On the Inefficiency of Preferential Treatment of Capital Gains

Via Greg Mankiw comes Alan Blinder on the taxation of carried interest:

An arcane debate is raging in Congress over the appropriate taxation of the bountiful incomes of people who manage private-equity and hedge funds – incomes that can range into the hundreds of millions a year. I don’t recommend trying to master the details unless you have either an accounting degree or insomnia. But one thing is easy to understand, though hard to swallow: Some people who are richer than Croesus are paying 15 cents in federal income taxes on the marginal dollar, while you may be paying 25 or 35 cents.

Mark Thoma found the following interesting:

Why do we have a preference for capital gains in the first place? The main argument is that lower taxes on capital gains boost investment. But the evidence on that point is iffy at best, and there are better ways to spur investment, like, say, the investment tax credit. Besides, lower taxes on capital gains reduce the tax bills of the rich relative to the rest of us – after all, they own most of the capital. But in this age of hyper-inequality, shouldn’t we be making the tax code more progressive, not less? A far more important objection is that the tax preference for capital gains undermines capitalism – a system in which capitalists, not the state, are supposed to make the investment decisions. When I discuss this issue with my Economics 101 students, I show them an example of a proposed investment that loses money before tax (and which, therefore, should be rejected) but which actually turns a profit after tax because of the preferentially low capital gains rate. (Accountants and tax lawyers live this example every day.) The government thus induces people to make bad investments, which is a good way to run an economy into the ground. Come to think of it, that’s just what the old Soviet Union did. It invested copiously, but badly. BUT would taxing capital gains like other types of income imperil our economy? No. The Tax Reform Act of 1986 did exactly that, and it did not end capitalism as we know it. In fact, the gross domestic product in 1987 and 1988 grew at about the same rate as in 1985 and 1986, and the investment share of G.D.P. barely budged. As the tax debate unfolds, you may find it difficult to follow the mind-numbing complexities. Who doesn’t? So just remember one simple principle: If we tax Activity A at 15 percent and Activity B at 38 percent, a free-market economy will give us more A and less B. Some of this shifting will represent genuine movements of resources out of B and into A – including those bad investments I just mentioned. The rest will be paper manipulations devised to avoid taxes. Which of these do you think our tax code should favor?

The distortion effects from preferential treatment of certain kinds of capital income is a point that I think deserves more attention. The pseudo-economists from the right (many who write for the National Review) want us to believe that cutting tax rates for capital gains promotes growth. Alan Blinder presents a very coherent argument that they may have this all wrong.