September, 2002

Fruits of Thought

Tax Reforms Needed

Each September the United Fresh Fruit and Vegetable Association holds its annual Public Policy Conference. Though typically focused on produce-specific issues, such as PACA, funding for the inspections service, pesticide issues, the Farm Bill, etc., produce industry organizations have long recognized that no industry exists in isolation. And so, trade representatives frequently have joined various coalitions to affect more general public policy issues. For example, many Ag community organizations have joined alliances to reduce or eliminate the estate tax.

Public policy has played a large role in our country’s economic travails. As policy debates start to bubble, the produce industry needs to look for opportunities to join alliances and fight for the kind of policy environment that will help produce prosperity. Some examples:

1. Equal tax treatment for interest and dividends.

As the law stands now, if a corporation raises money by selling bonds, the corporation can deduct the interest paid on the bonds as an expense. If the same corporation raised the same amount of money by selling equity, the corporation cannot deduct the dividends paid at all.

This “double taxation” of dividends – once at the corporate level and then again personally when the stockholder receives the dividend – has led shareholders to not value or demand cash dividends.

The consequences of this are enormous and not well recognized. First, to pay out cash dividends, companies need real money. This makes fraud much more difficult to perpetrate. As long as the company is retaining all earnings, it can be mere bookkeeping entries and, quite possibly, no one will be the wiser.

Second, earnings retained beyond the needs of the corporation are often poorly spent. As idle hands do the devil’s work, so unneeded funds are prone to either ill-advised investments or to needless extravagance. On the other hand, if a company pays out most of its earnings in dividends, the company has to make the case for major new investments to Wall Street. The capital markets will not be so quick to fund empire-building acquisitions or to build the Chairman an oceanside retreat.

Third, the high ratios of debt to equity encouraged by the differing tax treatment of dividends and interest adds tremendous risk to the system. Investors who have watched so many stocks tumble shake their heads trying to understand how the collapse could be so dramatic. How could a company lose so much of its value almost overnight?

Well, a few are frauds; a few were crazy New Economy fantasies that rose to astronomical heights. But in most cases, the answer is more plebian: high debt.

Think of a big investor in real estate. One year he owns $10 billion in real estate, has mortgages of $9 billion and so has equity of a billion dollars. He is a bona fide billionaire. Next year is a tough year, and property values decline by 11 percent. As a result last year’s billionaire still has $9 billion in mortgages but only $8.9 billion in equity. Last year’s billionaire is now dead broke.

There is a public interest in encouraging equity, not debt, because heavy debt loads can easily turn transitory downturns into bankruptcies and panics.

2. Loss deductibility must be expanded.

Of course investment losses are a part of investing. One of the real dangers of having everyone in Washington tar every executive with accusations of immorality, corruption and greed is that all this talk will make people hesitant to invest.

A far better approach would be to reform the tax system. Right now the government is your partner on all long-term capital gains profits, taking the government’s 20 percent with every transaction. But what if you have losses, not gains? Well, those can be deducted from your regular income only up to $3,000 a year.

If the government wants taxes on every gain, taxpayers should be able to deduct every loss. This would not only help a lot of people right now out of a jam, but, more important, it would change the risk/reward ratio on investments to encourage the kind of risk taking important if our economy is to continue to grow.

3. Allow rollovers for capital gains

There are trillions of dollars in investments locked up because people have big gains and don’t want to sell and pay big taxes. But the crucial element of capitalism is that we rely on capitalists to know where best to invest money. So we need a system where if a produce wholesaler in New York sees that, say, hydroponic greenhouses are a great opportunity, then he will sell his wholesale company and invest in greenhouses. But taxes are a big obstacle. The solution? A rollover system. Sell stock or a business and reinvest the money in a different stock or business and the tax basis rolls over from the first investment to the second.

Instantly we will be freeing capitalists to put capital to work where they expect the highest returns.

We can expect some to oppose all these tax reforms as supposedly increasing the deficit. But they would be incorrect. In the end, if we don’t get the economy moving, there will never be enough revenue to balance the budget, but if we do things to bring consistent growth, we will have rising tax revenue to cover all the things we, as a people, might want our government to buy.  pb