Back in March, 2001, I wrote a little fable about taxation for the op-ed piece of the Wall Street Journal. Several readers have asked me to post that fable here on the blog. Your wish is my command. At the bottom of this post, I’ll say a few words relating the fable to another recent blog post.
Once upon a time, a man went to work and earned a dollar. He used the dollar to buy a share of stock. The stock paid a dividend of 10 cents a year, 10% being the going rate of return in the land.
Thanks to wise corporate management, the dividend eventually doubled to 20 cents a year, causing the stock price to double as well. The man sold his share for $2, which he put in the bank. Eventually, his children inherited the money and reinvested it in the same company. They used their 20-cent annual dividend to purchase goods and services, happily ever after.
That was a fairy tale. Here is the reality:
Once upon a time, a man went to work and earned a dollar. After paying state and federal income taxes, he was left with 50 cents. He used the 50 cents to buy half a share of stock. When the stock price doubled, he sold his half-share for a dollar, paid a 10-cent tax on the capital gain, and put the remaining 90 cents in the bank. Eventually, his children inherited the money, paid 50 cents in inheritance tax, and reinvested the remaining 40 cents in the original company.
The company continued to earn a 10% rate of return, of which half went to pay corporate income and excise taxes. The children therefore received an annual dividend of 5%, which came to two cents a year. After paying personal income tax on the dividend, they were left with a penny a year in income. They used part of that penny to purchase goods and services, and the rest to pay sales taxes.
Okay, that’s a worst-case scenario. There are many things the man could have done to reduce his family’s tax burden. He could have chosen an investment that paid no dividends. He could have held his stock instead of selling it, accepting some extra risk. He could have spent everything he had before he died. For that matter, he could have chosen not to go to work in the first place. But the fact remains that after a series of perfectly reasonable economic choices, this family lost 95% of its income to taxes.
Ninety-five percent! From 20 cents a year down to a penny! How could such a thing happen? Simple: by taxing the same income five times.
Some aspects of multiple taxation are widely recognized, but others aren’t. Everyone knows about the “double taxation” of corporate income: first when it’s earned and then when it’s paid out as dividends. But not everyone realizes that capital gains are always caused by expectations of future income. That means the capital-gains tax amounts to a third tax on income that’s already slated to be taxed twice. Taxing both dividends and capital gains is like fining drivers for speeding and then fining them again for
having a high speedometer reading.
More important, each of these taxes — along with the inheritance tax and, for that matter, any tax at all on capital income — is ultimately a disguised tax on labor. That’s because Marx was right: Capital is the embodiment of past labor. Today’s capital income is a deferred reward for yesterday’s hard work. Tax that reward and you’re taxing the work that made it possible.
A tax on capital — whether it comes in the form of a tax on dividends, corporate income, capital gains or inheritance — is equivalent not just to a tax on labor, but to a highly discriminatory tax on labor. It penalizes the labor of the young (who have many years of saving ahead of them) far more heavily than the labor of the old (who tend to spend their income as it arrives). So not only are people penalized for working, they’re penalized doubly for working early in life.
A tax on labor discourages work. A tax on capital discourages work disproportionately among the young, distorting saving decisions and retarding economic growth. So a tax on capital has all the disadvantages of an extra tax on labor, and more besides.
Moreover, a tax on capital is a deceptive tax. When your income is taxed on five separate occasions, you’re less likely to notice the bite than if it’s taken all at once. Arguably, that allows politicians to get away with higher total tax rates than if they were forced to operate in the open.
All of which suggests that we’d be better off with a single tax on labor income and no taxes at all on corporate income, dividends, capital gains or inheritance. A growing body of research in macroeconomics supports that suggestion. The main contributors to that research include Christophe Chamley of Harvard, Ken Judd of Stanford, Peter Diamond of the Massachusetts Institute of Technology, Patrick Kehoe at Penn, V.V. Chari at Minnesota and Robert E. Lucas at Chicago. Mr. Lucas is a Nobel laureate who has been recognized for 30 years as the world’s most thoughtful and influential macroeconomist. Here’s how he sums up the findings so far:
When I left graduate school in 1963, I believed that the single most desirable change in the U.S. tax structure would be the taxation of capital gains as ordinary income. I now believe that neither capital gains nor any of the income from capital should be taxed at all. My earlier view was based on what I viewed as the best available economic analysis, but of course I think my current view is based on better analysis.
Of course, further analysis will be forthcoming and the conclusions might change. But for now, the best thinking confirms common sense: Five taxes is at least four too many.
And so ends my Wall Street Journal column. Now a little context:
Last week, I explained that a tax on interest effectively taxes current and future consumption at different rates. In today’s fable, I’ve pointed out that a tax on interest effectively taxes current and future labor at different rates (penalizing labor when you’re young more heavily than labor when you’re old).
There’s a general principle in economics that says everything ought to be taxed at the same rate. (That’s not an assumption; it’s the conclusion of an argument I’ve not provided here, though it’s in all the textbooks.) Last week, we saw that if you apply this principle to current and future consumption, there should be no tax on interest; today we saw that if you apply the same principle to current and future labor, there should still be no tax on interest.