Opinion

Felix Salmon

The stupid complexities of the tax code

By Felix Salmon
August 22, 2011

James Stewart, on Saturday, looked at the narrow issue of how to tax carried interest, and made the very good point that it’s really just a small part of the much broader issue raised by the fact that we tax capital gains at a much lower rate than earned income:

The root of the problem highlighted by Mr. Buffett is the disparity between tax rates on capital gains and ordinary income. Were these rates the same, the debate over how to treat carried interest would vanish, along with much of the disparity between tax rates for the rich and people like Mr. Buffett’s secretary.

Is that so unthinkable? … Even some hedge fund and private equity officials concede that the argument for lower capital gains rates rests more on faith than science. “I’ve seen study after study that says lower capital gains rates have no impact on behavior,” the hedge fund official told me.

That view is also backed by a growing amount of academic research questioning the premise that lower capital gains rates promote growth. The evidence “is murky, at best,” said Leonard E. Burman… author of “The Labyrinth of Capital Gains Tax Policy.”

“It’s not the panacea for economic growth that advocates make it out to be,” he said. Mr. Buffett himself lent empirical support to this view in his column. “I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off,” he said.

The system we have right now — where we tax earnings from capital at much lower rates than we tax earnings from labor — is counterintuitive. If you have money, you really have no choice but to invest it somehow, and when you invest it you’re generally going to try to maximize the return you get on that investment. That’s true whatever the capital gains tax might be. On the other hand, people really do have a choice whether or not — and how much — to work. Taxing labor will, at the margin, mean less of it.

Meanwhile, the way that the capital gains tax is structured, it actually encourages bad investment. Here’s Alan Blinder, writing when the same debate came up four years ago:

Why do we have a preference for capital gains in the first place? The main argument is that lower taxes on capital gains boost investment. But the evidence on that point is iffy at best…

A far more important objection is that the tax preference for capital gains undermines capitalism — a system in which capitalists, not the state, are supposed to make the investment decisions. When I discuss this issue with my Economics 101 students, I show them an example of a proposed investment that loses money before tax (and which, therefore, should be rejected) but which actually turns a profit after tax because of the preferentially low capital gains rate. (Accountants and tax lawyers live this example every day.) The government thus induces people to make bad investments, which is a good way to run an economy into the ground. Come to think of it, that’s just what the old Soviet Union did. It invested copiously, but badly.

BUT would taxing capital gains like other types of income imperil our economy? No. The Tax Reform Act of 1986 did exactly that, and it did not end capitalism as we know it. In fact, the gross domestic product in 1987 and 1988 grew at about the same rate as in 1985 and 1986, and the investment share of G.D.P. barely budged.

Here’s a simple suggestion, then, for the super-committee taking the latest long hard look at US fiscal policy. Rationalize the tax code, pick a number for any given annual income, and declare that number to be the tax rate — no matter whether it’s for personal income or corporate income, income from labor or income from capital gains. It would probably put a significant number of tax lawyers and accountants out of work, but I’m sure they could find productive employ elsewhere.

If you did this while abolishing all the corporate tax loopholes and individual tax deductions, you could even sell the whole thing as a tax cut, keeping everybody happy.

But it’s not going to happen, because of the incentives facing politicians. If the tax code is complicated, and if politician are permanently fiddling with loopholes and deductions, then there are always monied interests throwing large amounts of money at those politicians in an attempt to move the tax code to their advantage. Simplify the tax code, and all that money goes away. No elected politician is ever likely to vote for that.

Comments
14 comments so far | RSS Comments RSS

Mr. Blinder has it wrong: the purpose of the capital gain preference is not to boost investment – although it is one that is repeated by the lobbyists defending it. The purposes are (1) to reduce the “lock-in” effect and to encourage capital to move to its most efficient place, and (2) to prevent the taxation of inflationary gains. Both of these things can be done, however, in ways that would increase government revenue. For example, every natural person could be given a modest annual capital gains exclusion – say $5,000. Cost basis could be, through some rather basic accounting conventions, indexed for inflation. Interestingly, an occasional capital gains hike (or temporary cut) would also facilitate capital movement as people would sell before the hike kicks in.

Posted by MrJones | Report as abusive
 

“If you have money, you really have no choice but to invest it somehow, and when you invest it you’re generally going to try to maximize the return you get on that investment.”

You mean, middle class folks have extra money to separately invest, that they’re not putting away in their 401Ks and IRAs, scrambling to pay their mortgages, paying their kids’ education, putting food on the table, and securing their iPhones, iPads and iBooks?

Posted by GRRR | Report as abusive
 

@MrJones: “prevent the taxation of inflationary gains” If you do this for capital gains, you ought to do it for income, too, which also suffers from inflationary gains. That sure opens a can o’ worms….

But i don’t see how the current policy prevents taxation of inflationary gains. No fixed tax rate (however low, if it’s non-zero) can do that. In fact, regardless of taxation, the investment itself is usually a hedge against inflationary loss.

@felix: your “modest proposal” doesn’t seem to me to fairly treat large sell-offs that are sometimes necessary in life, such as sale of a home upon retirement. All of a sudden, you are taxing most people in this situation for a one-time sale as if it were their typical income. Your scheme makes sense for an investor who is buying and selling constantly, but it does not seem fair in one-time situations like this.

i conclude that tax law is complicated because life is complicated, and because, even taking lobbyists and special interests into account, being fair is complicated and imperfect at best. But then again, i’m only a dog, and there’s a whole lot that is too complicated for me…

Posted by samadamsthedog | Report as abusive
 

I am not sure about this premise, which is central to your post – “If you have money, you really have no choice but to invest it somehow, and when you invest it you’re generally going to try to maximize the return you get on that investment. That’s true whatever the capital gains tax might be.”

While people may have “no choice but to invest” they do have choices on how they invest. The type of return (current pay investment vs. a growth investment) and how that is taxed is central to sophisticated financial planning. I always thought capital gains were taxed a lower rate to encourage investors to forgo current income on investments and allow capital to grow to encourage long-term investment. If you believe, as many economists do, that development of technology (in the general sense) is a key aspect of fostering continued growth in a developed economy, lower capital gains tax starts to make sense in order to encourage more long-term R&D type work. Return maximization is not always the central focus – some investors need current income and will give up growth to have it.

Posted by questioneer | Report as abusive
 

We had the nirvana of a 28% maximum capital gain rate and income tax rate until an unholy combination of Democrats and Republicans destroyed it. Ronald Reagan accomplished the feat with a major revision of the tax code in 1986, thereby essentially ending the tax shelter industry overnight.

The Republicans squandered this achievement by trading Clinton tax increases on high income for low rates on capital gains.

Posted by blades2000 | Report as abusive
 

@samadamsthedog Gains from the sale of a principal residence are generally tax-free up to $500K for a married couple – this is a separate rule from the capital gains rate. Except in the case of hyperinflation, labor gains aren’t subject to much inflation: most people are paid within a month of the performance of their labor. The capital gains preference as a means to prevent taxation of inflationary gains is “rough justice,” but that’s one of its original purposes.

Posted by MrJones | Report as abusive
 

There is already a strong economic distortion created by the way we differentially tax capital gains and dividends. Dividends (even if reinvested) are taxed upon distribution. Capital gains are taxed only when the asset is sold.

The effect of this is to encourage corporations to use their capital for acquisitions (which often struggle) rather than allowing investors to direct its use.

Let corporations manage the businesses they know best. Return the income generated to the shareholders, and let THEM decide where it ought to be invested.

The simplest solution is to tax consumption, not income.

Posted by TFF | Report as abusive
 

If anything, lower capital gains rates preference consumption over investment. Taxes encourage investment by encouraging deferral. Rather than promoting the best return, lower rates promote the extraction of that return.

Posted by MyLord | Report as abusive
 

Amen! The Laffer curve idea that tax rates discourage work certainly makes intellectual sense with earned income. If my labors are taxed at 80%, my desire to work, especially in my later years, is going to be near zero. The trade-off between labor and leisure if pretty clear. Investments on the other hand, is merely a question of current consumption or future consumption. For the vast majority of people who need to save for retirement, the question of whether the (non-IRA or 401(k)) GAINS on those savings are going to be taxed at 15% or 25% or 39% is irrelevant. You need to save that money, i.e. you can’t spend it now. The tax rate just should not modify the behavior.

Posted by AlexBBB | Report as abusive
 

I’m feeling a bit dense here, but I can’t think of an example that fits Blinder’s Econ 101 concept:

“a proposed investment that loses money before tax (and which, therefore, should be rejected) but which actually turns a profit after tax because of the preferentially low capital gains rate”

If I invest $100 today and sell for less than $100 in the future, how exactly could a lower tax rate on my loss result in a profit?

Does he mean that a project with negative NPV (but still pre-tax profitability) could be made to have positive NPV at a lower tax rate? Because in that case the lower capital gains rate is functioning exactly as designed, by encouraging additional marginal investment.

Posted by loudnotes | Report as abusive
 

” If you have money, you really have no choice but to invest it.”

Of course you have a choice. You can invest it or you can spend it.

Posted by DogFase | Report as abusive
 

“Here’s a simple suggestion, then, for the super-committee taking the latest long hard look at US fiscal policy. Rationalize the tax code, pick a number for any given annual income, and declare that number to be the tax rate — no matter whether it’s for personal income or corporate income, income from labor or income from capital gains.”

I’ve always thought this would be the best approach, as it would take away a lot of the politics of “Vote for me and I’ll raise taxes only on OTHER people” (which both parties tend to practice). I would add that it could also be a VAT rate as well. Ideally you’d have a system where there was one rate across all types of federal taxation, with one large individual income tax deduction and these were the only two levers people ever debated. No exceptions, no loopholes.

Posted by right | Report as abusive
 

I’m sympathetic to the idea of identical capital gains and ordinary income rates – with a top rate lower than the current maximum ordinary income rate.

That said, there are a few of Mr. Jones’s “rough justice” arguments for a lower capital gains tax, including not only inflation but also both (i) limitations on using capital losses to offset ordinary income and (ii) the fact that capital gains on C-Corp’s are also wound up in the whole question of double taxation of corporate income.

Posted by realist50 | Report as abusive
 

DogFase: Consumption would be better than savings. Consumption would result in ordinary taxable income to someone else, plus the multiplier effect of the money flowing thru the system.

As time goes on I also get confused about the logic of Long Term Cap Gains set at 365 days. That is a huge tax cut to simply hold onto an asset for several days to get a 57% cut in the tax rate. Especially for hard assets like Real Property, which shouldn’t be so speculative anyway.

Posted by april876 | Report as abusive
 

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