‘Unearned Income’
Is No Such Thing
By Tig Tillinghast

Governor Jim Douglas and House Majority Leader Gaye Symington have been arguing about how to spend a newly proposed funding source for Vermont, $21 million from a so-called "unearned income" tax. Neither seems to recognize the discouraging message this tax sends to entrepreneurs, or its likely long-term damage to the state’s economy.

Oddly enough, the proposed "unearned income" tax was suggested by Douglas, a Republican; his argument running that if the higher taxes were applied to mitigating property taxes, it really wouldn’t be considered a new tax at all. Perhaps predictably, Symington’s legislature embraced the idea of the new revenue, but does not want to spend it on reducing property taxes.

Both sides have called it a closing of a loophole on "unearned income," but this is misleading. When someone takes the risk of investing in a new business, she takes a big risk. She typically pays herself far less than she could make from an established employer. If, for whatever reason, her business fails, she bears all the cost. If she succeeds, she isn’t the only winner; her business is a new source of jobs and tax revenue for Vermont.

This person gets "paid" mostly through the increased value of the business that she created. If that business were sold, the folks in Montpelier would call that "unearned income." Over the past generation, governments have taxed this at a lower rate than typical income because it has the effect of generating future revenues as well as jobs.

Increasing taxes on these gains has actually reduced government revenues. When Ronald Reagan raised "unearned income" taxes, the revenue from those taxes in 1987 fell. When Bill Clinton reduced the rate later, the revenues rose in 2003. While some of that may have been because people were gaming the new rules, there are real and long-term structural reasons why lower investment taxes lead to greater economic activity and tax revenues. That is especially true in tight credit market times, like now, when the vast majority of new business creation and growth comes from earnings out of existing businesses.

Investors put their money where they think the payoff will be big enough to offset the risk that they might lose all of their investment. If you tax those occasions where the entrepreneur is successful, you change the balance of the risk/reward equation, often stopping that entrepreneur in her tracks.

Fortunately, the partisan bickering between Douglas and Symington left the proposal dead for this last legislative session. Unfortunately, it’s likely to be re-awakened in the coming one. That’s why Vermonters should ask both Symington and Douglas to take another look at their assumptions about this issue, and the wisdom of taxing funds that otherwise would be put back into the economy.

To her credit, Symington, who holds a business degree, has talked about exempting investment in Vermont firms, but it’s unclear how that sort of state discrimination would work. Usually, schemes designed by state legislatures to discriminate against businesses in other states get overturned in federal court on constitutional grounds, but those consequences typically come years after assurances to the contrary have been made.

One of the reasons unearned income is such a juicy target for politicians is that the people who have unearned income tend to be wealthier. Wealth taxes being as unpopular as they are, an unearned income tax comes pretty close to serving the same function but under a nicer-sounding name. But there’s one big functional difference: taxing wealth tends to punish lazy capital – the money that sits around in a bank account doing nothing. Taxing unearned income punishes the money that is sent out to go do something useful, like building a new business, investing in old ones, and creating jobs.

The special tax rate for unearned income isn’t a loophole; it’s a deliberate public policy. To go back on this practice can lead to only to two things: fewer people investing in Vermont’s future, and $21 million – probably less – of new taxes over which Governor Douglas and Speaker Symington can fight for in the press. For my part, I’d rather spare all that ink and tell investors in non-polluting business ventures that they’re safe and welcome to put their money to work in Vermont.

(Tig Tillinghast runs a publishing company in Thetford Center, where he is an avid sugar maker and a member of the selectboard.)