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Since all economic theories even Marxism and socialism recognize that capital formation is a key to long-run growth, higher wages, and improved living standards, it obviously doesnt make sense to penalize saving and investment.

Yet thats exactly what happens because of double taxation in the United States, as can be seen by this rather sobering flowchart.

So how can we fix the problem? The best answer, particularly in the long run, is to shrink the burden of government spending so that theres no pressure for punitive tax policies.

Good reform is also possible in the medium run. Policy makers could implement a big bang version of tax reform, replacing the corrupt internal revenue code with a simple and fair flat tax. That automatically would eliminate the tax bias against saving and investment since one of the key principles of the flat tax is that income gets taxed only one time.

That being said, theres no chance of sweeping tax reform for the next few years (and maybe ever), so lets look at some pro-growth incremental reforms that would reduce or eliminate the extra tax penalties on income that is saved and invested.

On the investment side of the ledger, any policies that lower or end the capital gains tax and the double tax on dividends would be desirable.

But lets focus today on the saving side. And lets start by explaining how a fair and neutral system would operate. Heres what I wrote back in 2012 and I think its reasonably succinct and accurate.

all saving and investment should be treated the way we currently treat individual retirement accounts. If you have a traditional IRA (or front-ended IRA), you get a deduction for any money you put in a retirement account, but then you pay tax on the money including any earnings when the money is withdrawn. If you have a Roth IRA (or back-ended IRA), you pay tax on your income in the year that it is earned, but if you put the money in a retirement account, there is no additional tax on withdrawals or the subsequent earnings. From an economic perspective, front-ended IRAs and back-ended IRAs generate the same result. Income that is saved and invested is treated the same as income that is immediately consumed. From a present-value perspective, front-ended IRAs and back-ended IRAs produce the same outcome. All that changes is the point at which the government imposes the single layer of tax.

The key takeaways are in the first and last sentences. All savings should be protected from double taxation, not just what you set aside for retirement. And that means government can tax you one time, either when you first earn the income or when you consume the income.

Our friends to the north can teach us some lessons on this issue.

Here is the original post:
Canada Shows How to Eliminate the Tax Bias against Saving