Equalizing the rate of tax on income and capital gains?

by on July 30, 2007 at 7:13 am in Economics | Permalink

Alan Blinder had a good column yesterday, summarized and discussed by Mark Thoma.  The current movement, supported by Greg Mankiw I might add, is trying to raise the rate of taxation on private equity income so that Warren Buffet is not paying a lower tax rate than someone poorer than me.  More generally, it seems to many people that the rate of taxation on capital gains should be the same as the rate of taxation on ordinary income.

It’s hard to go against the weight of that opinion, but I would like to refocus the debate on the difference between stated and real rates of capital taxation, most of all with regard to loss offsets.  I haven’t seen this discussed in the very recent debates, though it is an old theme in public finance.

My uninformed-by-ever-having-been-a-tax-lawyer sense is that loss offsets for the capital gains tax are worth a great deal to some investors.  Sell your winners to coincide with selling some losers and claim a net gains income of zero or very low.  Let the asset winners ride and they will end up in your bequest and have their taxable values reset upon your death.  If your option values line up the right way, you have enough diversification, and you are not liquidity constrained, it seems that for many people the de facto rate of capital gains taxation is not 15 percent but rather close to zero.  (Maybe not quite zero in expected value terms; it’s tricky because if the losses exceed the gains you can deduct only $3000 of the losses from regular income but on the upside you’re taxed all the way.  On the other hand, you can offset with charitable deductions.)

Let’s say we raised the book rate of tax on capital gains to forty percent.  For some people the net real rate of tax on capital gains could still be zero.  For other people it would be forty percent.

Let’s say we raised the book rate of tax on capital gains to eighty percent.  For some people the net real rate of tax on capital gains could still be zero.  For other people it would be eighty percent.

Under which of these scenarios have we equalized the tax rates on capital gains and labor income?

For any published capital gains rate, it seems there are two or more (and possibly wildly disparate) real rates de facto.  Again, I’m no tax lawyer, but it seems any capital gains tax hike falls disproportionately on the non-diversified (if you hold only one asset and it is a huge winner, where can you get a loss offset from?  The quality of your tax accountant probably matters too.  Any other factors?).

No matter what, capital gains rates for some investors are too high and for others the rates are too low.  And don’t be shocked if many of those "too low" rates are enjoyed by the wealthy.  There will be unfairnesses when compared with income taxation as well.  It is a question of choosing your unfairness, not being able to eliminate unfairness or differential treatment.  So the mere fact that one apparently unjustified unfairness has been pointed out…well…I’m not yet ready to cry uncle.

One reason why the Clinton tax hikes weren’t so bad for capital formation is because capital gains taxes can be avoided in various ways.  The Bush defenders should recognize that and admit that K gains tax hikes are not always a disaster.  On the other hand, the notion of equalizing income and capital gains rates is a myth, and always will be.  There simply isn’t a single capital rate that ends up applied to everyone, no matter what it says on paper.

You might go down another path and talk about eliminating the loss offset.  I wonder if that can be done feasibly.  For instance it would mean that assets A and B, held together in a mutual fund are worth more than assets A and B held separately.  You can think of other problems with this in your spare time.

Yet another (and better) path is to institute a consumption tax, but in the meantime these other kinds of unfairness are not going to disappear.  See also Martin Feldstein on other costs of capital income taxation.

It makes perfect sense to say: "we’ve already spent the money, taxes somewhere have to go up."  But the Buffet example, taken alone, doesn’t convince me much.  Let’s start by taxing negative externalities at a higher level, not by focusing on major creators of wealth.

1 John Duncan July 30, 2007 at 8:13 am

the problem is that with a high rate on gains, nobody sells the winners to invest in other assets. we need liquidity in the capital markets to develop new technology

2 Jonathan July 30, 2007 at 8:49 am

Andrew’s last paragraph is indeed a solution, and one that we actually use for zero coupon bonds, for example. (Well, not quite, but we tax imputed income.) But it has its own problems. First, imagine making people pay capital gains once they exceed $250,000 gains on their primary residence. Then will they get get tax gains as the values of houses fall? And who will be marking these highly illiquid assets to “market?” And small business valuation — don’t get me started.

3 mkl July 30, 2007 at 9:19 am

Taxing mark-to-market gains does make more sense and pretty much all development in public
accounting is in the direction of marking everything to market.

Assuming a given desired level of tax revenue it strikes me the main tax policy question is how to
minimize the distortion of economic activity imposed by the tax system. The general answer to this
is to tax the largest base at the lowest marginal rate. That is to make it costly to get dollars away
from taxation and to minimize the benefit from doing so.

The biggest step toward doing this is to marginally increase taxation of assets and decrease
taxation of income. It sure is progressive if you want that, and also promotes wealth creation over
retention – tax burdens will fall on those whose high economic output equals high current income and
likewise discourage idly sitting on assets.

Of course the fact that high marginal tax rates can be used to grossly distort economic activity
is regarded by many in government as a feature, not a bug.

4 alkali July 30, 2007 at 10:03 am

Re: Andrew (Jul 30, 2007 8:41:46 am): It does not necessarily follow from the fact that there are adverse economic consequences to capital gains taxation that the capital gains tax rate should be lower than the ordinary income tax rate. There are adverse economic consequences to taxation of labor and other income as well. It may be that the adverse consequences of capital gains taxation are so much worse than the adverse consequences of taxation of other income that it makes sense to have a lower capital gains tax rate, but you can’t perform that comparative analysis by looking only at one side of the balance.

5 robertdfeinman July 30, 2007 at 10:23 am

There are three cases being conflated.
1. Regular capital gains obtained by buying and selling assets on a regular basis.
2. Tax sheltered gains such as assets in an IRA or 401k.
3. Gains realized by an estate at time of death.

The effect on the tax rate of type 1 transactions has been argued for decades. It seems to me that if the answer were blindingly clear as to what the best way to tax these transactions was the debate would have ceased. Thus claims must be influenced by ideology to a greater degree than a “scientific” discipline would accept. I call this the “Viagra” rule. When something comes along that really works news spreads quickly and people stop using ground rhinoceros horn or whatever faith-based nostrum they tried before.

2. Type 2 gains (and the whole idea of tax deferred or sheltered investments) is a band-aid solution to the changes in the way pensions are offered. With the demise of the guaranteed pension there have been various attempts to get people to participate in creating their own plans. Tax incentives are just one of approaches. Whether this is the best solution to the pension problem is separate from the tax issues.

3. Type 3 gains typically only help the extremely wealthy. They are the only ones whose estates are large enough to be taxed heavily and they are the only ones with enough assets that the capital gains are substantial. Depending on who you believe this is from 1-5% of the population. Does it make any sense to have basis resetting that shields $40 billion in taxes for the Walton family while the rest of us might see our estates save $30K in taxes?

Those who like to argue from a philosophical basis really need to look into the practical outcomes of some of these policies. In most cases the true beneficiaries are those who are already in the highest economic strata. They use their wealth to promote the ideological positions which argue for “fairness” or economic “efficiency”, but what they really are after is saving their estates.

If you haven’t seen this report before it details how just 18 super wealthy families have been responsible for the bulk of the funding of ideological efforts to support preferential tax policies. If you dig a little further you will find that many of your favorite think tanks are funded by these same families.

Report (PDF)

6 Jacob July 30, 2007 at 10:42 am

I never understood the capital gains tax. Your taxing me because my property went up in value, or I suckers someone into paying too much for it? Now dividends are income and should be taxed at the income tax rate, but it would SEEM that the sale of property could only potentially be taxed by a sales tax.

Now lets think about a sales tax here. Tax the sale of property in a commercial enviroment at a flat rate. Imagine a tax on every stock sale in America. Probably kill the market, but at least is consistant.

7 John Thacker July 30, 2007 at 11:11 am

I’ve long felt that the stepped up valuation upon death should be eliminated at the same time as the estate tax. In fact, the proposals that the House had for permanent repeal of the estate tax did exactly that, which seems like a fair trade-off to me, but also seemed to be mostly missed at the time. (Except for estate planning groups and small businesses and others who already knew how to do their estate planing, which disliked the idea of losing the stepped up valuation.)

8 a smithe July 30, 2007 at 11:54 am

For many people isn’t capital gains (like estate) taxes constitute double taxation. It seems like the proponents of increasing the tax are going after the super-rich who make the majority of their income from investments. What about the middle-class salaried worker, who pays income tax, invests what he can on the money (that he’s already paid a tax on), then again has to pay tax on top of that if he’s sees any capital gain? It seems like most of the tax laws are targetting a really small population, who is savvy at finding a new way of avoiding tax penalties, while the middle / upper-middle class suffers.

9 Sameer Parekh July 30, 2007 at 12:23 pm

I think James has the right idea. Rather than eliminating the capital gains tax, the more clear thing to do would be to equalize the tax rates and eliminate the corporate income tax, passing all the tax liability directly onto the shareholders. Corporations don’t pay taxes, people do. I don’t think you need to worry so much about infinite deferral, because a company that doesn’t pay dividends will still have its shares appreciate, and that can then be taxed.

10 Norman Pfyster July 30, 2007 at 12:55 pm

Worth noting the Mankiew is talking only about carried interest (whether it should be taxed as capital gains or ordinary income) and not whether tax rates on capital and income should be equalized. Blinder is conflating the two issues for rhetorical effect.

11 Floccina July 30, 2007 at 2:28 pm

robertdfeinman one reason for copr taxes is to discourage limited liability that corps give relative partnerships. The limited liability of corporations so distorted the tabbacco settlement that the supposed victims (the smokers) are paying the settlement.

12 nelsonal July 30, 2007 at 4:13 pm

Mr. Buffett has worked his entire life to minimize taxes, as he is a genuinely bright fellow and good strategic thinker, it should come as little surprise that he was successful in accomplishing his goal.

13 TGGP July 30, 2007 at 10:52 pm

robertdfeinman, did you know that McGovern’s presidential campaign was also funded by a very small number of wealthy donors and would not have been possible under today’s campaign finance laws? Bryan Caplan has shown that income is a pretty lousy predictor of political opinion (think of Warren Buffet advocating higher taxes on himself, all the people in the entertainment industry and the trial lawyers that support the Democrats while the poorest state in the country is solid Republican). Class conflict theories of politics just don’t fit the data (even libertarian ones) because political actors are not self-interested and/or rational. While we may think it odd that today low-income people will vote Republican because the candidates are pro-life, in fact this is not unprecedented but politics as it was normally practiced before the aberration that occurred with the advent of the new deal.

14 Anthony August 2, 2007 at 1:01 am

I am still waiting for the day that a laywer finally starts suing the government about incorrect implementation of capital gains tax.

Capital gains tax is based on nominal value increase but does not take into consideration inflation.

Correct implementation of capital gains tax should be based on increase in real value of the goods or stock and not be impacted by a devaluating dollar or inflation

Or do I have to wait until inflation gets high again and then finally someone wakes up?

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