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12/09/2014 06:13 am ET Updated Feb 08, 2015

Bruce Henderson's Amazing Tax Plan

It's tucked away, almost like a dirty little secret, in the Boston Consulting Group book Perspectives on Strategy, and it comes with a health warning. It's relegated to a short Part Five of the book labelled Social Commentary. The contents of these essays, we are told by the book's editors, "are highly personal - they reflect Bruce's character and beliefs [as if his other Perspectives do not], and not necessarily the views of BCG". None of the essays is so hot to handle as the one on tax, and it is surprising how little attention has been given to it.

Until now.

The beauty of Bruce's thought is that it is derived from first principles. And he starts with a surprise -- a remarkably modern surprise.

A Social Democratic Bruce?

As is well known, Bruce was a thorough-going capitalist, whose belief in free enterprise was total, or extreme, depending on your viewpoint. But when he comes to discuss taxation, he starts in an arresting way:

Taxes raise money to finance government spending. That is obvious. Taxes also redistribute income and control the creation of wealth. That may be the more important consequence.

Now, the reader -- at least, this reader -- expected this to be a prelude to a denunciation of high government spending and excessive control on the creation of wealth. This is where most right-wing commentators go today. But, like a master toreador, Bruce totally side-steps that discussion. He seems simply to accept those objectives, and then asks whether the current tax system -- broadly that of all countries today -- is fulfilling those objectives.

Such tax practices do raise revenue [tick for the first objective] and they do reduce the after-tax incomes of those who are the most productive [another tick, though perhaps expressed in a slightly back-handed way].

Yet, says Bruce, they have an unfortunate side-effect:

But such policies may substantially curtail productivity and leave the average man much worse off than he needs to be.

So the direction of his argument becomes clear. He is going to accept what we would now call the populist or social-democratic objectives, and argue that there is a better way to achieve them:

It is possible to encourage capital formation, capital investment, and the creation of wealth and to increase productivity by the direction of tax policy.

This is a new objective introduced by Bruce -- and who could object to it? But he insists that the third objective need not conflict with the first two social-democratic objectives:

It is possible to redistribute the power to consume [note the careful wording; he does not say wealth] and at the same time to limit that power as much as desired.

Bruce's Amazing Plan

Taxes should be levied when, and only when, individuals disinvest in order to consume. Capital still at work should not be taxed at all. Our taxes could be made both to increase average income and to level actual consumption by individuals.

Bruce has in mind a universe in which investment is made by individuals in order to generate future wealth for society and for themselves -- what today we would call an entrepreneurial society. Even when companies invest, their funds are derived from their individual investors, and so the simplicity of Bruce's model is not compromised. Only if companies pay dividends to their shareholders are they taking money out of "production" and putting it into "consumption." This simple model of the economy has a lot in common with that of Karl Marx. It is also a very useful way to think about the economy and society.

Bruce's basic point is that wealth is a function of investment. We may quibble that today it is a function of intellectual capital -- personal imagination -- as much as capital itself, but having observed venture capital at close quarters, from both sides of the table, I am sure that capital is still a vital component, and often quite a lot of capital too, in order to establish competitive dominance.

When, for example, Jeff Bezos started Amazon.com, he said that he would not make a profit at all for the first five years, ploughing what could otherwise be earnings back into lower prices and better customer experience. As a result, Amazon used prodigious amounts of capital. Even today, Amazon makes only a 1 percent return on its revenues, when it could easily choose to make that two or three times larger (and will no doubt eventually do so.)

That "West Coast" model for digital businesses -- worry about the land grab, about market growth and segment market share, rather than profits for the first decade or so -- has proved incredibly successful for entrepreneurs, investors, consumers, and society.

So basically I think Bruce was right. If you care about creating social wealth, you need a lot of investment. Tax policy should encourage investment.

But how do you do that without compromising the first two objectives of funding government and redistributing income?

Bruce's Rabbit Out of the Hat

Time for a big drum roll. How can Bruce possibly square the circle of creating a bigger pie and not allowing the rich too big a share of it?

His argument is that it is not wealth that society should be restricting or redistributing, but rather personal consumption of that wealth. The two are not at all the same thing:

Ownership of productive wealth confers no real benefit except future security until it provides an opportunity to consume. A progressive income tax can be restrictive enough to put any desired limit on the ability to consume, if that tax is based on consumption instead of income itself.

In other words, if someone owns a productive asset -- such as a share in Amazon.com -- he or she should not be taxed on that while the money remains in the productive system, and is not used for personal spending. Similarly, tough Bruce does not say this, income from working generates social wealth and should not be taxed until the money is spent by the person earning it. If an individual puts money back into the economy and society by investing in productive wealth, that should not be taxed at all until the money is withdrawn and spent.

I think it is very hard to argue against this proposition, and it sets the current debate about the rich allegedly getting richer in a totally new light. If the balance sheets of the rich are getting bloated but they don't spend the money, they are not really "rich" in any way that detracts from the welfare of anybody else. In fact, they are increasing that welfare. This is a totally different argument from that used by socialists when discussing the rich in the nineteenth century or before. Wealth used to derive ultimately from land, and holding land (unless you plonk a factory or a fish farm or a windmill on it) does nothing to generate additional future social wealth. There is a very strong intellectual case for a land tax, but the case for a tax on the fruits of capital and income, unless spent, is really weak -- if you think from Bruce's first principles.

Bruce's Radical Tax Proposals

If you follow Bruce's three objectives -- including, remember, the two social-democratic objectives -- you arrive at a much simpler and more effective tax code. In Bruce's ideal world, this is what you would do:

• Corporations should not be taxed at all. They are only surrogates for individuals, not the ultimate consumer. Tax the consumer, not the producer.

• If corporations are to be taxed at all, then tax the dividends

• Eliminate capital gains taxes. Instead, credit all net investment as a direct decrease in ordinary taxable income. [In other words, if there is new investment in venture capital, this can be offset against income tax. The UK tax code now allows that, though only partially. It has been very successful.] Likewise tax all net disinvestment as a direct increase in ordinary taxable income.

Bruce does not say how to tax "net disinvestment" and how to relate that to consumption. There are practical problems. For example, if I receive a large sum from selling a venture capital investment when the company is sold, and I keep the money in the bank, should I be taxed on that? To stick with Bruce's principles, I should only be taxed when I consume. But I don't think he envisaged having a massive sales tax and no income tax. The problem can be solved by having a time limit on reinvestment of my gains, perhaps 2-3 years. If I don't reinvest the money, then I can be taxed on the gain.

Also, Bruce does not seem concerned with income tax, which is just as much a tax on socially generated wealth as capital gains. Indeed, he explicitly states, The progressive personal income tax can be increased as necessary to equate tax revenues. But this ignores the fact that personal effort in a job can increase social wealth -- and although an imperfect measure, the best measure, perhaps the only measure we can realistically have, is what people are prepared to pay for the hours individuals put into work rather than more wholly personal objectives. Having a high personal income tax does conflict with wealth generation, though nobody knows how much and at what levels.

So ultimately, I don't believe that Bruce totally squared the circle. But his method is to be emulated and I do think he comes close to some incredibly valuable results:

• Work out tax policy from first principles that can be expressed on one page of paper. Three objectives, probably those Bruce came up with, are enough.

• Find a way to insist that the objectives do not conflict, or at least do not in wide parts of tax policy.

• Adopt his policy for investment in new companies (not for simply buying shares on the stock market, which is a secondary market that mainly does not provide new capital) -- offset all such investment (which limits consumption) 100% against income tax

• Tax the proceeds from dividends and capital gains the same -- as income, unless reinvested within 2-3 years in new ventures or new money for existing companies

This would greatly simplify not just the process of tax collection and greatly lower its cost, but more importantly, would be based on principles of fairness with due respect for what generates new wealth.

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