivizing in our tax code US businesses to pay their US employees higher than the national average, this value will be so high it may never be able to be calculated!

So let’s see how these two reforms can actually work.

I always want to piggyback on any existing IRS or other laws with my reforms.

IRS law currently has a “Small Business Healthcare Tax Credit.” We could use this section’s definition of “Average Annual Wages”, with the following exceptions:

1. All seasonal employment compensation should count for the business towards what is calculated for their Average Compensation Raking.

2. None profit work and compensation should not apply.

3. No wage, salary, or compensation can be counted positively by any business towards their Average Compensation Ranking if that compensation goes to any person who owns anything more than the least powerful form of publicly traded stock or profit sharing plan in that business.

So how does this ranking work in the real world and more on it:

Firstly, one of the great things about these two tax reforms is that a business would expose themselves greatly to the IRS if they were to attempt to game these two reforms.This is primarily because these reforms have to do with US employee compensation, which are the single most documented and confirmed accurate forms of data that the IRS has.

That stated, I think the most effective yet simply way to implement this lower tax rate for C Corporations and large QBID qualifiers who “pay their US employees above average wages” would be the following:

Both C Corporations and large QBID qualifiers would calculate their Average Compensation Ranking yearly and with quarterly estimates. Prior to this the IRS would publicly post quarterly, National and Regional Average Compensation Rankings.

These businesses would be ranked from 1 to 20 comparing their ACR to the National ACR, and 1 to 20 comparing their ACR to their Regional Average Compensation Ranking. The business’s two rankings are then averaged, with their Regional ACR only averaging half their total ACR to the degree to which they only employ in one Region. Then those businesses with totaled scores above 10 would then be able to reduce some of their income tax rate.

Scores above 10 can be subdivided creating three or more higher subdivisions above the average. For example, scores between 10 and 12.5 could achieve .25 of the possible tax cut, 12.5 to 15 half the cut, 15 to 17.5 would get .75, and above 17.5 the largest cut. And of course, businesses with scores below 10 would have their top tax rate increased from 25% up to 35% accordingly in reverse.

Importantly, the National and Regional Average Compensation Rankings made by the IRS should never be actual or even predicted actual averages. These averages should be closer to a 55 percent/45 percent split, where closer to 55 percent of US businesses would be above average. This would be a better policy for economic growth and predictability, while not at all affecting the goal of these reforms nor possible tax gaming. We can always talk further as to why this policy should exist.

And yes, having Regional ACRs will complicate tax preparation. Yet, regions could be made extremely large, but small enough to reflect important urban versus rural wage differences.

Another IRS rule would need to be that no business could take any total dollar amount of tax reduction that is above 80 percent of their yearly US employee compensation expense.

Also, at every point possible with these two reforms we should try and mirror the C Corp law with Qualified Businesses Income Deduction law. This policy would be helpful economically, politically, and administratively.

We could also raise some federal tax revenues and create a pay for by creating an employee wage requirement and attaching it to the C Corporation tax reductions in 2017’s TCJA. New federal revenues would be raised because many C Corporations have few to no US employees and other “dormant” US C Corps are used for tax avoidance.

The above Average Compensation Ranking system could also be employed in my capital gains tax reform by Rankings needing to be higher than average for Four Special Financial Investments that have relatively few total US wage expenses to quantify.