Taxing Capital Income Is Unfair

Based on the past election I would guess that the majority of Americans have no idea what Socialism is, nor do they have the slightest bit of knowledge about economics.

Last February, Scott Sumner, an Economics Professor at Waltham’s Bentley University, wrote an excellent piece in the Economist, explaining why the proper tax rate on capital income should be zero:

ONE of the most basic principles in economics is that the taxation of capital income is inefficient. Taxes on interest, dividends, and capital gains represent a sort of “double taxation”, of wage income. For some reason many people have difficulty grasping this concept, and one often sees even Nobel Prize-winning economists talking about “income inequality” using data that includes both wage and capital income. This makes about as much sense as adding up blueberries and watermelons and calling it the “number of units of fruit”.

To see why this is so, consider twin brothers who each make $100,000 in wage income. Most people would regard these two people as equally well off, even if one freely chose to consume his income now, while the other chose to consume later. But not advocates of the income tax. They insist the more patient twin brother is “richer” and deserves to be taxed at a higher income tax rate. For instance, compare a 40% wage tax with a 40% income tax. Under the wage tax (sometimes called a “payroll tax”) the spendthrift brother is able to consume $60,000, which is 40% less than in a no-tax economy. Now assume the thrifty brother invests the after-tax wage income for 20 years, and sees the money double to $120,000. Then he can consume $120,000 20 years in the future, which is also 40% less than the no- tax consumption level. This sort of tax is neutral with respect to saving and investment; it's essentially a flat rate tax on consumption, whenever it occurs.

But that's not good enough for proponents of taxation of capital income. They want the thrifty brother to pay a 40% income tax on the $60,000 in capital income, leaving him with only a net gain of $36,000. Now the thrifty brother can only consume $96,000 in 20 years, thus he essentially paid a 52% tax on his consumption (as he would have consumed $200,000 in a no-tax scenario). The mistake people make is forgetting that the present value of $120,000 worth of consumption 20 years in the future is the same as $60,000 today. And in a sense that should be obvious, as both brothers are free to spend their money when they choose in the no-tax situation, so obviously the thrifty brother would not be economically “better off” merely because he chose a different year to consume his income. Both are equally “wealthy”, where wealth is the present value of lifetime consumption.

If a picture is worth a thousand words, then a video is worth a million (with a tip of the turban Hat Tip to Xanthippa's Chamberpot):

YouTube, Economist Steven Landsburg Discusses Incentives and Taxes

While Obama likes to talk about the wealthy paying their "fair share," the truth is that taxing the wealthy is unfair to wage earners. If taxes on dividends and other forms of capital formation were reduced to levels of the 1920s, average wages and real incomes would be about 17 percent higher.

The American Magazine, Don’t Raise Capital Gains Taxes

taxing capital income is unfairIncreasing taxes on capital income goes against current economic thinking on how to finance government spending. Indeed, taxing capital income ultimately hurts the very people it was supposed to help. It reduces investment, which reduces the amount of capital in the economy. A lower capital stock reduces economic growth, productivity, job creation, and wages.


A growing number of economic studies conclude that raising taxes on capital income leads to a substantial drop in capital formation. America’s capital income tax rates are about twice as high today as they were in the 1920s, and capital formation rates are much lower today than they were then. Economists use the “capital-output” ratio—the ratio of the capital stock to gross domestic product—to compare rates of capital formation over time. The capital-output ratio was almost 90 percent higher in the 1920s than it is today.

What would happen if the United States returned to the capital income tax rates of the 1920s? Its capital stock would be about 50 percent larger, and average wages and real incomes would be about 17 percent higher.

Taxing the rich more, hurts everyone who is not rich.

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