Considering the ill-advisedness of favoring capital income
by Linda Beale
crossposted with Ataxingmatter
Dealing with the Sunset of the Bush Tax Cuts (Part III in a series)–considering the ill-advisedness of favoring capital income
During the Bush administration a number of significant reductions in revenue were enacted, especially in the 2001 and 2003 tax bills, but with a sunsetting provision that (extended in some cases) generally will mean that the pre-existing provision will be reinstated after 2010. Both individual and corporate taxes were reduced. Many of the corporate and business provisions involved accelerated expensing provisions, allowing businesses to write off purchases much faster than the economic depreciation of the asset would require and thus amount to a significant tax reduction for businesses. Rates on capital gains were reduced, and dividends, which have traditionally been treated just like interest income and taxable at ordinary rates to individuals, were temporarily made subject to the preferential capital gains rates. The estate tax was phased down and then completely eliminated for the 2010 tax year. As a result of these and other changes, capital income is especially favored under the temporary provisions, and the wealthiest 1% who own a substantial portion of the financial assets received significant benefits.
Much of the argument in favor of reducing taxation on the income from capital is spurious. It is a claim that by taxing returns from capital less heavily than returns from labor, those who receive those returns will invest them in new businesses, spurring entrepreneurship. The returns from capital that are favored, however, are not closely correlated with reinvestments in businesses. Most of the returns are those gained merely from secondary market trading and those increases in capital do not go to businesses but to other investors or financial institutions. There is a special provision that taxes initial issuance corporate stock gains more favorably, but that is only a small piece of the capital gains preference.
In terms of the economy, it is highly likely that tax cuts for lower income taxpayers will be spent domestically and thus provide important impetus to economic growth at this point in the recession. Tax cuts for the wealthy and owners of financial assets at the top of the distribution are much less likely to spur economic development–the wealthy are well known for utilizing tax shelters (legitimate and not so legitimate) and for moving assets offshore into tax haven jurisdictions (sometimes through illegitimate use of foreign banking secrecy laws to evade US taxation). The wealthy may reinvest their gains in new businesses (or private equity funds that spend some part of their accumulated assets in funding new businesses), but they are also likely to invest much of those gains abroad or to put them into the shadow banking system, which played a role in the financial crisis (that developed into a full blown recession) by creating a huge amount of leverage and interconnectedness.
Those with considerable amounts of financial assets also tend to be the ones who make possible the riskier types of investments. Yes, we want some adventuresomeness, but the appetite for risk and high returns that led to the financial crisis and recession was problematically high. Higher taxes on capital income would tend to temper that appetite for risk.
Further, concentrations of wealth create problems for democratic societies, especially at a time when at least 8 million Americans find themselves out of work and many out of their homes at the same time. Wealth concentrations lead to gated communities and the isolation of the wealthy from the mainstream of society. The ability to understand problems and to understand the distribution of benefits and burdens diminishes. When there is a group of people so well off that they are simply not “in the same boat” as everybody else, society is negatively impacted. Tax policy cannot cure the problem, but it can address it and ameliorate the worst of the consequences of concentrated wealth accumulation.
These are concepts that Congress should bear in mind as it considers whether or not to enact new tax cuts that will extend the Bush tax cuts longer.
Excellent post. I would like to add a clarification. The argument that tax cuts for the less rich stimulate demand more is valid and at present (and next year and the year after) very important. We are in a liquidity trap. However, in normal times (read 1939-2007) high consumption crowds out investment and/or net exports.
There is an extensive theoretical literature on optimal taxes on capital income (which clearly influences the policy debate a bit). The logic of low taxes on capital income is that they cause socially optimal consumption/savings decisions. So it is about consumption not investment. The idea is that taxes on capital income cause people to consume more than they would in the first best. The first best involves lump sum taxes. Basically the result is that it is better to confiscate wealth before the rich know what hit them than to tax capital income. The problem is that people with capital income consume too much. The case for cutting taxes on capital income is the case that such taxes cause them to consume more. This hypothesis is overwhelmingly rejected by the data. The data say that, if we can’t confiscate wealth, then we should have high taxes on capital income.
The mathematical result (for standard very very strong assumptions) is that in the long run the tax on capital income should go to zero. Ideologues (many of whom are top academic economists) have decided that we should act as if the long run is now. This is backward. The mathematical result is consistent with extremely high taxes on capital income now falling to zero in the long run.
I wrote the simplest possible model of taxes on capital income and got the result that they should be zero when all income inequality is eliminated and everyone has the exact same income and should be as high as possible until then. http://tinyurl.com/2vwkl8k
(warning PDF which was very kindly and heroically constructed by Sigve Indregard whom I have never met — isn’t the internet wonderful)
Now the perfect equality result follows from the standard silly very strong assumptions, but the basic idea that taxes on capital income should be very high until they are no longer useful for reducing inequality follows directly from the standard assumptions used by people who argue for low taxes on capital income.
I guess none of those advocating higher taxes want to quote Romer’s article in June’s American Economic Review. She and her husband say tax hikes are significantly contractionary. The American Economic Review is arguably the most prestigious economic journal in the United States. It’s not assoicated with Foxnews. Romer is Obama’s top economist.
Again, here is the abstract
This paper investigates the impact of tax changes on economic activity. We use the narrative record, such as presidential speeches and Congressional reports, to identify the size, timing, and principal motivation for all major postwar tax policy actions. This analysis allows us to separate legislated changes into those taken for reasons related to prospective economic conditions and those taken for more exogenous reasons. The behavior of output following these more exogenous changes indicates that tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes.
Truman, Kennedy/Johnson, and Jimmy Carter all cut taxes to stimulate growth. That’s all the post war democratic presidents with the exception of Clinton and Obama. Clinton’s idea was that in balancing the budget he would cut interest rates and this would lead to economic growth. This idea seems a bit arbitrary given the fall in interest rates over the last 8 years in the face of massive deficits. But it was an idea. Obama on the other hand has no idea on what his policy is. He just does stuff, they hand him a mike, and he starts talking.
Robert – “However, in normal times (read 1939-2007) high consumption crowds out investment and/or net exports.”
How does supposed “high consumption” crowd out net exports?
There was no shortage of available investment dollars for corporations that sought to offshore production prior to the recession.
The mix of imports in all nations (whatever they may be) would determine whether net exports grow or fall.
“Much of the argument in favor of reducing taxation on the income from capital is spurious.”
Erm, no, actually it isn’t. It’s a standard of the literature on the economics of taxation. So much so that we’ve actually got a nice table from the OECD about it:
All taxes have distortionary effects and when we look at the effects of such distortions upon future economic growth we can see a spectrum, from least impact to most. Least impact is property taxation (and land value taxation, of course, is a form of this) through consumption taxation (a VAT or sales tax) to income taxation, corporate taxation and capital taxation.
Free lunches are rare in economics but this is one of them. Reduce capital and corporate taxes, increase consumption and property taxes and for any given level of overall taxation we get more future growth.
This isn’t spurious, this is simple, straight down the line, economics of taxation.
This is one of the dumber articles I’ve seen on this dopey socialist web site. As an example:
“Most of the returns are those gained merely from secondary market trading and those increases in capital do not go to businesses but to other investors or financial institutions”
Hello, earth to dopey socialists, were it not for secondary trading in the capital markets, there would be no primary investment in the capital markets, which would mean no capital formation, which would mean no jobs.
I don’t think this is a socialist website. However, the slightly left of center economic commentary, which is fine with the main posts, has drifted down to the comment section in the form of a light censorship. I don’t see any of the columnists wanting to take on the Romer paper. And when I brought it up the best I got was a vague claim that I did not understand the paper. And when I responded to this in a reasonable way my post was deleted. I think this is a sign of the times with those on the left closing their minds and trying to enforce this will where its not wanted by the majority.
I have just found your comment which the spam filter grabbed. You do not make a good case on tax cuts by using an abstract…if you think tax cuts do such, do some research as well. But please read the paper first.