I am opposed to all taxes on interest, dividends and other forms of capital income. Supporters of these taxes keep making the same fallacious argument. The purpose of this post is to shame those people out of ever making that argument again. (They are, of course, free to make other arguments.)
The fallacy I have in mind goes like this: First, economics teaches us that everything should be taxed at the same rate to avoid unnecessary distortions. Second, QED.
With appropriate caveats, the first part is true. The problem is with getting from there to the second part.
Let’s try an example. Suppose you spend your income on scones, which you buy at a dollar apiece, and suppose the interest rate is 100% per day (not very realistic, but of course the example works just as well with realistic numbers). And suppose you earn $2 a day.
The first observation is that any tax on income is effectively a tax on scones. That is, the only reason it hurts to pay taxes is that you end up with fewer scones. With that in mind, consider three scenarios:
Scenario 1 (no taxes): You earn two dollars, with which you can buy either two scones today or (after saving and earning interest) four scones tomorrow.
Scenario 2 (a 50% tax on wages): You earn two dollars, of which the government takes half. With your remaining dollar, you can buy either one scone today or (after saving and earning interest) two scones tomorrow. Either way, your consumption is cut in half. In effect, current and future scones are both taxed at 50%.
Scenario 3 (a 50% tax on both wages and interest): You earn two dollars, of which the government takes half. With your remaining dollar, you can buy either one scone today or (after saving, earning a dollar interest, and paying half that dollar in taxes) one-and-half scones tomorrow. If you spend today, your consumption is cut in half (from two scones to one); if you spend tomorrow, your consumption is cut by 62.5% (from four scones to 1 1/2). In effect, current scones are taxed at 50% and future scones are taxed at 62.5%.
Now in scenario 3, the government collects more money, and can therefore afford to lower the tax rate below 50%. But it remains the case that future scones are taxed at a higher rate than current scones.
So here’s the right argument: First, economics teaches us that everything should be taxed at the same rate to avoid unnecessary distortions. Second, it follows that current and future scones should be taxed at the same rate. Third, therefore there should be no tax on interest.
Now you might say that “taxing everything equally” is an ambiguous criterion—if you apply it to sources of income you get one answer, and if you apply it to what the income gets spent on you get another. What this overlooks is that the criterion was not just pulled out of the air; there are reasons for it—reasons you can find in any good microeconomics textbook. And if you interpret the criterion in light of the reasons we adopt that criterion in the first place then there’s no ambiguity. A scone today should be taxed at the same rate as a scone tomorrow. QED.