Why capital gains should be taxed as income

By Felix Salmon
June 5, 2013

Last week’s Munk debate featured one of those strange-bedfellow moments, when Paul Krugman agreed with Art Laffer that the tax rate on capital gains should be the same as the tax rate on income. (In fact, Laffer went one step further than that, saying that even unrealized capital gains should be taxed at the same rate.) Normalizing the capital-gains tax rate so that it’s the same as the income-tax rate is an easy way to bring a lot of money into the public fisc — some $161 billion per year, according to the CBO. So why aren’t we doing it?

Evan Soltas does his best to answer that question with his “Defense of the Capital-Gains Loophole”. Here’s the meat of his argument:

Most tax breaks create distortions. The tax break for capital gains does the opposite: It reduces a distortion. Investment is really deferred consumption. Taxing consumption tomorrow at a higher rate than consumption today — which is what a tax on investment income does — encourages people to shift consumption forward in time, and that’s inefficient.

This doesn’t make a lot of sense. Firstly, investment really isn’t deferred consumption. The amount of money invested, in the world, is going up over the long term, not down — which means that once you look past the natural tidal movements of money in and out of various investment vehicles, it’s reasonable to say that money, once it gets invested, stays invested. Pretty much forever. The amount of money being saved, plus the amount that the investments have grown, is nearly always going to be greater, in aggregate, than the amount of money being withdrawn for the purposes of consumption. That’s the inefficient thing: money that could be cycling through the economy at high velocity is instead tied up in investment vehicles, and might not be spent for decades, if at all.

Soltas comes up with an example to show that if I invest my money today and then spend it in ten years’ time, then I’m going to end up being taxed at 50% — a higher rate than the 40% income tax. This example is a subset of the annoying dual-taxation meme. But in any case it ignores the much bigger amount of dual taxation which goes on with regard to spent money.

If I earn money and spend it today, my spending is going to become someone else’s income. If that person then pays tax on that income and spends the remainder, we’ll get yet another round of income tax out of it. And so on and so forth. It’s a constant high-velocity money-go-round, which is driving tax revenues all the way. By contrast, if my money is tied up in savings for a decade, it’s not generating any tax revenues at all. As a result, saved money generates much lower tax revenues than spent money. At the very least, then, it should be taxed at the same rate as spent money.

That said, savings do have an important role to play in the economy. Do we want to endanger that? Here’s Soltas again:

In theory, this is a strong disincentive for saving and investment, leading to less accumulation of capital and lower incomes over time. The empirical evidence is admittedly less impressive. Still, this reasoning explains why economists leant towards a preferential rate of capital-gains tax in a recent survey.

My theory is that economists lean towards a preferential rate of capital-gains tax for two reasons: they like theory over reality, and they tend to be rich people with capital gains income. The fact is that there’s really no empirical evidence to suggest that raising the capital gains tax to the income-tax rate would actually reduce savings; neither is there any good evidence to suggest that if savings were reduced, then incomes would trend lower over time. In order for the capital-gains loophole to be justified, we would need to be reasonably certain on both counts. We’re not even close to certain on either: my feeling, indeed, is that both are downright false.

Soltas does have a good point that capital-gains taxes become particularly onerous when inflation rises — an asset with zero real growth can still be subject to large capital gains if it’s held over an inflationary period. As a result, I’m open to persuasion on the idea that capital gains should be adjusted for inflation before being taxed. But the bigger picture is clear: as Soltas himself explains, “the capital-gains tax ignores investments in human capital and thereby creates a disincentive for that particular form of investment”. Unless and until Soltas can come up with what he calls “an equivalent subsidy for human capital”, we should treat all income equally for tax purposes — whether it comes from income or whether it comes from capital gains.

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