Five Arguments for Taxing Investments Less

Earlier today, the Washington Examiner’s Tim Carney tweeted out the following question:

why should investment, one means of value creation, be taxed at a lower rate than labor, another means of value creation?

Being a bit of an overachiever, I responded that I had five arguments, and asked how many of them he wanted to hear. He suggested that I blog all of them, so here we are. Without further adieu, here are my five arguments for why investment income should be taxed at a lower nominal rate than labor income.

1. Capital gains aren’t indexed

The first argument is pretty straightforward, and ably articulated by David Friedman:

[C]apital gains are calculated on nominal, not real, values. To see why that matters, consider someone who bought an asset in 1981 for $100 and sold it in 1998, the year the study’s figures are based on, for $200. On paper, he has a capital gain of $100. But over those seventeen years, prices doubled; $200 in 1998 was worth the same amount as $100 in 1981. His real capital gain is zero. If instead he sold the asset for $300, the capital gain reported on his schedule D will be $200, his real capital gain only $100.

Since capital gains taxes do not account for inflation, applying the same rate to investment income as to labor income would be to treat investment income disadvantageously.

2. Marginal vs. Effective Rates

Because we have a progressive income tax, saying that capital gains should be taxed at the same rate as labor income is ambiguous. Typically proposals of this sort involve treating capital gains as ordinary income, which would mean by and large it would get taxed at a person’s marginal rate. But labor income is not all taxed at the marginal rate. Therefore, applying the same marginal rate to investment and labor income would mean investment income would get taxed at a higher effective rate.

3. Double taxation

Typically the argument with double taxation and capital gains involves the corporate income tax. The problem is that the evidence suggests all or most of corporate taxes end up coming out of workers wages, rather than equity holders. There is, however, a parallel argument for double taxation based not on the corporate but on the personal income tax, as explained here by Steve Landsburg:

Alice and Bob each work a day and earn a dollar. Alice spends her dollar right away. Bob invests his dollar, waits for it to double, and then spends the resulting two dollars. Let’s see how the tax code affects them.

First add a wage tax. Alice and Bob each work a day, earn a dollar, pay 50 cents tax and have 50 cents left over. Alice spends her fifty cents right away. Bob invests his fifty cents, waits for it to double, and then spends the resulting one dollar.

What does the wage tax cost Alice? Answer: 50% of her consumption (which is down from a dollar to fifty cents). What does it cost Bob? Answer: 50% of his consumption (which is down from two dollars to one dollar). In the absence of a capital gains tax, Alice and Bob are both being taxed at the same rate.

Now add a 10% capital gains tax. Alice and Bob each work a day, earn a dollar, pay 50 cents tax and have 50 cents left over. Alice spends her fifty cents right away. Bob invests his fifty cents, waits for it to double, pays a 5 cent capital gains tax, and is left with 95 cents to spend.

What does the tax code cost Alice? Answer: 50% of her consumption (which is down from a dollar to fifty cents). What does the tax code cost Bob? Answer: 52.5% of his consumption (which is down from two dollars to 95 cents).

So there you have it: A 50% wage tax, together with a 10% capital gains tax, is equivalent to a 52.5% tax on Bob’s income. In fact, you could have achieved exactly the same result by taxing Bob at a 52.5% rate in the first place: He earns a dollar, you take 52.5% of it, he invests the remaining 47.5 cents, waits for it to double, and spends the resulting 95 cents.

4. Deadweight loss

The prior three arguments all assume that you want to achieve some sort of neutrality between investment income and labor income, neither favoring nor burdening one more than the other. But suppose you don’t care about that. You just want to get as much tax money from people as possible (preferably from rich fat cats). In that case, you still are going to want to tax capital gains at a lower level than the marginal rate for labor income. A review by Greg Mankiw shows that “In the long run, about 17 percent of a cut in labor taxes is recouped through higher economic growth. The comparable figure for a cut in capital taxes is about 50 percent.” That’s despite the fact that marginal income tax rates tend to be higher than capital gains rates. What this suggests is that means that the revenue maximizing rate is going to be lower for capital gains than for labor income.

5. Growth

Why is the deadweight loss associated with capital gains taxes so  much higher than for labor taxes? One possible answer is that capital is more mobile. It’s easier to alter the timing of your realization of capital gains based on the tax rate than it is with labor income. Another possibility, however, is that dollar for dollar investment leads to a greater amount of wealth creation than does labor. If that’s right, and if we care about economic growth (and who doesn’t), then that is an argument for preferential treatment for investment income.

So there you have it. Those are my five arguments. None of them are earthshattering. They may even be wrong. But they are what they are.