The capital gains preference

Why Mitt Romney's taxes are so low and whether economics justifies it

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.

Slate’s Matthew Yglesias is on the same track as Matthews here, writing that “Mitt Romney’s effective tax rate is very low. Most economists think it should be.”

Even researchers like Thomas Piketty and Emmanuel Saez (see “A Theory of Optimal Capital Taxation”) who dissent from the standard no taxation of investment income position think capital income should be taxed more lightly than labor income.

I’d note that in that report, Piketty and Saez write that an optimal capital tax rate would be between 50 percent and 60 percent. Moreover, there’s an increasing amount of dissent amongst economists, if you take the word of The Economist, which is nobody’s idea of a left-wing rag:

But some economists are questioning the prevailing view, not least because reductions in capital-tax rates appear to have delivered more inequality than growth…

That is because the growth costs of capital taxes are overestimated. The old models contend that capital supply is highly sensitive to changes in tax policy, and that a zero tax rate is needed to prevent capital from drying up over the long run. This looks unrealistic, the authors reckon. Most capital-income taxes are paid by working-age adults saving for retirement, who will continue to save despite taxes. Stubborn savers make for a stable supply of investment capital, limiting the impact of taxes on growth. In the authors’ estimation, a 36% capital-income tax rate is justified.

And just how solid is that economic consensus about low capital taxes? I’d say it’s at least worth noting that Paul Krugman, the leading liberal economist, says that capital shouldn’t be privileged over other income (emphasis mine):

So, the case for low rates on capital gains is that by taxing investment income as ordinary income, we effectively discourage saving: if you spend your income now, you pay taxes only once, while if you invest for the future, you pay taxes twice, so eat, drink, and be merry.

There is, however, no evidence that this effect is at all important.

Meanwhile, by taxing income at very different rates depending on how it manifests itself, we create huge incentives to manipulate income to make it come out in the favored form. And this has real economic costs.

Mark Thoma agrees with Krugman. So does Jared Bernstein. So does Dean Baker, who writes, “It is most definitely not the case that economists agree that Mitt Romney should be paying his current 14.1 percent tax rate or less as Washington Post readers were told by Dylan Matthews today.” Uwe E. Reinhart is on board, as is Tax Policy Center (for capital gains), the Congressional Research Service, etc. etc.

Nocera concludes that “The idea that a lower capital gains rate spurs economic growth is one of the enduring myths of conservative thought.”

It’s an enduring myth in liberal thought too—at least in some circles.

Further Reading:

Wealth Over Work. The Washington Post excels; Indiviglio misses the point.

WSJ Revisits the Carried-Interest Tax

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum. Tags: , , , ,