One of the tax changes in the just-passed bill to avert the so-called fiscal cliff is a rise in the long-term capital gains tax for upper-income people (over $400,000 for single filers). During the George W. Bush years, the tax on capital gains (and dividends) dropped to 15 percent. Under the new law the tax will rise to 20 percent for those wealthier taxpayers. During the recent controversy over taxes, some people wondered why capital gains should be taxed at a lower rate than ordinary wages and salaries, the top rate on which is now 39.6 percent. Is this a favor to the rich or does the difference have a basis in sound economics?
On the face of it, the difference looks suspicious, indeed. Why should "unearned income," which is what investment income is called in the tax code, be less subject to taxation than "earned income," wages and salaries? But such a framing of the question prejudices the matter. In fact, there is a sensible reason—if income is going to be taxed at all—to hit capital gains at a lower rate, or better yet, not at all. It's time people put aside their emotions and looked at the matter with clear heads.
Capital gains is of course not ordinary income. It results from an investment decision, that is, a decision to forgo consumption in the present, perhaps for greater consumption in the future. Someone buys an asset, say, shares in a company today with hopes to sell it at a higher price later. The difference between the purchase and sale prices is a capital gain (assuming inflation hasn't made the gain illusory.) But note that in order to buy the asset, the investor had to put off consumption. The gain consists at least partly in the reward for waiting while others use his capital in a productive purpose. (This is most clear if the person lends the money and reaps interest.) Time is valuable, and other things equal, people prefer present goods to future goods. That's why the present value of future goods is discounted. This is known in economics as "time preference." In the market one is normally rewarded for letting others use one's capital for production rather than devoting it to immediate consumption. The person who invests $1,000 in hopes of having 10 percent more in a year demonstrates that he prefers $1,100 a year from now to $1,000 today.
Income taxation introduces a complication. Obviously, a tax on income reduces the money at one's disposal by transferring it to the government. If the tax were intended simply to raise money, it would have to be designed so that it neither rewarded nor penalized some kinds of activities over others. That rule might seem to suggest that there be a single rate on all types of incomes, but that is where the analysis often goes wrong. Ironically, a rate that does not distinguish among types of income is in fact biased against investment income, and hence investment itself. A more neutral tax would treat income from investment differently.
Imagine receiving a paycheck not subject to income tax. The full amount is yours, and you are free to divide it between consumption and investment according to your subjective preferences. But if your wages are subject to tax, you receive less than 100 percent of your pay. The taxman takes the rest. If you spend your take-home pay on consumption goods, that's the last you'll see of the income-tax authorities with respect to that money. (Sales taxes are another matter.)
What if you choose to invest the money so that you can consume more in the future? Because of the tax, you have less to invest than if the tax did not exist. In that respect the tax is "neutral" between consumption and investment.
But that's not the end of the story. When you reap your reward for investing, that money is also subject to income taxation. Thus while consumption activities are taxed but once by the income-tax system, investment activities are hit twice: once when the income along with the potential investment return is reduced and again when the (already reduced) capital gain is taxed later.
Look at a concrete example. You're paid $1,000 for work. Without an income tax, you could spend the $1,000 on consumption or you could invest the $1,000. If you invest the money at 10 percent, you could look forward to having $1,100 a year from now.
Now add a flat 10 percent income tax to the picture. Instead of receiving a check for $1,000, you get one for only $900. Your ability to consume is reduced by $100. At the same time, your ability to invest has also been reduced by $100. You can invest only $900 and therefore look forward to only $90 a year from now, rather than $100. Because of the tax, the return on investment is lower than it would have been.
But here's the rub: You will have to pay the 10 percent tax on the $90 gain, leaving a real gain only $81.
Investment is thus taxed twice, while consumption is taxed only once. "The tax on interest or other returns to investment, including dividends and capital gains, biases decisions against saving, investment, entrepreneurship, and business expansion, and in favor of consumption spending," economist Roy Cordato of the John Locke Foundation writes.
Things are even worse, however, for as Cordato points out, "In addition the government, at both the federal and state levels, further punishes investors with a separate corporate income tax. The corporate tax, which at the federal level is 35 percent, adds a third layer of tax on both dividends and capital gains."
In light of all this, it should be clear that if income must be taxed, it should be taxed no more than once. "The most straightforward way to remove the bias is to exempt from taxation all returns from saving... An alternative way of removing this bias is by eliminating all saved income in the current time period from the tax base, taxing it only when it is withdrawn for consumption purposes," Cordato writes.
Regardless of what one thinks of the inherent fairness or unfairness of the income tax, double (and triple) taxation should offend everyone. It simply is not the business of government to reward and punish the different ways in which people may use their incomes. A basic principle of a free society is that people may go about their peaceful business unmolested by government.
Moreover, it's patently ridiculous for the government to penalize investment, because economic growth and rising living standards depend on saving and investment—that is, deferred consumption—despite what the Keynesians say. (John Maynard Keynes believed that saving can harm an economy because reduced consumption causes unemployment and discourages investment. He thereby showed his ignorance of an industrial economy's multistage capital structure, as elaborated by his rival in the 1930s, F. A. Hayek.) When people put off consumption, their money isn't stuffed in mattresses; it's made available to investors, who extend and improve the capital structure. This in turn makes possible higher productivity; new, improved, and cheaper products; higher wages, and other forms of progress.