Capital (gains) vs. labor (income)

Posted: 20 January 2012 in Uncategorized
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The controversy over capital gains, provoked by Mitt Romney’s admissions concerning his high income and low taxes, has once again been ignited. As a result, friends and students have been asking me to clarify the issues surrounding the controversy.*

Here’s the bottom line: while the justification for a low tax rate on capital gains is that it encourages risk-taking and job-creation, the only jobs it creates are for accountants and tax advisers, who are hired in droves by wealthy individuals to help them convert ordinary income (such as wages and salaries) into capital gains and thus shield them from higher taxation. Thus, low taxes on capital gains lead to more inequality in the distribution of income and wealth, and starves the state of an additional source of tax revenues (thus imposing an even higher burden on the vast majority who have no choice but to earn income by selling their ability to work and to pay the taxes on ordinary income as specified by the federal income tax code).

What the participants in the debate concerning capital gains taxes leave untouched (including those who are critical of the existing low rate) is the presumption that investment—and therefore jobs—can only take place when wealthy individuals decide not to consume part of their income and, instead, choose to use it to purchase stocks, bonds, and corporate assets. That presumption ignores, first, that much of what the wealthy invest is based on debt and leveraging, not transfers of current income, even though they realize the gains as additional income (which is then taxed at a low rate). Even more important, it ignores the possibility that those who actually produce the surplus that, for society as a whole, forms the potential investment fund might make the decisions about where and when some portion of that surplus can be plowed back in to create additional jobs.

So, what do we know about capital gains and taxes on capital gains?

1. Most capital gains (75 percent or so) go to the top 1 percent of the population, and the current rate on capital gains (15 percent) is much lower than the top tax rate on ordinary income (35 percent).


2. Capital gains raise the income share of the top 1 percent—for example, from 18.29 percent of total income to 23.5 percent in 2007.


3. The capital gains tax rate has not always been so low. According to Steven Mufson and Jia Lynn Yang, it was much higher under Reagan (28 percent) and was only lowered by Clinton (to 20 percent) and then Bush II (to the current 15 percent).

“The irony is that Reagan got rid of the preferential rates for capital gains and Clinton put them back in,” [Marty] Sullivan [an economist and a contributing editor to Tax Analysts] said.

The fact is, wealthy individuals in the United States have been winning the battle of capital vs. labor for the past three decades. As the controversy over Romney has now revealed, those in the top 1 percent have managed, first, to acquire ta large share of income-generating assets and, then, to shield a large portion of their subsequent income by demanding—and getting—changes in the tax code that privilege capital gains over labor income.

And we put up with this why?

* Additional information about and discussion of capital gains taxes can be found in pieces by Greg Anrig, Kevin Drum, Paul Krugman, Jared Bernstein, and the Tax Policy Center.

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  1. Alex Bujorianu says:

    One of the ideas behind the capital gains tax is that investing capital assumes risk, and therefore should be taxed at a lower rate: essentially a “pay them extra for their risk-taking” type thing. Of course, economics tells us that investments that are naturally more risky–e.g. speculative house buying–will, by definition, command higher interest rates, and thus increased revenues, than compared to, say, someone who stores their money in the bank (where it might be invested in pet-grooming shops, for example).

    Evidently, if economies intrinsically increase pay based on risk, the capital gains tax is pointless in that regard.

    Another principle behind the tax is that “investment” is somehow preferable to income from labour. If developed countries had a shortage of capital, this would be true; however, one of the defining aspects of developed markets is that they possess great amounts of capital for their own economies, and, indeed, that of developing nations’.

    Now there are actually instances where there *isn’t* enough capital floating around–in fact, the second major reason for the failure of start-up business is lack of capital. The irony is that the tax tends to favour the very people who are causing the shortage: the very-wealthy who are spending vast amounts of capital on enormously overvalued housing bubbles instead of on businesses.

    A logical counter to this would be to introduce greater restrictions on mortgage lending, something that has been shown by some studies conducted in the US and Australia which I can’t be bothered to look up right now.

    Inequality is the side-effect of this tax, and possibly harms economic growth as earners in the lower-rung no longer believe they can reach the wealth of their higher-up peers. (The IMF and the OECD have both expressed concerns over increasing income inequality.)

    This tax is also regressive, as extremely wealthy individuals move their wealth from labour income to capital gains.

    Perhaps someone can enlighten me, but I fail to see how this tax exemption is supposed to improve economic growth.

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