Fairness and The Capital Gains Tax

President Obama, in his weekly radio address today, again called for millionaires and billionaires to pay the same tax rate as plumbers and cab drivers. Since the former currently pay federal income taxes at a nominal marginal rate of 35%—I say ‘nominal’ because the phasing out of deductions makes the marginal rate considerably higher at certain income levels—and average earners pay a nominal marginal rate of 15% or 25%, and since changing ‘marginal’ to ‘average’ would only intensify this difference, there are only a few possibilities:

  • The President has in mind not just federal income taxes but payroll taxes as well. Add in the average worker’s 15.1% (including the employer’s portion) and the middle earner could indeed be paying a higher marginal rate than the person with an income over the cap. If that’s what Obama has in mind, he should be arguing for a top rate of at least 40.1%. (Plenty of people who are not millionaires pay at the 30% rate but have incomes not over the cap, which puts their marginal rate at 45.1% plus the effect of deduction phase-outs; for these unfortunates (myself included), the current marginal rate is over 50%.) But this is a dangerous argument for him to make, because it shatters the illusion that Social Security is an insurance system rather than a tax-and-welfare system. As Milton Friedman pointed out years ago, Social Security is a bad (i.e., regressive) tax system coupled with a bad (i.e., not means-tested) welfare system. Its supporters, however, probably don’t want people to see it that way.
  • The President is really talking about capital gains taxes. Currently, capital gains are taxed at 15%, which is below many people’s income tax rate—though the disparity is much smaller than it seems, because the 15% is both an average and a marginal rate, applying to all capital gains, while higher marginal income tax rates apply only to the next dollar of income. Many Democrats seem to think it’s unfair for capital gains to be taxed at a rate less than that applying to ordinary income. After all, people labor for ordinary income, but not for capital gains! They apparently just fall like manna from heaven. If this is what he has in mind, however, the President’s plan is puzzling, for it doesn’t change the capital gains rate.
  • The President is just lying, relying on class resentments and economic illiteracy.

I think it’s worth reminding people how we got to a 15% capital gains tax rate. Keep in mind that people already paid taxes on the income they invested, and are paying the 15% on all gains, most of which, for many long-term investments, are due to inflation. (Most European countries, for this reason, don’t tax capital gains at all.) And keep in mind that investment is vital to economic growth and increases in productivity, which lead to growth in real incomes. So, we want economic policies that reward investment. Punishing investment success is bound to lead to less of it, which in turn leads to stagnation. Raising the capital gains tax sacrifices the future.

But there’s another consideration that is immensely powerful and was the primary reason for the bipartisan consensus to cut the capital gains rate from 28% (in the 1986 tax reform) to 20% and then 15%: Higher rates produced less revenue. Say all you want about supply-side economics in general. In this instance, the Laffer curve is highly confirmed, and seems to point to a maximum revenue point of about 15%. Raise the rate and you reduce revenue. Why? Because investment income is discretionary in a way that ordinary income isn’t. If you increase the tax rate, people are less likely to sell the stock, investment property, or company. Fewer sales, less capital gains income, and less revenue.

Raising the capital gains tax rate, then, sacrifices both the future and the present. For what? Someone’s idea of fairness.

That idea of fairness, moreover, must be essentially punitive. What John Stuart Mill wrote about sin taxes in On Liberty applies here (replacing ‘the best interests of the agent’ with ‘fairness’, etc.):

A further question is, whether the State, while it permits, should nevertheless indirectly discourage conduct which it deems contrary to [fairness]; whether, for example, it should take measures to render [investments] more costly…. To tax [capital gains] for the sole purpose of making them more difficult to be obtained, is a measure differing only in degree from their entire prohibition; and would be justifiable only if that were justifiable. Every increase of cost is a prohibition, to those whose means do not come up to the augmented price; and to those who do, it is a penalty laid on them for [succeeding]. Their choice of pleasures, and their mode of expending their income, after satisfying their legal and moral obligations to the State and to individuals, are their own concern, and must rest with their own judgment. These considerations may seem at first sight to condemn the selection of [investments] as special subjects of taxation for purposes of revenue. But it must be remembered that taxation for fiscal purposes is absolutely inevitable; that in most countries it is necessary that a considerable part of that taxation should be indirect; that the State, therefore, cannot help imposing penalties…. Taxation, therefore, of [capital gains], up to the point which produces the largest amount of revenue (supposing that the State needs all the revenue which it yields) is not only admissible, but to be approved of.
Anything more than that, Mill implies, is punitive and illegitimate.

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