Actually, Taxing Capital Gains Might Not Be A Bad Idea After All

EXECUTIVES thunder that America’s corporate-tax rates are to blame for economic weakness. Mitt Romney’s campaign accuses Barack Obama of waging a “war on capital.”

In fact, America’s taxation of capital is more murky than confiscatory. At 39.2% (including state and local tax) its top corporate rate is the rich world’s highest but loopholes mean most companies end up paying 27.6%, similar to Britain’s effective rate of 27.4% and below Germany’s 31.6%.

America’s tax rate on capital gains, at 15%, is lower than in many other countries. And if Mr Romney is the more ardent defender of capital, both men agree on the need for reforms. This is less a battle, more a skirmish.The more interesting fight is going on within economics. For a generation, the profession’s message on capital taxes has been simple: the lower the better. Most economists would prefer no tax on capital income at all.

This seeming fanaticism is rooted in sensible models, developed in the 1970s and 1980s and built on a pleasing simplicity. Taxation inevitably involves trade-offs. Governments tax in order to fund public goods and limit inequality, but taxes are no free lunch. People and businesses respond–a tax on carrots, say, reduces carrot consumption–and these responses distort the economy and may reduce its potential growth rate.

Most capital-income taxes are paid by working-age adults saving for retirement, who will continue to save despite taxes. 

In these models, inequality was seen as a problem of pay differences, best addressed through taxes on labour incomes. Taxes on capital were reckoned to have large costs. Capital, or savings invested in new production, raises future growth and consumption. If a tax on capital income discourages investment, that impact compounds indefinitely into the future.

As a result, zero tax on capital income should be preferred, even by individuals who don’t earn any such income. Economists became vocal in calling for reduced tax rates, and policymakers responded. Top capital-income tax rates in America and Britain fell by more than half from the 1950s to the 1980s. There is pressure to go further.

But some economists are questioning the prevailing view, not least because reductions in capital-tax rates appear to have delivered more inequality than growth. In a 2008 paper, Juan Carlos Conesa of Universitat Autònoma de Barcelona, Sagiri Kitao of the University of Southern California and Dirk Krueger of the University of Pennsylvania argued that taxing capital was “not a bad idea after all”. Capital markets are imperfect, they observe, and households are unable to insure themselves against all of life’s ups and downs. Taxing away some of the return to capital to provide social insurance against risks is appropriate.

That is because the growth costs of capital taxes are overestimated. The old models contend that capital supply is highly sensitive to changes in tax policy, and that a zero tax rate is needed to prevent capital from drying up over the long run. This looks unrealistic, the authors reckon. Most capital-income taxes are paid by working-age adults saving for retirement, who will continue to save despite taxes. Stubborn savers make for a stable supply of investment capital, limiting the impact of taxes on growth. In the authors’ estimation, a 36% capital-income tax rate is justified.

In a new NBER working paper, Thomas Piketty of the Paris School of Economics and Emmanuel Saez of the University of California at Berkeley poke different holes in the conventional view. The old models, they point out, ignore inheritances. In the real world inheritances strongly influence income levels, particularly among the very rich. Mr Romney recently reinforced this very point by exhorting students to borrow from parents if necessary. Taxes on wages and salaries are inadequate to the task of limiting inequality because they punish those who owe high incomes to greater ability and effort, rather than to inheritances. Messrs Piketty and Saez also question the scale of the threat to growth. They point to ratios of capital to output, which are surprisingly stable over time despite tax swings. Their model finds that the optimal tax rate on inheritance could be 50-60% or more.

Inheritance taxes are a minor source of government money, accounting for less than one percentage point of the 8-9% of GDP in revenues that Messrs Piketty and Saez estimate is raised by capital taxes. But taxing capital gains or corporate income, which is responsible for much of the rest, is also justifiable, they say. The often-fuzzy line between income from capital and labour means a large gap in relative tax rates breeds tax avoidance. When wage taxes are high and capital taxes are low, firms simply shift compensation from salaries to stock options and dividends, cutting revenue without boosting growth. All told, capital-tax rates as high or higher than those on labour may make sense, they think.

Pressure valve
A recent paper by Emmanuel Farhi of Harvard University, Christopher Sleet and Sevin Yeltekin of Carnegie Mellon University, and Ivan Werning of the Massachusetts Institute of Technology makes another argument against abolition. The authors point out that rising inequality is a destabilising political force, which may encourage future governments to expropriate wealth through heavy taxation. That threat could discourage saving and investment now, something a weak economy cannot afford. Paradoxically, a progressive tax on capital in the present may lead to more investment by keeping inequality in check and by convincing firms that their wealth is (mostly) safe over the long term.

Fretting over high capital-tax rates still makes sense, not least because capital is highly mobile. If countries differ in their approach, firms may simply invest more in those with more congenial rates. But from a global perspective, as inequality rises, having taxes on capital income will look increasingly attractive–and, by some reckonings, more sensible than previously thought.


Taxing capital? Not a bad idea after all!“, Juan Carlos Conesa, Sagiri Kitao and Dirk Krueger, American Economic Review, March 2009

A theory of optimal capital taxation“, Thomas Piketty and Emmanuel Saez, NBER Working Paper, April 2012

Non-linear capital taxation without commitment“, Emmanuel Farhi, Christopher Sleet, Ivan Werning and Sevin Yeltekin, Review of Economic Studies, January 2012

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