Forbes, as Joe Nocera points out this morning, thinks that its list of the 400 richest US billionaires “instills confidence that the American dream is still very much alive.”
That’s because, Forbes says, “Seventy percent of the Forbes 400 members made their fortunes entirely from scratch.” I’m sure none of them had pops fork over some startup capital, but let’s leave that aside.. If the American dream is the ability for a handful of people to grab virtually all of the economic gains of the country and to get so rich you can pay lower tax rates than your maids, then the dream is surely still alive.
Nocera uses the 400, who on average added half a billion in wealth last year, and news on Mitt Romney’s super-low tax rate as pegs to examine why our tax system favors the very wealthiest people. The reason is the long-term capital gains tax, which at 15 percent is less than half the 35 percent top tax rate on labor. Should wealth be taxed less than work? Since most people would say no, the framing has become: Do taxes on wealth discourage investment more than taxes on labor discourage work?
Over at Ezra Klein’s Washington Post Wonkblog, Dylan Matthews argues that “Romney’s tax rate should be low”:
The rationale economists—even liberal ones—give is quite different. Take Emmanuel Saez and Peter Diamond. Saez is best known for the work he’s done with Thomas Piketty detailing the rise in inequality over the last century. Diamond is best known for winning a Nobel prize even as congressional Republicans blocked his appointment to the Federal Reserve’s Board of Governors. All three have advocated marginal tax rates far above those being considered by either Democrats or Republicans right now. And yet, even they think savings and investment income should be taxes at a lower rate.
The basic idea here is that you investing is a form of savings. And economists don’t really want to tax savings, in part because the effects of taxing savings can be a little weird. Saez and Diamond imagine that there’s a 30 percent tax on income, whether or not it’s saved. They then imagine you save that money for 40 years, and earn 5 percent interest every year. If savings weren’t taxed at all, then you could take that money out after 40 years and pay the 30 percent rate. But if the savings were taxed before it was saved and after it’s pulled out, the total rate comes to a staggering 60.6 percent. So there is, in effect, a massive incentive to spend money now rather than save it and spend it later on.
But Matthews is wrong here. First, most of Romney’s income came from capital gains. Those are only taxed on realization, not every year like interest and dividend income are. Saez and Diamond specifically exclude capital gains from the formula in their report (they also exclude 401(k)s and IRAs, the latter of which has shielded much of Romney’s wealth from taxation.
Second, interest income (which was 22 percent of Romney’s 2011 haul) is taxed at the same rate as regular income, not at the lower rate afforded dividends and capital gains.
Third, principal isn’t taxed (at least until you die, and only if your fortune is more than $5 million). What’s taxed is in the income from the principal or the increase in its value. In other words, if I put $1,000 in Widget Corp. shares and I sell them in five years for $1,500, I’m only taxed on the $500 increase. In other words, investors get the benefit of their investment compounding (assuming it goes up) tax-free until they sell it, at which point they pay 15 percent of the gain. It’s true that if your investment goes up at the rate of inflation, you get taxed on that inflation and ultimately lose money, but that’s a separate question.
Finally, most of Romney’s capital gains come from the carried interest loophole (something Matthews doesn’t mention) which lets FIRE partners magically turn their labor income into capital gains for the purposes of slashing their taxes.