Evan Soltas
Jun 29, 2013

Prefer Capital Gains

(Originally published here.)

A new report from the Congressional Budget Office says high earners benefit most from the complexities in the U.S. tax code -- which isn't exactly surprising. The system is a thicket of deductions and credits. Those who can pay for professional help or shift their income around benefit most. The preferential rate on investment income is among the largest of these tax breaks.

Long-term capital gains are taxed at a top marginal rate of 23.8 percent as compared to 39.6 percent for ordinary income. That reduces annual revenue by $161 billion, the CBO found. This is also the most regressive of the tax breaks: 93 percent of the benefits accrue to the top fifth of earners and two-thirds to the top 1 percent.

For many, that's enough to prove capital-gains taxes are too low. Yet there are compelling reasons to tax investment income at a preferred rate. 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.

Suppose that the U.S. taxed ordinary income (earnings from employment) at 39.6 percent and investment income at zero. Then the tax on consumption today would be the same as the tax on consumption deferred -- 39.6 percent. Now suppose that both ordinary and investment income are taxed at 39.6 percent. Also suppose that the real return on investment is 4 percent and inflation is constant at 2 percent. The tax on consumption today is the same as before, 39.6 percent. But the tax on consumption deferred for ten years is now 50.2 percent -- and the tax on the real (after inflation) capital gain is 54.8 percent. (For a simulator that lets you plug in other tax and inflation rates, go here.)

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.

The distortion due to capital-gains tax is especially sensitive to inflation. If inflation were 3 percent in the scenario just discussed, rather than 2 percent, the tax rate on real capital gains would leap 7 percentage points. The solution is to index gains to a measure of prices and tax only inflation-adjusted gains. That wouldn't eliminate the distortion, but it would reduce it -- especially if inflation were to rise.

Another big flaw in the capital-gains tax is that its definition of eligible investment is too broad. It allows the highest earners to enjoy what is consumption in all but name at a preferential rate. Suppose I enjoy vacations at the beach. If I rent a vacation home for 10 years, my spending is taxed normally. If I buy a vacation home and sell it after 10 years, I benefit from the preferential capital-gains treatment -- even though my outlays were as much for consumption as for investment purposes. There are many other examples: jewelry the owners wear, art the owners display in their home and so on. The investment-income tax break shouldn't apply to capital gains realized on assets like these -- assets that provide consumption services. It's a simple test: If you derive enjoyment from it now, it shouldn't count as investment for tax purposes.

Higher taxes on the consumption of the highest earners would be a better solution than destroying the preference for (genuine) investment income. This would answer an otherwise-damning critique of the preferred rate on capital gains -- that it's a handout to the rich. The goal is capital accumulation, and this needn't conflict with desire for fairness.

There are other interesting arguments against such a preference. One is the practical benefit of treating all income the same. Economist Arthur Laffer has made this argument, and I’m sympathetic. The weakness of this claim is that, over the long run, even modest gains from capital accumulation should outpace the additional costs of tax enforcement. Another supposed justification for the preference is that the capital-gains tax ignores investments in human capital and thereby creates a disincentive for that particular form of investment. This is correct -- but a better response would be an equivalent subsidy for human capital.

Tax reformers, take note: The preferred rate on capital gains is a loophole that makes sense.