Monday, August 22, 2011

The case for taxing capital gains like any other income

James Stewart at The New York Times:

The notion that low capital gains tax rates are a good thing because they promote investment, lead to job creation, encourage people to sell assets without fear of tax consequences and actually raise total tax revenue is so entrenched in both parties that the idea of equalizing capital gains and ordinary income rates is barely mentioned or, when it is, is quickly denounced. It’s become a third rail of tax policy and electoral politics. “It’s now so woven into standard thinking that it’s become a cultural norm,” a prominent hedge fund official told me this week...

It does seem intuitive that lower taxes and thus potentially greater rewards would encourage risk-taking and investment, and surely at some rate high taxes can discourage any endeavor. But even some hedge fund and private equity officials concede that the argument for lower capital gains rates rests more on faith than science. “I’ve seen study after study that says lower capital gains rates have no impact on behavior,” the hedge fund official told me.

That view is also backed by a growing amount of academic research questioning the premise that lower capital gains rates promote growth. The evidence “is murky, at best,” said Leonard E. Burman, the Daniel Patrick Moynihan professor at the Maxwell School of Syracuse University. Mr. Burman is also a former deputy assistant Treasury secretary for tax policy in the Clinton administration and author of “The Labyrinth of Capital Gains Tax Policy.”

“It’s not the panacea for economic growth that advocates make it out to be,” he said. (Warren) Buffett himself lent empirical support to this view... “I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off,” he said.

Whatever benefits lower capital gains rates might generate, they indisputably complicate the tax code and have spawned a multibillion-dollar industry in tax avoidance. “Every imaginable individual income tax shelter is driven by the differential,” Mr. Burman noted. He added that the tax code was needlessly complex. “Have you looked at the alternate rate schedule on the back of Schedule D? It’s so complicated. It’s insane. That alone is a really good argument for change.”

But the biggest reason for equalizing capital gains rates may be that it would generate a vast amount of additional revenue for the Treasury. The Internal Revenue Service reports that for taxpayers with the top 400 adjusted gross incomes, capital gains in 2008 amounted to an eye-popping average of $154 million for each of those taxpayers, or 57 percent of their adjusted gross income, and this in a year when the stock market plunged. In 2007, it was $229 million each, or 66 percent. Much of the windfall from higher capital gains rates could be offset by cutting the rate on ordinary income. For antitax zealots who vow they won’t accept one more penny of federal tax, all of it could be offset by lower rates on ordinary income. And for advocates of reducing the government deficit at least in part through higher taxes, tax reform is an appealing approach.

Though controversial, this isn’t a new idea. The most prominently successful advocate of a drastically simplified tax code that treated ordinary income and capital gains the same was Ronald Reagan, who made it a centerpiece of his successful 1986 tax reform proposal. (The lower rate reappeared as part of the Taxpayer Relief Act of 1997, championed by Newt Gingrich, the former Republican speaker of the House, and signed by Democratic President Bill Clinton.)

In the end, the most compelling argument for equalizing tax rates on capital gains and ordinary income may not be economic efficiency, growth incentives, higher tax revenue or reducing the deficit. It’s simple fairness. It’s hard to quantify or put a dollar value on a just society. “I’ve earned both, and in my experience earning income from capital gains is a lot easier than earning ordinary income,” Mr. Burman said. “Why not tax both at the same rate? It only seems fair.”
Economist Jared Bernstein added a useful chart to this conversation, showing that rates of investment and tax rates on capital gains have virtually no correlation:
Cap gains bounces around based more on politics than policy, while investment pretty much grows with the cycle.  Hard to see anything in the picture supporting the view that either the level or changes in cap gains taxes play a determinant role in investment decisions, just like Warren said.

Sources: Citizens for Tax Justice and BEA

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