The Real Answer to America's Fiscal Disaster

In case you haven't been paying attention, problems with the fiscal situation in the U.S. have reached epic proportions. The federal government has run some of its largest deficits in history, and the sluggish economy has put a limit on how much tax revenue the government can collect to offset massive federal spending.

As a result, people are discussing the inequities of the current tax system and whether better alternatives exist that could help solve some of these problems. On one side, some believe that Congress should allow the tax cuts passed nearly a decade ago to expire, sending marginal rates up somewhat from their current levels. Others espouse radical departures from current tax policy, such as presidential candidate Herman Cain's 9-9-9 tax proposal.

In this article, I'm not going to find the magic answer that solves America's problems in one fell swoop. But what I will do is reveal one secret that no one seems to understand -- but which could make any eventual solution a whole lot more productive. It comes down to this:

Stop changing the rules!
I won't deny that arguments on both sides of the debate over the "fairest" tax system have some merit. Raising taxes in the middle of a near-recession could push the economy over the brink. Yet those who point to income gains being concentrated among top-income taxpayers reasonably want more equitable distribution of the products of economic activity.

But what we've dealt with ever since the tax cuts in the early 2000s is that there's no certainty about what the tax laws will be in the future. Consider:

  • This year, employees got a 2% boost in after-tax income thanks to a temporary drop in payroll taxes. Will that break expand, as the Obama administration has proposed, or return to its old higher level?

  • Last year, millions of taxpayers got their first chance to convert retirement accounts to Roth IRAs. Yet many are scared to do so because they don't trust Congress to keep Roths tax-free.

  • Long-term investors love the lower taxes on capital gains and dividends. But with those provisions slated to expire at the end of next year, there's no certainty about the taxes you'll pay in the future.

All of these issues exist, but they're hard to quantify. Fortunately, there's one concrete example of this phenomenon that is among the most controversial discussion topics today.

Bring the money home
Thanks to quirks of the U.S. tax system that are too complicated to explain in a short article, U.S. corporations have a big incentive to keep money they earned overseas rather than returning it to their domestic businesses. In an effort to try to capture some of the lost tax revenue from this money, the government allowed companies to repatriate overseas cash at a lower rate back in 2004.

Many companies jumped at this opportunity. Some of the biggest were health-care giants Pfizer (NYS: PFE) , Merck (NYS: MRK) , and Johnson & Johnson (NYS: JNJ) , with Pfizer topping the list at $35.5 billion. In addition, tech companies Hewlett-Packard (NYS: HPQ) and IBM (NYS: IBM) also took advantage of the opportunity to pay roughly 5% on that income rather than the nominal corporate tax rate of 35%.

Now, this issue has come up again, because companies increased their overseas holdings after the 2004 tax break. The reason: they expect the same sort of rule-change to lead to a lower tax bill. In other words, they'd be idiots to pay the tax rate on the books -- only to see weak-kneed legislators give in on a supposedly one-time break. And a coalition of companies and other interested parties, including Eastman Kodak (NYS: EK) and EMC (NYS: EMC) , want to see incentives to bring that foreign capital back to U.S. shores -- at attractive tax rates for them.

Similarly, taxpayers routinely wait for favorable changes before making decisions that incur tax. The reason that capital gains cuts lead to increased tax revenue is that taxpayers are smart enough to wait for them, holding back on high-tax sales until they can get the best rate possible.

Final answer?
In the end, it isn't as important what rules lawmakers pick as their tax policy as it is that they decide once and for all what they'll be. Near-constant rule-changing only encourages enterprising taxpayers to work harder to escape paying what some would say is their fair share. If lawmakers ever learn that lesson and stop messing with the tax laws, everything will eventually look a lot fairer in the long run.

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At the time thisarticle was published Fool contributor Dan Caplinger hates watching disaster movies, let alone being part of one. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of IBM, EMC, and Johnson & Johnson. Motley Fool newsletter services have recommended buying shares of Johnson & Johnson and Pfizer, as well as creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is too even-handed to run for political office.

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