Does capital taxation hurt an economy?

Following my Econoblog debate with Max Sawicky, Kevin Drum writes:

Basically, I’m on Max’s side: I think taxation of capital should be at roughly the same level as taxation of labor income. However, I believe this mostly for reasons of social justice, and it would certainly be handy to have some rigorous economic evidence to back up my noneconomic instincts on this matter. Something juicy and simple for winning lunchtime debates with conservative friends would be best. Unfortunately, Max punts, saying only, "As you know, empirical research seldom settles arguments."

Let me repeat the chosen comparison: capital taxes vs. gasoline taxes and no subsidies for housing.  That is a no-brainer.  But still you might be interested in the question of capital taxes vs. labor taxes.  Here are some points:

1. Supply-siders writing on capital taxation often make exaggerated claims.  Even if you like their conclusions, beware. 

2. Taxing dividends, corporate income, returns to savings, and capital gains all involve separate albeit related issues.  I am willing to consider zero for the lot.  Of that list, the corporate income tax is probably the biggest mess.  The capital gains tax is the least harmful.  The tax on dividends is the least well understood (in perfect markets theory, the level of dividends should not matter at all).  By the way, if you are worried about noise traders, a transactions tax is a better way to address this problem than a capital gains tax.

3. The U.S. currently lacks exorbitantly high levels of capital taxation.  Joel Slemrod estimates a rate of about fourteen percent, albeit with many complications and qualifications.  N.B.: We lower the rate of tax on capital by engaging in crazy-quilt and distortionary adjustments.  Nonetheless it is incorrect to argue "we have high rates of capital taxation and are doing fine, better than Europe."  Do not confuse real and nominal tax rates.

Take the capital gains tax.  Once you consider bequests and options on loss offsets, the effective rate of tax is arguably no more than five percent.  But it is still set up in a screwy way.  Bruce Bartlett points me to this short piece on real tax burdens on capital.

4. Peter Lindert has good arguments that favorable capital taxation has helped European economies finance their welfare states.

5. Larry Summers did the best empirical work on how abolishing capital income taxation would boost living standards. 

6. Encouraging savings will have a big payoff.  If you tax capital at zero, in the long run you will have much more of it.  This holds in most plausible views of the world.  Max’s examples aside, the supply curve for savings does not generally slope downwards; nor need you write me about various strange counterexamples from Ramsey models.  Sooner or later, more capital will kick in to mean a much higher standard of living.

7. Bruce Bartlett points me to this excellent CBO study.  It shows how much capital is taxed unevenly; one virtue of a zero rate is to eliminate many of those distortions in a simple way.

8. Remember those arguments about how more money doesn’t make you happier?  And we are all in a rat race where we work too hard to win a negative-sum relative status game?  I’ve never bought into them, but it’s funny how they suddenly stop coming from the left once the topic is capital vs. labor taxation.

9. The same excellent Slemrod paper (and he is no right-wing supply-side exaggerator) also suggests that the revenue lost from a zero rate on capital would be small.  N.B.: The references to this paper are the place to start your reading on this whole topic.

10. Kevin Drum’s belief in social justice should not necessarily lead him to look for arguments for taxing capital.  Even if we accept his normative views, there is the all-important question of incidence.  Taxing capital can hurt labor.  If you are truly keen to tax capital, this is a sign of a high time preference rate, not concern for the poor.

11. Some forms of human capital also should receive favorable tax treatment.  Vouchers for primary education and state universities are two examples.  I am also happy — in part for equity reasons — to subsidize human capital acquisition through an Earned Income Tax Credit.

12. What is really the difference between capital and labor?  Is it simply measured elasticities?  The size of each potential tax base?  The greater "future orientation" of capital and the possibility for compound returns?  All of the above?  How much does your answer depend on whether you view capital as a "fund" or as a "collection of capital goods"?

The bottom line: It all depends on the margin.  If your levels of government spending allow you to keep labor rates of taxation below 40 percent, I don’t see comparable gains from lowering tax rates on labor.  If you have equity concerns, express them through other policy instruments.  But if your marginal tax on labor is 65 percent and your tax rate on capital is 15 percent, cut the tax on labor first.

I know it hurts, but all of you non-right-wingers out there should consider a zero rate of taxation on capital.  Comments are open.


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