To anyone with knowledge of public finance theory, reading media reports of capital gains taxation is almost painful. Here’s an example from Bloomberg:
A group of economists recently argued in the Chicago Booth Review that the prevailing wisdom among scorekeepers that the revenue-maximizing rate is about 30% may be misplaced — and could allow for an even higher rate. A pair of Princeton University economists published research in December showing that hikes may raise “substantially more tax revenue” than scorekeepers currently believe and that the revenue-maximizing rate may be about 40% — almost exactly where Biden’s proposal falls.
Economists and analysts have also made the case that cuts in capital gains rates have a negligible impact on investment decisions and economic growth. (Though, like much around capital gains, that debate isn’t entirely settled.)
If capital gains taxes have almost no impact on behavior, then why isn’t the revenue-maximizing rate 100%? And why does the revenue maximizing rate even matter? I don’t know of any public finance model where the optimal tax rate is the revenue-maximizing rate.
You also see the media discuss the “principle” that capital gains should be taxed the same as wage income. That’s about as sensible as saying that “in principle”, a gallon of gasoline should pay the same tax as a gallon of Scotch whiskey. Exactly what principle is that? Capital gains income is nothing like wage income, indeed calling both “income” is nonsensical. For instance, the real and nominal tax rate on wage income is identical, and the real and nominal tax rate on capital gains is very different. So if it’s a matter of “principle”, then why should we set the nominal tax rates equal? Why not equalize the real tax rates? And if they are merely two forms of “income”, then why don’t we allow full deduction of capital losses from wage income?
A wage tax essentially taxes current and future consumption at the same rate. A capital gains tax taxes future consumption at a higher rate than current consumption. What “principle” suggests that patient people should be taxed at higher rates than impatient people—even if they have the same lifetime wealth?
There are reasonable arguments for capital gains taxes (related to catching people who evade wage taxation). But you almost never see those arguments presented in the media.
READER COMMENTS
Todd Moodey
Apr 26 2021 at 12:47pm
Scott–
Since the Bloomberg articles cites some number of “economists” in a way that makes it seem that this issue (broadly, the equivalence of capital and wage income and the policy implications thereof) is settled in a way that you don’t, where in your view does the issue stand among economists? Your position seems so clear and obvious that it’s difficult for me to believe the views depicted in the article are widespread.
Thanks,
Todd
zeke5123
Apr 26 2021 at 12:48pm
One of the more annoying facts arising from the Laffer Curve is the focus solely on revenue maximizing. I think, as a basic model, the Laffer Curve makes sense (especially if the tax is easy to avoid, such as capital gains where the taxpayer can avoid the tax by not selling). The insight is that raising rates likely doesn’t result in the same tax base (i.e., raising rates will result in marginally smaller amounts of revenue). But as you point out raising revenue is not the sole consideration when thinking about taxes — indeed two taxes schemes could be identical in revenue creation but one could result in significantly different economic effects compared to the other. We care about those economic effects.
The Laffer Curve should’ve been a useful model to understand one part of the equation, but in public debate it seems to occupy the field.
Scott Sumner
Apr 26 2021 at 5:02pm
Yes, indeed as you approach the top of the Laffer curve, the deadweight loss of an additional dollar in tax revenue approaches infinity.
Peter Gerdes
Apr 26 2021 at 12:58pm
Many of us who want to equalize the capital gains tax rate and the wage income tax rate exactly want to set the *real* capital gains tax rate to equal to the real wage income tax. At least on average. Yes, that would mean different nominal rates but I think there is a pretty strong fairness argument for doing something like this (with some trickiness about dealing with risk and making sure that you don’t impose too much transaction costs).
robc
Apr 26 2021 at 2:15pm
Actually, you wouldn’t have to do different nominal rates at all.
Long term capital gains are, by definition, purchased and sold in different years, so a cost-basis adjustment based on the year of purchase and year of sale would be fairly easy to implement.
Then make the nominal rate the same and the real rate of LTCG and regular income would be the same.
If years is too rough a calculation, there could be exact date adjustments within the year, but that might be too hard to do. But much better than taxing them both at the same nominal rate.
And a long-term investment that is just an inflation hedge would have no adjusted gain, so no taxation.
Scott Sumner
Apr 26 2021 at 5:08pm
Peter, Taxing real capital gains doesn’t even begin to solve the problem. What do you do with capital losses?
But the more fundamental problem is that comparing wage and capital income is comparing apples and oranges. With capital income, you are double taxing the same wage income. That makes no sense. Think in terms of tax rates on present and future consumption; it’s that rate that should be equalized.
There’s a reason that other countries don’t apply the same tax rate to labor and capital income.
If you insist on the same tax rate, then apply the tax only once, as in a 401K.
stoneybatter
Apr 26 2021 at 5:37pm
Scott, I never understood the “taxing the same wage income” twice argument. By that logic, a consumption tax is also double-taxing the same income that was taxed when it was earned as wage income. The same applies to almost any pair of taxes. What am I missing?
Scott Sumner
Apr 27 2021 at 1:35am
It taxes the same income twice if spent on future consumption, but only once if spent on current consumption. Suppose you had a VAT that was 20% on stuff bought with money earned this year, and 25% on stuff bought with money earned in previous years.
BTW, what I’m saying here is not controversial among public finance specialists.
marris
Apr 27 2021 at 7:35am
That is correct. A consumption tax on top of an income tax would also be double taxation. The consumption tax is usually proposed as a substitute for income tax. It is better than an income tax because it first frees up more resources for private spending and then incentivizes investment over consumption.
Lysseas
Apr 28 2021 at 12:09am
Perhaps what you are missing is a) when the capital gains income is finally used for consumption, it will be taxed again, for the third time and b)investment is more desirable than consumption for the society /economy.
Lysseas
Apr 28 2021 at 12:37am
OK, I realized that my a) above only holds for c. gains equal to or smaller than inflation. So, hmmm…
Thomas Lee Hutcheson
Apr 26 2021 at 1:04pm
As I see it, the reason to tax (real) capital gains is that they are income as are interest and dividends, so why not tax them as income? [I am aware of arguments for taxing consumption rather than income, but that’s another argument.]
Scott Sumner
Apr 26 2021 at 5:13pm
“Income” is a meaningless term in this context. It’s like saying that gasoline and Scotch whiskey are both “liquids”. A cap gains tax taxes the same income twice.
Dylan
Apr 26 2021 at 7:00pm
How so? Has my bitcoin produced income that was previously taxed? Or my Monet?
Scott Sumner
Apr 27 2021 at 1:37am
The money you invested in your Bitcoin was after tax income.
Andy G
Apr 27 2021 at 1:46am
How do you tell this story to explain the fortunes of the most successful founders (Musk, Gates, Zuckerberg, Buffet, Bezos, Page & Brin, etc.)? Taxing the billions in capital gains is double taxing their original modest investment? Really???
Scott Sumner
Apr 27 2021 at 12:19pm
To the extent that their fortunes represent labor income, you can argue that it should be taxed as labor income. But surely it’s not all labor income. And the capital gains tax applies to activities where the labor component is zero, as when I buy an index fund.
So what’s the argument for making the cap gains tax identical to an income tax?
Steven R.
Apr 28 2021 at 12:06pm
I’m confused. Yes, the money I used to buy an item is after-tax (the basis in the asset). But you subtract the basis to arrive at the gain to be taxed. Only the amount above the previously taxed basis is subject to capital gains tax. So how is the basis being taxed twice?
Steven R.
Apr 29 2021 at 10:54am
Since the above was my first comment and they needed to verify my email address before posting it allowed me some time to do additional digging on my own. I <think> the answer is that I’m thinking as an accountant and not an economist. As I understand it, the economist perspective is that the future price is a derivative of future after-tax rate of return on the asset. Therefore, taxing the capital gains is effectively taxing those returns twice.
I’m not sure I buy that, though. Surely the future after-tax returns are part of what is being taxed but there is also a subjective value component that may have nothing at all to do with future earnings. The melt-up of GameStop comes to mind. So, maybe on average or in the aggregate it works but it seems ripe for one-off violations of the ‘rule.’ I think…
John Rote
Apr 26 2021 at 9:33pm
I’m not sure I follow, but I’m new to some of these topics.
Since capital gains calculations exclude the cost basis, I’m not sure that cap gains tax is a double tax, because the money previously taxed (cost basis) is excluded. The money made/earned/gained is previously untaxed, and that’s what the tax applies to.
But I might be missing something obvious…
Scott Sumner
Apr 27 2021 at 12:20pm
A better way to explain it is that a cap gains tax double taxes future consumption. Income is a meaningless concept, which only serves to confuse people.
Brett
Apr 26 2021 at 1:11pm
If you don’t structure the nominal rates for capital gains and personal income taxation so that they’re equal, then in practice you’re incentivizing people to creatively structure income to be capital gains rather than personal income. That tends to be regressive, since it’s easier to do that if you are rich than if you are a middle-class or poor person.
Scott Sumner
Apr 26 2021 at 5:11pm
Equal in real or nominal terms?
Dylan
Apr 26 2021 at 7:03pm
If nominal rates for long-term capital gains and income are the same, wouldn’t that push the incentive in the other direction, you’d want more “normal” income and less capital gains?
Andy Gardner
Apr 26 2021 at 1:27pm
While I agree with your viewpoint, I’m saddened by the general ignorance of the implications and unfairness of the Step-Up-In-Basis rule. Why should people who can afford to carry their capital gains to their death have a tax rate of 0% on capital gains when those who need their assets in their lifetime pay 20% or higher? How many assets are in unproductive uses because people late in life don’t sell for tax reasons? Many of the richest Americans (e.g., Musk, Bezos, Gates, Buffet) have fortunes based on long term capital gains that will never be taxed. The historical argument that capital formation is necessary seems archaic — the capital won’t disappear, it will be bought by pension funds and other investors.
Do you agree that the Step-Up rule is a neglected topic?
The liberal tendency is to focus on headline tax rates and the conservative tendency is to focus on cashflows, depreciation and other deductions. Besides these tendencies, what could account for this neglect?
Alan Goldhammer
Apr 26 2021 at 2:13pm
The inheritance tax is “supposed” to deal with large untaxed capital gains but keeps getting watered down. Until legislators take fundamental tax reform seriously and eliminate all the preferances in the tax code, eliminate the corporate tax (it’s a small percentage of the US govt income and getting smaller because of tax avoidance) and implement a VAT, I cannot take any of this seriously. I don’t worry much about cap gains taxes as I seldom sell any of the equity holdings in the taxable account.
zeke5123
Apr 26 2021 at 2:37pm
If you worry about the step up on death creating lock-in, then you have to worry about lock in due to higher rates.
Perhaps Biden can, instead of changing rates, change that step up at death.
Andy Gardner
Apr 26 2021 at 2:55pm
I agree — but how do we make the Step-Up-In-Basis rule politically salient?
Scott Sumner
Apr 26 2021 at 5:17pm
I’d prefer that investment income be handled on a 401k basis, with the tax being paid when the money is spent.
I also worry about the carried interest loophole, where wage income gets converted into capital gains.
Henri Hein
Apr 26 2021 at 1:28pm
In general, my sense is the Gell-Mann amnesia effect is particularly strong when the topic is Economics.
Andy Gardner
Apr 26 2021 at 2:04pm
A more cynical interpretation of the focus on increasing nominal capital gains tax rates on wealthy individuals is that the intent of the tax change is not to increase tax revenue, but rather to decrease the perception of income inequality by discouraging income recognition among the wealthy. That is, the policy is income inequality theater…
Scott Sumner
Apr 26 2021 at 5:18pm
Good point. That’s why even the Democrats seem to shy away from things that would actually hurt the rich, like luxury taxes, or closing the carried interest loophole.
sacher
Apr 26 2021 at 9:52pm
Isn’t the incidence of the luxury tax mostly on the suppliers i.e. the middle class workers and not the wealthy consumers? In that case a luxury seems like the perfect move for Democrats if they want to engage in inequality theater. I’m not so cynical. I think Democrats genuinely think they are addressing income inequality even if they are wrong about the effects.
Scott Sumner
Apr 27 2021 at 12:23pm
Just the opposite, it’s income taxes on the rich that (to some extent) fall on average people. A progressive consumption tax is the only way to actually tax the rich.
sk
Apr 28 2021 at 2:15pm
Doesn’t your comment re progressive tax rate on consumption assume the very rich will buy less; otherwise does it not fall upon suppliers, etc. who will see less business and therefore have less income?
Scott Sumner
Apr 29 2021 at 12:44pm
If they don’t consume less then they clearly don’t pay the tax. You are more likely to get them to consume less if you tax their consumption rather than if you tax their income.
robc
Apr 26 2021 at 2:10pm
I think it matters, for the opposite reason. While there is nothing that says we should be taxing AT the revenue-maximizing rate, it is clearly an error to tax ABOVE the maximizing rate. That is just vindictive and petty. I don’t think spite is a good excuse for policy.
That said, great article. Everything else is dead on right.
Dale Doback
Apr 26 2021 at 3:45pm
Scotch and gasoline are not substitutes. Payments to workers can be made as wages or capital gain benefits. In this case, companies are reclassifying their gasoline as Scotch so as to avoid paying a gas tax. The “principle” is to close this loophole.
Scott Sumner
Apr 26 2021 at 5:22pm
When workers are given things like stock options, those benefits are taxed as ordinary income, as they should be. No doubt there are some loopholes that I am unaware of, and they should be closed.
Dylan
Apr 26 2021 at 7:18pm
Sort of yes, but that causes its own issues. For instance, one of the things you can do when you get options in a startup is take a 83B election, which lets you recognize as income the entire value of your stock option grant at the time they are given, as opposed to only when they vest. That’s a great deal if you expect the company to rise in value, but it also means you have to pay your tax all upfront, which can be impossible to do, because the income you are being taxed on isn’t liquid.
I’m actually facing this right now, I work part time for a startup and am paid entirely in stock. My tax bill for that stock is greater than all of my cash income from all other sources for the year. Luckily, I have the resources (barely) to cover that, and I think there is a good chance that the bet will pay off very well for me…but I had to turn down a larger grant from the company, simply because I don’t have the means to pay the additional income tax. People who are not as well off as I am wouldn’t even have the option to take as much as I did.
Dale Doback
Apr 26 2021 at 7:24pm
I can assure you that most stock options are not taxed as ordinary income. Capital gains tax is payed when the stock is sold after holding for at least a year.
Anonymous
Apr 26 2021 at 9:51pm
That doesn’t make sense. You mean AFTER the option is exercised, then when the stock is sold, THEN you pay capital gains tax? But the option itself is taxed at the ordinary rate, right? It’s only if the stock appreciates afterwards that you have a capital gain- correct?
Scott Sumner
Apr 27 2021 at 1:40am
I’m pretty sure you have to pay a wage tax on the value of options granted to workers. Of course if the investment does well you pay cap gains taxes on the increase, which is appropriate.
robc
Apr 27 2021 at 6:56am
Depends if it is an ISO or NSO.
ISO’s only have two tax events — exercise and sale. Exercising the option only results in an AMT event, not regular income tax. Sale results in cap gains tax if you hold for a year (or to the next year, I am unclear on that) or regular income tax if within the year.
For an NSO, there are 3 tax events, grant, exercise, and sale. For them, you may* have to pay the value of the stock option grant as regular incomes tax.
I am not a tax attorney, so I can’t guarantee that this is 100% accurate, but it is close enough.
*if the company is actively traded and the value can be calculated.
Joe Kristan
Apr 27 2021 at 8:19am
Most stock options are taxed as ordinary compensation income on exercise. “Incentive Stock Options” are less common. These are subject to alternative minimum tax on exercise, but for regular tax generate capital gains if certain holding periods are met.
The amount treated as compensation income to the shareholder generates a similar deduction to the employer. As corporations are taxed at 21%, while the top individual rate is 37%, plus 1.45% employer and employee Medicare tax and and a .9% ACA tax, there is a significant arbitrage in the government’s favor. Even so, the non-cash corporate deduction is often derided as a “loophole.”
sk
Apr 27 2021 at 9:23am
Stock grants whee the recipient receives stock as all or part of compensation is taxed, but stock options taxed to recipient upon being given options i think is not taxed until the option is exercised .
David Seltzer
Apr 26 2021 at 3:55pm
Scott, an increase of the “revenue-maximizing rate” from 30% to 40% is a 33% increase. What does that mean in terms of dead weight loss? It seems marginal decisions such as assuming the risks of entrepreneurship, investment or working overtime depend on marginal incentives in the form of extra income post taxes.
zeke5123
Apr 26 2021 at 4:57pm
It is also worth pointing out that there is changes within a given class. That is, higher capital gains could make more risky investing a profitable strategy.
Let’s say one transaction costs 100 dollars and has a 60% chance of a 200 return (i.e., cash out of 120) and 40% chance of losing the investment.
Alternatively, one transaction costs 100 dollars and has a 100% chance of returning 120 dollars (i.e., cash out of 120).
Economically, they are the same (i.e., EV of 120). But there is a big tax benefit with higher capital gains rate to the loss assuming there are other capital gains. So, for tax motivated reason you do transaction one. Assuming other capital gains, you do transaction one even if the EV is much lower (i.e., if capital loss is worth 43 cents for each dollar of loss, then you only need a 60% chance of returning about 128.33) which actually means the EV is negative!
Scott Sumner
Apr 26 2021 at 5:31pm
Deadweight losses are very hard to estimate. There’s a lot of guesswork.
David Seltzer
Apr 26 2021 at 6:13pm
Scott, I believe there is some sequential Bayesian filtering being done with regard to DWL. A friend in the econ PHD program at Notre Dame mentioned this.
Scott Sumner
Apr 27 2021 at 1:41am
One problem is that many of the costs are extremely long run costs.
Alex F
Apr 26 2021 at 5:53pm
What’s a good definition of capital gains?
Example 1: Person buys real estate in SF, does nothing, capital gains of 1M. Example 2: Person buys bookstore in declining rust belt town, pays self a wage income, but is the best bookstore operator in the world and increases the value of the business by 1M. In the abstract, both increases are capital gains. In practice, one was a function a rising market and the other was a function of skill. My question is: do you care? Do you want to incentivize one but not the other? Do you think it’s too difficult to distinguish between the two of them?
Farsi
Apr 26 2021 at 9:53pm
Example 1 could be dealt with by a land value tax- or rather, a windfall real estate appreciation tax which is the only practical way to implement an LVT at this point
Henri Hein
Apr 27 2021 at 12:36am
It’s unclear where the 1M comes from in the second example. Does he pay himself out of revenues? In which case, it’s not capital gains. If the 1M was from selling the business itself, it is something of a non-sequitor, since it was really his human capital that was worth the 1M, not the business.
Scott Sumner
Apr 27 2021 at 1:43am
Yes, it can be hard to distinguish between wage and capital income in some cases, but not all. If I buy a S&P500 mutual fund, that’s obviously not wage income I’m earning.
Bob
Apr 26 2021 at 5:55pm
Stock options are considered income… but are stock options priced accurately? And how much can you affect the growth of the stock? Because really, in a small enough company, the growth of the stock can have a lot to do with your labor. Stock options are both taxed very unfavorably (you get to pay taxes on execution, not when you sell them, thanks to AMT shenanigans), but as shares of a pre-market comany, you can often get very high returns for what is, in practice, labor, as it’d be impossible to for most people to invest in said company at all. Your labor purchases the chance of buying heavily discounted shares of a rocket ship.
Me, and a whole lot of people like me, made very serious amount of money via compensation packages that, over a 4 year window, were 80% capital gains, 20% salary. The fair market prices of the shares, in an open market, would have been extremely different from the paper evaluations.
While I can at least defend your argument when the capital bought is just a blind trust that invests on indexes, things are nowhere near as clear to me when the capital is one you have a lot to do with its pricing.
Scott Sumner
Apr 27 2021 at 1:43am
I agree.
John
Apr 26 2021 at 8:09pm
Scott,
If an appreciated asset was purchased with borrowed money (which is often the case) how is it that the taxation of the realized gain upon sale represents “double taxation of wage income”?
Scott Sumner
Apr 27 2021 at 1:49am
It’s still taxing future consumption at a higher rate than current consumption. That’s the core problem with any tax on capital. If the tax rate on current consumption is 23%, then the tax rate on future consumption should also be 23%.
Yaakov
Apr 26 2021 at 8:26pm
You are looking for fairness in a field which is governed by jealousy and greed.
When taxation stopped being an issue of financing government and became an issue of distributing wealth, it lost all connection to justice and logic.
Andy G
Apr 27 2021 at 2:47am
I agree with your first sentiment. But, I don’t believe that there has ever been a golden age of just taxation. Historically, capital has had a favored position in American taxation (depreciation, depletion allowances, step-up-in-basis, and lower rates). Perhaps this has been to our collective benefit when capital markets were rudimentary, physical and economic capital were in short supply, and human capital was of secondary importance. But, it would be naive to think that raw power (legislative lobbying, etc.) hasn’t always played a part.
I’m not advocating the Biden plan. I’m merely making the case that comparing the current economy to that of earlier eras, at the margin, human capital needs more support now and economic capital probably needs less.
On economic incentive grounds, the step-up-in-basis rule is terrible. The beneficiaries of the subsidy receive the subsidy long after the success has been achieved. This subsidy doesn’t provide capital when it’s needed — it is received upon death to those with great fortunes. Compare that to a enhanced child credit which provides subsidies to human capital when it is most needed. Which would you expect to generate better outcomes and higher returns?
P.S. I don’t have theoretical issues with depreciation when it is economically valid — but the combination of favorable depreciation rates and step-up-in-basis is a recipe for sheltering more and more income over generations.
P.P.S. Depletion allowances seem like saying that income from mineral rights isn’t really income because I used to have all that untaxed wealth in the ground and now I’ve lost it. Should human capital be taxed but mineral capital not? Why is that fairness?
robc
Apr 27 2021 at 7:02am
Did capital have a favored position pre-income tax? I think for a majority (small majority now, we are getting close to the flipping point) of US history, there was no advantage between wage income and capital income.
1776-1913 is 157 years.
1913-2021 is 108 years.
Yep, had to do the math, another half century before income tax era becomes majority.
Thomas Lee Hutcheson
Apr 27 2021 at 6:18am
Do we have an idea of the revenue collection effects of 401K-ing investment income? How how much personal rates need to change to make this revenue neutral (or close the full employment deficit)?
Rhetorically, Scott, I suggest you argue about taxing uses of income rathe than sources. Argue that we should not tax a capital “gain” or a dividend until it is consumed, but then argue that we should not tax wage income until IT is consumed. Preferentially taxing income according to source is a kludge.
Matthias
Apr 27 2021 at 6:36am
Well, I’m just glad we don’t have capital gains taxes here in Singapore.
Ketil Malde
Apr 27 2021 at 8:29am
Isn’t the “principle” due to it being easy to shift income from wages to capital gains, especially if you are running a small business?
If the tax rates are very different, income will just be shunted to the lower taxation. In particular, if capital gains are taxed much lower, it allows the presumably-rich people in control of companies to receive compensation without taxation.
Perhaps it’s just that I don’t get how capital gains tax is taxing future consumption more?
Hanoch
Apr 27 2021 at 9:52am
I don’t see how one can plausibly argue that wage income and capital gains are equivalent. An employee has a legal right to the income he has earned and thus (absent some unusual circumstance, such as employer insolvency) is guaranteed to be paid. Investment, however, entails no such guarantee, and could even result in capital loss. Consequently, the different treatment in the tax code seems to make eminent sense.
Max Goedl
Apr 27 2021 at 10:43am
Why? Income is the maximum amount of consumption that leaves your net wealth the same. That was Milton Friedman’s definition of income, if I recall correctly. If your stocks go up $1,000, you can consume $1,000 more and still have the same net wealth.
Scott Sumner
Apr 28 2021 at 11:02am
The problem is that this approach implicitly treats present and future income as having the same price. In fact, the price of future consumption is 1/(1+i) times the price of current consumption.
Consider two identical twins, who each inherit zero dollars when young and have identical lifetime wage income. Shouldn’t their lifetime consumption be taxed at the same rate? With a cap gains tax, the thrifty twin is taxed at a higher rate.
Larry
Apr 27 2021 at 1:20pm
I have been a retail stock buyer and seller for years and I am glad the tax rate for long term gains is less than for wages.
But this is how I think about it:
Since I own stock I am considered an “owner.” Yet I have no real say in how the business is run. Nor do I want any.
As far as I am concerned being called an “owner” may be technically correct but is a fraud.
The only interest I have in buying a stock is to see it “win” that is increase in value.
As far as I am concerned buying stock on a retail level is no different than betting on a horse race.
And therefore any capital gains should be taxed the same as winning bets at the horse racing track. They should be taxed as ordinary income.
For retail investors buying stocks is gambling.
For investors who start a new business or significantly add capital to an existing business, then a lower tax rate may be appropriate.
That was fun!
Billy Kaubashine
Apr 27 2021 at 3:17pm
The unintended result of higher capital gains tax rates will be that assets will be held longer than economically optimal to avoid recognizing gains and paying tax. That will probably result in inefficient re-allocation of capital resulting in slower growth and fewer new jobs.
Just more sand in the economic gears that will slow the machine.
Michael Rulle
Apr 28 2021 at 10:45am
It is very counterintuitive to most people that the combination of taxing ordinary income, taxing inflation, and taxing capital gains at ordinary rates (or any rate) results in almost close to zero returns on nominal pretax income. For example, assuming a 30% tax rate on nominal income, and a 30% tax rate on capital gains, and a 3% inflation rate, one would have to earn an annualized rate of 8% on one’s savings over a 20 year period ——assuming securities are sold at the 20 year point—-to have the same real wealth on as ones pretax nominal income in year one.
The 40 year annual total return of the S&P 500 is about 7%. (since 1981)
That is an example of why your 401k idea is excellent—-although it does not fix the inflation problem.
Scott Sumner
Apr 28 2021 at 11:03am
A 401k structure does fix the inflation problem.
Michael Rulle
Apr 29 2021 at 10:05am
Hmmm——-I assume you are right—-but need to think about it
Michael Rulle
Apr 29 2021 at 10:47am
I think I disagree, as I believe you leave out the idea of “opportunity cost”.
While taxing once, either when income is received day 1, or when it is received in the framework of 401k, the nominal dollars owned are the same after “X” periods of time. So taxing once either up front or in the future, has the same nominal value all else equal. However, in both cases one is still paying taxes on inflationary gains.
The only way this is not “true” is if one chooses to believe the actual income achieved in 401k is the true current income. In which case one will conclude inflation is not taxed—-as it is current income.
But that is a construct that is not true except through semantics. I of course am open to the idea my framework of analysis is all wrong
Michael Rulle
Apr 29 2021 at 10:52am
Ignore my replies. Thank you
Michael Rulle
Apr 28 2021 at 10:55am
The 7% nominal total annualized return is from 2000, not 1981—sorry about that.
Brian Donohue
Apr 28 2021 at 12:35pm
Scott,
For most people in the US, wealth accumulation takes place inside tax-deferred retirement vehicles, with distributions taxed as ordinary income. How does this color the analysis, if at all?
Scott Sumner
Apr 29 2021 at 12:50pm
In that case there is no problem, as long as they are not forced to withdraw the money before they are ready to consume it. I believe Congress is considering removing the mandatory disbursement age.)
Speaking for myself, I save money both ways, and I presume many other people people do so as well.
Evan Taylor
Apr 28 2021 at 1:13pm
If labor income is taxed at a higher rate than capital income this can shift investments away from human capital into physical capital in an inefficient way. As an example, suppose I can make a investment either into my human capital, which will increase my productivity and wages by $1,000 every year for the next 25 years, or into a piece of physical capital which will pay out $950 every year for the next 25 years. If these investments cost the same and there is no taxation, I should make the investment in my human capital. However, if capital gains are taxed at a lower rate, then I might make the less efficient investment in the physical capital.
Another way of putting is that taxes on labor also tax current and future consumption in different ways when there are investments in human capital. Your argument seems to be taking labor income as fixed and exogenous.
Scott Sumner
Apr 29 2021 at 12:52pm
True, and that’s an argument for making human capital formation tax deductible. Thus making it exempt from a VAT. If the person is too poor to benefit from a tax deduction, you can subsidize education. And in fact we do heavily subsidize education–too heavily in my view.
steve
Apr 28 2021 at 5:29pm
I understand the equalizing of tax on current vs. future consumption but a tax on consumption with elimination of tax on income or capital is not going to happen . So, the issue i think boils down to a tax rate that does not mean lower after tax and inflation purchasing power to be unchanged and hopefully increased.
So much of investment in stocks is just trading of paper and as to tax rates have not seen where some level of tax on capital gains will result in less volume of stock activity. In fact from what i have seen when cap. gains tax raised more trading actually took place. So, if not hurting capital formation, the starting of new biz. then am not sure of the harm, but does depend upon the tax rate.
Lastly, perhaps a lowering of the tax rate on cap gains a decreasing rate the longer the holding period beyond year one would address any number of issues.
Pols know they can only raise taxes on wage income so much; and thus look to raise it on capital gains being more acceptable by many in public particularly when the tax not kick in until one has income above $1MM( putting aside issues with that level)
Carried interest benefit remains as the Pols. know where the money comes from for them to go get votes. Easy low hanging fruit that has not been picked for obvious reasons.
SP
Apr 30 2021 at 4:36pm
Is it fair that someone who invests a significant portion of their income will, over their life, pay more taxes than someone with the exact same income-from-labor that lives hand-to-mouth? Hard to say. I’d still rather be in the former group.
In so many ways, planners/investors subsidize the indulgent/complacent in modern society. This is just one more way.
As long as capital gains taxes aren’t excessive, the wise will still invest.
As to the unwise, no tax policy will get them to delay gratification.
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