Felix Salmon

Treasury answers your tax questions

By Felix Salmon
November 12, 2010

I love the way that Michael Mundaca, the assistant Treasury secretary for tax policy, has taken to the blogs to help up some of the perennial confusion surrounding taxes. And yes, he tackles the biggest question of all, about those 1099s:

While businesses do not need to start filing information returns on the expanded set of payments until January of 2013, some groups have already raised concerns about the burden that this new provision may impose. As the President has said, it is important to look at whether this burden is too great for businesses to manage. Treasury and IRS are sensitive to these concerns and will look for opportunities to minimize burden and avoid duplicative reporting… Already, we have used our administrative authority to exempt from this new requirement business transactions conducted using payment cards such as credit and debit cards. So, whenever a business uses a credit or debit card, no information report will need to be filed, and there will thus be no new burden under the new law.

This is a start, even if it’s clearly insufficient; the good news, at least, is that there does seem to be a bit of time to fix things. If we can’t reach bipartisan consensus on this, then we’re never going to be able to pass anything in the next two years.

More interesting is the way that Mundaca defends the way in which dividend and capital-gains tax rates are lower than income-tax rates. I’ve never understood it, but Mundaca gives the best explanation I’ve yet seen:

The arguments in favor of taxing capital gains at a rate lower than that for ordinary income include offsetting the taxation of purely inflationary gains; reducing the tax on risky investment that would otherwise be disadvantaged by the tax system, especially because of the limits on deducting capital losses; and offsetting the “lock-in” effect where high capital gains rates can impede economically desirable asset and portfolio reallocations by imposing a tax on the sale of capital assets that can be deferred to the extent that the assets are not sold. With the exception of a few years following the Tax Reform Act of 1986, long-term capital gains generally have been taxed at preferential rates since 1921.

I’m not convinced, and I’d still love to see the tax rates brought into line with each other, if only because financial engineering makes it pretty easy to take income and convert it into capital gains, if you’re rich enough. (Don’t get paid yourself, just set up a company, then sell the company.) That’s what the private-equity honchos all did, and their low tax rates are unconscionable.

Still, the inflation argument is a good one: inflation is bad enough without having to pay taxes on it. The next argument, about encouraging risky investment, is weak—capital’s always going to flow to where it gets the best return. And as for “lock-ins”, I have some sympathy, but suspect that if it was really a problem then total return swaps would simply become a lot more popular.

In any event, let’s have more of these forums where Treasury technocrats talk directly to the public. Anything which disintermediates journalists has to be a good thing, right?

Update: Jimmy P reckons that far from raising capital gains taxes so that they’re the same as income taxes, they should instead be lowered to zero!

4 comments so far | RSS Comments RSS

“[C]apital’s always going to flow to where it gets the best return.”

Yes… the best tax-adjusted return. That’s his point there.

Posted by absinthe | Report as abusive

I would think indexation of cost basis would be better than a kind of crude approximation with a different rate. (I would index cost basis fairly aggressively, but would tax any gain over that adjusted basis at usual income tax rates.) Is it thought that this would be too complicated?

In a world with only a single, risk-free asset, I wouldn’t tax gains on previously taxed capital at all, but it’s clear that some of the returns people get are real, and not simply time-shifting of consumption.

Posted by dWj | Report as abusive

“More interesting is the way that Mundaca defends the way in which dividend and capital-gains tax rates are lower than income-tax rates. I’ve never understood it, ”

There’s an important point from the basics of the economics of taxation here. As ever, there’s a trade off.

All and any taxes have deadweight effects. There’s economic activity that doesn’t happen because of the tax. And yet we must have taxes for we’ve got to pay for the State in some manner (let’s leave aside the argument about how much State and thus how much tax we’ve got to have for a moment).

The thing is, different taxes have different deadweight costs. It is entirely uncontroversial (meaning that you could get everyone from Tyler Cowen through to Krugman, Stiglitz and the younger Galbraith to sign up to it) that there is an ordering of taxes, from lowest deadweight costs to higer.

From taxes on immovable property and land, to consumption taxes, to income taxes and then, the most cost for the revenue raised, on capital and corporate profits.

As, over the long term ,economic growth is what we actualy desire, we therefore want to raise the money we need at the least cost to that future growth. Which is why we should be taxing capital and corporate profits less heavily than income. Indeed, shifting tax from those two to, say, property taxation, provides us with a free lunch. We get both more of the growth we desire and also the money we need to run the State.

In fact, we can actually go further than this. Imagine that you wanted a high tax, high services social democracy (like, say, the Nordics). But you also wanted to have some economic growth (like, say, the Nordics). In order to be able to raise the money you want you therefore need to be raising it with the fewest deadweight costs. Like, say, the Nordics do.

Capital is taxed lightly, as are corporate profits. Income taxes are high, yes, but the real tax burden is upon consumption in the form of a heavy (25%!) VAT.

If you tried to get the same revenue by taxing capital and corporations it’s very doubtful that you’d have any growth at all.

So that’s why we do and should have lower capital and corporate taxation: because raising the money we want and need in other areas costs us less in growth foregone for the revenue raised.

Posted by TimWorstall | Report as abusive

The alternative way to deal with the lock-in effect (at least for publicly-traded securities) is to tax them on a mark-to-market basis. That removes tax planning from the investment decision. It also taxes shareholders and wage-earners equally on their economic income. For a proposal to do exactly that for large corporations and the wealthiest and highest-income individuals, see See http://www.cadwalader.com/assets/article  /120505MillerTaxNotes.pdf and govinfo.library.unt.edu/taxreformpanel/m eetings/docs/miller_052005.ppt

Posted by comment1 | Report as abusive

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