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:

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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.

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