Luskin Thinks That Eliminating Taxation of Capital Income Generates More Tax Revenues

Should I thank or curse our friend Mark Thoma for emailing me the latest lunacy from Donald Luskin:

Don’t hike the capital gains tax rate. Don’t lower it, either. Eliminate the capital gains tax entirely. How can tax revenues be increased by eliminating a tax? It’s simple, when the tax in question is on capital gains. Capital itself exerts a multiplier effect that benefits the entire economy. Investment in new plant, equipment, business processes and whole companies creates new and higher paying jobs, and higher levels of economic activity, all of which generate additional tax revenues far in excess of what government would lose by foregoing cap-gains taxes. This idea has broad theoretical support. Former Clinton Treasury Secretary Lawrence H. Summers has written, “the elimination of capital income taxation would have very substantial economic effects” which “might raise steady-state output by as much as 18%.” Economist Jack L. Treynor has shown that “the level of taxation on capital that is ‘fairest’ – i.e., most beneficial – to labor is zero.” And Nobel Prize-winning economist Robert E. Lucas, Jr., has concluded, “neither capital gains nor any of the income from capital should be taxed at all.” These economists think in terms of very complex models. But the real-world intuition here is quite straightforward … The cost of eliminating the barrier is foregone revenues from that particular tax. But those revenues are small, usually deferred and non-recurring. In their place, government receives large and recurring revenues from corporate taxes, sales taxes, wage taxes and dividend taxes – all generated by new economic activity.

OK, this is rather stupid but we often hear this babble so I should thank Mark for the opportunity to address the claim that if we eliminate taxation on capital income, the direct impact on tax revenues will be small while the supply-side benefits will be large. Luskin is following an Ann Coulter trick by cherry picking things certain economists may have said and then twisting their meanings. The first Daily Howler that I ever read involved Ann Coulter’s tendency to do the same:

Maslin has some fun with this footnote, but gives too much credence to others. “A great deal of research supports Ms. Coulter’s wisecracks,” she writes—apparently not understanding how much of this “research” has simply been made up by Coulter. Do reviewers ever fact-check books? If Maslin had checked the “780 footnotes” she approvingly cites, she might have seen – and she might have told readers – how much of this book is just false.

I knew exactly what Bob Somerby was saying having endured this sort of behavior from those “economists” that Jim Saxton hires using our taxpayer funding.

Before I start in on Luskin’s misunderstandings, let me suggest folks take a look at Simulating U.S. Tax Reform written by our friend David Altig along with Alan Auerbach, Laurence Kotlikoff, Kent Smetters, and Jan Walliser. It is a long paper, but this part of their abstract is all I need for now.

This paper uses a new large-scale dynamic simulation model to compare the equity, efficiency, and macroeconomic effects of five alternative to the current U.S. federal income tax … It predicts major macroeconomic gains (including an 11 percent increase in long-run output) from replacing the federal tax system with a proportional consumption tax. Future middle- and upper-income classes gain from this policy, but initial older generations are hurt by the policy’s implicit capital levy. Poor members of current and future generations also lose.

Altig et al. posed a fiscal neutral switch from income taxes to consumption taxes. While there are a few second order differences, eliminating taxation on capital income and raising employment taxes in a fiscally neutral way would have similar effects.

Let’s be clear about a few basics. Altig et al. are using a long-run growth model that assumes full employment, which is similar to the Solow model. So when Luskin talks about a “multiplier effect” aka the Keynesian aggregate demand model – he is already way off base. When Lawrence Summers noted an 18 percent steady state effect or Altig et al. noted “an 11 percent increase in long-run output”, the dynamics of the model suggest that the increase in output in the first few years is tiny. Steady-state effects will be approximated much later in the century.

But Luskin paints the picture as if output jumps by a double-digit amount very quickly. This assertion of course is absurd. But it is key to the free lunch fallacy of the Laffer-Luskin crowd. They want you to believe we can cut taxes on capital income without raising taxes on employment income. But if we “give people their money back”, they will consume more and hence save and invest less. Unless of course we slash government spending. Ah but the Laffer-Luskin crowd never get around to admitting the need to have fiscal neutrality.

Folks like Greg Mankiw are not so incredibly stupid. Greg would admit that the need for fiscal neutrality. But as Altig et al. model, cuts in taxation for owners of capital must be offset by increases in taxes for the rest of us. And the rest of us still pay more in taxes under this new regime even during the steady state. Folks like Greg might be smart enough to realize these distributional consequences but seem to be not so interested.

In the meantime, folks like Luskin babble their free lunch fallacies as they surround themselves with their own incredible ignorance of even basic economics. And the Wall Street Journal op-ed page is still dumb enough to print this stupidity.

Update: I should also note that Altig et al. considered the impact of a

progressive variant of the flat tax called the ‘X tax’.

AB reader Ian alters us to a recent discussion of a progressive consumption tax by Sabine Jokisch and Laurence J. Kotlikoff:

The FairTax offers a potential alternative to this dismal economic future. The FairTax proposes to replace the federal payroll tax, personal income tax, corporate income tax, and estate tax (not modeled here) with a progressive consumption tax delivered in the form of a federal retail sales tax plus a rebate. According to our simulation model, these policy changes would almost double the U.S. capital stock by the end of the century and raise long-run real wages by 19 percent compared to the base case alternative.

Note that their model also has the output gains only slowly being realized over time. The authors note that there will be winners and losers, but this FairTax has different distributional implications from the proposal favored by Luskin.

Update II: AB reader 2slug offers up Taxing Capital: Not a Bad Idea After All by Juan C. Conesa, Sagiri Kitao, and Dirk Krueger:

In this paper we quantitatively characterize the optimal capital and labor income tax in an overlapping generations model with idiosyncratic, uninsurable income shocks, where households also differ permanently with respect to their ability to generate income. The welfare criterion we employ is ex-ante (before ability is realized) expected (with respect to uninsurable productivity shocks) utility of a newborn in a stationary equilibrium. Embedded in this welfare criterion is a concern of the policy maker for insurance against idiosyncratic shocks and redistribution among agents of different abilities. Such insurance and redistribution can be achieved by progressive labor income taxes or taxation of capital income, or both. The policy maker has then to trade off these concerns against the standard distortions these taxes generate for the labor supply and capital accumulation decision. We find that in our model the optimal capital income tax rate is significantly positive. The optimal (marginal and average) tax rate on capital is 36%, in conjunction with a progressive labor income tax code that is, to a first approximation, a flat tax of 23% with a deduction that corresponds to about $6,000 (relative to an average income of households in the model of $35,000). We argue that the high optimal capital income tax is mainly driven by the life cycle structure of the model whereas the optimal progressivity of the labor income tax is due to the insurance and redistribution role of the income tax system.