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One of the most useful insights of public economics is the "theory of second best." The idea is that adopting some but not all of the features of optimal policy—the seminal article on the subject called this “piecemeal policy recommendations”—may actually make the economy less efficient.
A great example is the argument for eliminating taxes on capital gains, as Senators Marco Rubio and Mike Lee will reportedly propose as part of their tax reform plan. They say it’s an incremental step toward a consumption tax, which would be much more efficient than an income tax because it would eliminate the tax bias against saving. But repealing the capital gains tax is not a step towards a better tax system because it would only reduce the tax on certain forms of saving, creating a bias among investment choices. Without other changes in the tax code, it would only hurt the economy
Under a consumption tax, the returns to saving of all forms (not just capital gains) are not taxed. In addition, interest expense would no longer be deductible. Like many economists, I think replacing the income tax with a progressive consumption tax—along the lines proposed by AEI economist Alan Viard and coauthors—would boost the economy (although by less than some fervent supporters believe).
But that doesn't mean taking one step towards a consumption tax—exempting capital gains from tax while leaving other capital income taxable and interest expense fully deductible—would be productive. In fact, it would likely hurt the economy. Put differently, unless Congress is willing to completely replace the income tax, it ought to keep the capital gains tax.
Lowering tax rates on capital gains alone (1) distort work and investment decisions into activities that produce income taxed as capital gain instead of ordinary income, and (2) create a giant loophole that can be exploited via tax shelters.
Cutting capital gains taxes creates a huge incentive to make bad choices. The top effective federal income tax rate on ordinary income (e.g., wages, salaries, rents, royalties, interest income) is over 40 percent. The effective tax rate on capital gains is less than 25 percent. Thus, every million dollars that is shifted from ordinary income to capital gains tax saves more than $150,000 in tax. (The tax savings would top $400,000 if capital gains were exempt from tax.)
Unsurprisingly, this gives people an artificial incentive to favor capital gains over rents and interest so it distorts their investment choices. In addition, they can turn labor income into capital gains—as private equity partners and hedge fund managers do—providing themselves a huge boost in after-tax income, even if their talents are better suited to another line of work.
The other problem is that the low tax rate on capital gains is the lynchpin of almost all individual income tax shelters. The classic tax shelter creates current deductions, which reduce taxable income, and ultimately generates capital gains. Tax shelter investments generate pre-tax losses that turn into after-tax profits because of the tax benefits. As Columbia law professor Michael Graetz has said, “A tax shelter is a deal done by very smart people that, absent tax considerations, would be very stupid.”
The capital gains tax break encourages a lot of “stupid” and unproductive activity, and a huge amount of very talented human capital is wasted in the pursuit.
This was the crux of my recent debate with Scott Sumner in the Wall Street Journal. He thinks discouraging saving and investment entails big economic costs and is concerned that inflation causes real capital gains to be overstated. He says that policymakers can pass specific legislation to discourage tax shelters while keeping a preference for capital gains.
I think the effects of taxing capital gains on overall capital formation and growth are small because saving is largely insensitive to rates of return. Besides, most investment capital comes from sources not affected by the U.S. capital gains tax. It is true that inflation is a problem, but more so for interest, dividends, rents, and royalties that are taxed every year, than for capital gains that can be postponed for years or even decades. That deferral offsets part of the costs of inflation—and more the longer the asset is held.
What about legislating away tax avoidance transactions piecemeal without systemic reform? Good luck. It is like playing a game of whack-a-mole. It may work for a while, but another scheme for converting ordinary income to capital gain (or 10) will just pop up somewhere that policymakers did not expect.
Eliminating or even cutting capital gains taxes is a perfect example of the theory of second best. If you want a consumption tax that eliminates taxation of the return to saving, go for it. But eliminating taxation of only selective returns to saving and some forms of compensation by exempting capital gains from tax is a piecemeal policy recommendation of the worst sort.
PS, The issues involving taxation of capital gains are fascinating and go far beyond my WSJ bit or this blog post. If you’re interested, I developed them at some length in The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed.
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Posts and comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.