Getting It Right

The New Yorker arrived today, leading off with this letter to the editor about income tax rates:

…The very rich pay at significantly lower rates, because most of their income consists not of compensation for services but of capital gains and dividends, which are capped at a fifteen per cent rate.

This is wrong, wrong, wrong, wrong, wrong, wrong, wrong, and you can’t begin to think clearly about tax policy if you don’t understand why. Even if capital gains taxes were capped at one percent, income subject to those taxes would be taxed at a higher rate than straight compensation. That’s because capital gains taxes (like all other taxes on capital income) are surtaxes, assessed over and above the tax on compensation.

It always pays to think through stylized examples. Alice and Bob each work a day and earn a dollar. Alice spends her dollar right away. Bob invests his dollar, waits for it to double, and then spends the resulting two dollars. Let’s see how the tax code affects them.

First add a wage tax. Alice and Bob each work a day, earn a dollar, pay 50 cents tax and have 50 cents left over. Alice spends her fifty cents right away. Bob invests his fifty cents, waits for it to double, and then spends the resulting one dollar.

What does the wage tax cost Alice? Answer: 50% of her consumption (which is down from a dollar to fifty cents). What does it cost Bob? Answer: 50% of his consumption (which is down from two dollars to one dollar). In the absence of a capital gains tax, Alice and Bob are both being taxed at the same rate.

Now add a 10% capital gains tax. Alice and Bob each work a day, earn a dollar, pay 50 cents tax and have 50 cents left over. Alice spends her fifty cents right away. Bob invests his fifty cents, waits for it to double, pays a 5 cent capital gains tax, and is left with 95 cents to spend.

What does the tax code cost Alice? Answer: 50% of her consumption (which is down from a dollar to fifty cents). What does the tax code cost Bob? Answer: 52.5% of his consumption (which is down from two dollars to 95 cents).

So there you have it: A 50% wage tax, together with a 10% capital gains tax, is equivalent to a 52.5% tax on Bob’s income. In fact, you could have achieved exactly the same result by taxing Bob at a 52.5% rate in the first place: He earns a dollar, you take 52.5% of it, he invests the remaining 47.5 cents, waits for it to double, and spends the resulting 95 cents.

Why is this so terribly hard for so many intelligent people to understand? Here, I think, is why. They see a guy with a million dollar capital gain on his investment, and they forget that in the absence of wage taxes, he’d have invested twice as much and earned a two million dollar capital gain. In that sense, the capital gain is taxed in advance.

There’s plenty of room for reasoned debate about who should or should not be paying higher tax rates. But there’s no room for reasoned debate about the actual impact of the tax code. This is a matter of arithmetic: Anyone who pays taxes on capital income is effectively paying at a higher total tax rate than anyone who doesn’t. I’ve explained this before. Don’t make me have to explain it again!

Edited to add: Several commenters have raised the issue of Carl, who never worked a day in his life, but inherited five million dollars from his grandmother and therefore never paid any taxes. But Carl’s grandma, who earned ten million dollars, paid five million in taxes upfront. As a result, Carl inherited not ten million but five million, and every single day his income is halved as a result. So Carl is in fact already paying an implicit 50% income tax before you ever start taxing his capital income. You can reasonably argue that Carl is undeservedly fortunate; you can reasonably argue that he ought to be taxed even more; but you can’t reasonably argue that he’s not already giving up half his income to the tax code. (Unless of course his grandma worked in an era when wages were taxed at a much lower rate.)

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57 Responses to “Getting It Right”

1. 1 1 Anon

Another thing is that the 15% dividend/capital gain rate is misleading: the corporation has already paid corporate taxes on that money, at 35%. So even ignoring the argument above, this money is actually taxed at 44.75%, not the stated 15%.

2. 2 2 Doctor Memory

At the risk of seeming obtuse: this example seems only trivially correct on its own terms, since Alice and Bob both sprang fully formed from the head of Zeus with no particular prehistory and an equal ability and need to trade their labor for a dollar a day.

I’m not sure what, if anything, it tells us about a (strictly hypothetical, of course) quasi-oligarchy where Alice was born into the world already in possession of a nice portfolio of property, equities and bonds all inherited from her great-grandmother, and Bob’s family are tenant-farmers on Alice’s estates. What meaning does the comparison have if one party has no (or token) wages to be taxed in the first place?

3. 3 3 Al

Steve,

What capital gains tax rate are you considering? 5%, 10% or 15% ?

“Now add a 15% capital gains tax…”

“Bob invests his fifty cents, waits for it to double, pays a 5 cent capital gains tax, and is left with 95 cents to spend.”

“…together with a 10% capital gains tax…”

But CEOs at large corporation pay very little taxes on their wages (since their compensation mostly consists of stock options). There’s no double-taxing for them.

5. 5 5 Harold

Having just had a look back to the previous post to refresh my memory, I have a few comments.

There is a big distance from where we are to where Steve would like us to be. Pyramid Head’s comment is similar to Benkyou Burrito’s in the previous post. I think the response is: if the stock options are actually compensation for work, then they should be taxed as income. The stock option thing is a loophole that should be closed. It is crucial to the argument that “compensation” is not taxed as “capital”. However, taxing interest is a clumsy way to correct this problem.

There are two arguments here:
1) Tax on capital interest results in a different rate of tax.
In a strict sense, I think this is true and unarguable. If you are taxed on capital income you pay a higher rate of tax overall.

From where we stand at the moment, I would accept a higher overall tax rate for the wealthy who obtain their income from interest.

6. 6 6 Ellen

This is like my parents insisting that we give the church 10% of their estate when they die. Their savings already had 10% taken out when they first earned the money. Not all taxes go to the government.

7. 7 7 improbable

This is a good explanation, and I make this argument regularly to friends. I think however that people often (hazily) have in mind scenarios a little different to the Alice/Bob one you describe.

Doctor Memory’s comment is a good one. When people think about this, they are often imagining someone living on capital gains from inherited money. The grandson did not work for the money, and did not pay much tax on it. Logically it would make much more sense to tax his grandfather’s estate, but if this is unpalatable / unenforceable, then a capital gains tax does have some of the same effect. (As well as other, undesirable, effects.)

The other possible justification you can imagine is this: suppose you are trying to implement something equivalent to a consumption tax, and that in the year 2008 you raised this tax. Clearly for Alice you raise the income tax and you’re done. But to tax Bob’s consumption in 2009 the same way, you should tax his capital gains (on investments made before 2008) at some rate. A blanket capital gains tax would implement this, in addition to undesirable effects.

8. 8 8 Steve Landsburg

Doctor Memory:

The property, equities and bonds that Alice inherited were all halved through taxation long before Alice was born, and therefore her income from them is permanently halved by that long-ago taxation. In that sense, she continues to be taxed every single day, before she pays a penny in capital taxes. Is she earning a million dollars a day on bonds her grandmother left her? If so, she’s also (implicitly) paying a million a day in taxes because she’s not receiving two million a day.

You could reasonably argue that Alice is undeservedly lucky and you could reasonably argue that her undeserved luck should be taxed still further. But I don’t think you can reasonably argue that it’s not already taxed (unless, of course, her grandmother earned that income in an era when compensation taxes were much lower, in which case my response to your comment is — touche).

9. 9 9 Steve Landsburg

Improbable:

The grandson did not work for the money, and did not pay much tax on it.

On the contrary, per my reply to Doctor Memory, the grandson implicitly pays tax on it every day. The grandma worked for the money, earned two million, paid a million in taxes and invested a million. The grandson receives the income from that million, as opposed to the income from two million. The income he’s not receiving, due to the money that was never invested, constitutes a tax on the grandson.

As far as consumption taxes — a tax on wages *is* a tax on consumption. A tax on capital income skews the tax so that different people’s consumption is taxed at different rates.

10. 10 10 improbable

Yes, I understand that the inherited money has already been taxed once.

The point I wished to make was this: I believe many people feel the the estate tax is too low, they would like more of the money inherited by Carl to be taken as tax. Yet they may also be against a “death tax” because it sounds bad / they imagine it happening to their house / they think it is too easily to avoid. They realise that a capital gains tax will take money from Carl, and so they support it, without thinking much about other cases where it would also apply.

I guess it is a little screwy to be arguing about which misconceptions it is most important to aim at (there are so many!)… It just seems that every time I have this argument with people, they are implicitly expressing a wish for higher estate taxes, but they have some mental block about coming right out and saying it, and this mental block is what warps their thinking on capital gains. My giving the alice/bob example never seems to help them see this.

Actually it seems like what the people I’m arguing with _most_ want, intuitively, is for Carl to be handing pieces of gold this year to pay for this year’s common goods, like everyone else. And they get to vote…

11. 11 11 Pat

I think Anon’s answer is better because he avoids any debate over Alice needing to spend her money right away on immediate needs. Some people don’t have the luxury of being able to invest.

The corporate tax reduces the present value of future cash flows which reduces any capital gains or dividends now.

12. 12 12 Steve Landsburg

Al: Thanks for the correction — the original post read “Now add a 15% capital gains tax”. I’ve repaired this to “Now add a 10% capital gains tax”, as it should have been in the first place.

13. 13 13 Harold

Ignoring for the moment the irony of such a mistake in a post titled “Getting it right”…

It is a feature of many tax systems to include a progressive element: those on higher incomes pay a higher rate of tax (at least nominally, the wealthiest probably pay a lower rate). This seems to go against the argument that consumption should be taxed equally. Taxing interest is really an extention of this. If Bob saves only a small fraction of his income, then the increase in his overall tax rate will be very small. Using a stylised example, Bob and Alice earn \$20,000 per year testing hypothetical situations arising from quantum mechanics. This is taxed at 50% so each pays \$10,000. Bob manages to save \$100, and gets interest at 10%. Alice spends all hers. Assuming Bob was able to put away the whole \$100 on day 1, he earns \$10, minus the \$1 capital gain tax. Total tax on consumption: \$10,001 or 50.005%. Alice only pays 50%. So for small savers, it is almost insignificant to their overall tax rate. Only those with a significant amount of their total income derived from capital will pay a significantly higher rate, and they can afford it. This of course a very different argument from the one made in the letter to the New York Times.

If we are to have this sort of progressive tax, why this one, and not, say, higher estate (death) taxes, or just a one-off tax on capital? Politics, I suppose.

14. 14 14 Ricardo Cruz

Several commenters have raised the issue of Carl, who never worked a day in his life, but inherited five million dollars from his grandmother and therefore never paid any taxes.

Sounds like those people are against inheritance, period. They should be suggesting death taxes, or a downright prohibition on inheritance, not dividend taxes.

15. 15 15 Al V.

Isn’t the overall point that capital gains taxes discourage investing? I’m definitely not rich, but I have gotten socked with capital gains taxes in the past due to the fluctuations in the stock market, and I have to either pay those taxes out of income (reducing my discretionary spending) or out of the gains (reducing my investment). of course, all taxes discourage something, but I think the point is that encouraging people to invest in something, rather than spending their entire income, is good for our economy as a whole; and capital gains taxes discourage that desirable behavior.

16. 16 16 improbable

Only those with a significant amount of their total income derived from capital will pay a significantly higher rate, and they can afford it.

But how do you know this?

Maybe Bob works himself half to death in his 20s and now devotes himself to educating the masses, spending the same amount every month as Alice, who has had a constant salary. He already paid a higher rate of tax while earning, and you are going to treat him as rich and tax his capital gains too? Why?

You are also taxing this Bob more than Dave, who didn’t quit his high-paying job, but spends it all as he goes along. Why?

Or are you imagining Carl, who didn’t earn the money, but was born rich?

17. 17 17 Al V.

I agree with @improbable. There are plenty of people (esp. retirees) whose income is solely from investments. Assume a retired couple who saved \$100,000 for retirement. They of course already paid income taxes on the income that was saved. Due to good investment strategy, that investment has doubled to \$200,000. Now they plan to sell \$20,000 per year to live on in their retirement. They therefore must pay capital gains on the \$100,000 that the investment appreciated, or in other words pay capital gains on \$10,000 each year. Would you say that they are rich, and can afford the taxes? I wouldn’t say that living on \$20,000 a year is a good income at all. And there are many, many people in this situation – my wife’s parents for two.

18. 18 18 Destin

It’s a different issue, but what about tax shelters, deductibles, and the like? I often hear this more than the capital gains tax argument.

A long time ago, Warren Buffet said he was taxed less than his secretary. He thought he should be taxed more. I don’t know if this is actually true, and I would really like to know how much the rich truly get taxed.

19. 19 19 Greg B

First, it isn’t clear to me why Bob’s consumption is two dollars in your calculation. Bob earns one dollar in wages, and fifty cents in capital gains. Why isn’t Bob’s consumption \$1.50?

Second, I’m curious what are your thoughts concerning discretion in compensation. For example,

Alice owns a business and pays herself one dollar in wages.
Bob owns a business, but in lieu of wages, pays himself a one dollar dividend.
Carl owns a business, but in lieu of wages, issues himself one dollar worth of stock.

Are Alice, Bob, and Carl taxed the same? If so, how, and if not, shouldn’t they be?

20. 20 20 Harold

Whatever system you use, there will be examples of those who are treated unfairly. Some of this can be sorted using a capital gains allowance – the retirees cited above could easily come under this. There are also tax reliefs in some systems for retirement savings, which can help. But, yes, most retired people are basically living off interest on savings or investments, and many are not wealthy.

Why should we come up with all these “fixes” to solve a problem that could be removed by abolishing tax on capital income? I suppose it depends if you believe in progressive taxation, and if so, is there a better way to divide the tax take? The alternative is for the Govt. to spend less (which some desire) or the workers will have to pay more (which may prove unpopular).

21. 21 21 Paul

Sorry Steven, but you are way off. The original comment that you are responding to claimed that the rich pay lower INCOME TAX RATES because a significant portion of their income (i.e. that income which is classified as capital gains) is taxed at a lower rate. You then proceed to analyze these taxes from the perspective of percentage of reduced consumption. But this is comparing apples and oranges. Income taxes are not consumption taxes, and it is highly misleading to measure income taxes based on consumption. You may think the the ultimate measure of a tax is its affect on consumption, but then all you are really questioning is the validity of income taxes at all as opposed to a consumption tax (such as a VAT, sales tax or as you correctly point out, a wage tax or tax on compensation is also a form of consumption tax.) But the reality is that we are talking income taxes here, and thus the real measure of the tax is its reduction of income and not consumption. This is the very nature of the tax. Since income that comes in the form of capital gains is taxed at a lower rate, those whose income consists largely of capital gains ARE taxed at a lower income tax rate. One may have good or bad reasons to oppose that form of taxation, and perhaps we should prefer a consumption tax, but let’s not confuse the issue by claiming that someone is taxed less without being clear on what is being taxed.

22. 22 22 Steve Landsburg

Paul:

But the reality is that we are talking income taxes here, and thus the real measure of the tax is its reduction of income and not consumption.

Yes indeed. But what you are overlooking is that a tax on past wages affects your current flow of capital income. So a tax on wages is (among other things) a tax on capital income.

23. 23 23 Paul

Steve:

I am perfectly aware that a reduction in income would reduce the amounts available to save or invest and therefore would also reduce future capital income. That fact is irrelevant to my point. My point is that income and consumption are two different things, and therefore it is a non sequitor to measure an income tax by it’s affect on consumption.

Let me give an example to make my point clearer. In income tax is a effectively a wage tax combined with a wealth tax (i.e. a tax on returns from wealth). Given certain assumptions a wage tax is equivalent to a consumption tax, such that a 50% reduction of wages will reduce consumption by 50% regardless of how long that consumption is delayed. So we can substitute a sales tax for our example. The second part of the tax is a wealth tax and we can substitute another type of wealth tax like a real estate property tax for our example. So two people have \$100,000 income. One spends all his money and pays a 10% sales tax, which means his consumption is reduced to 90% of what it otherwise would be. The other person spends all his money on a house and also pays 10% sales tax, but this person now also has to pay a 1% property tax on his house (let’s say it’s included in escrow and the total purchase price and tax come to \$100,000 for even numbers here.) So person one’s consumption was reduced 10% and person two’s consumption was reduced roughly 11%. So obviously person two is taxed at a higher rate, right? No. This argument is just silly, person two is not being taxed at a higher rate, but being taxed on different things. But this is effectively the same argument you are making about income taxes.

24. 24 24 Ken B

Another example of “what is seen and not seen”. The amount my extra dollar of investment could have earned had it not been taxed is not seen — but a real effect none the less.

25. 25 25 Steve Landsburg

Paul:

Suppose I create the following tax system:

If you’re poor, you pay a tax equal to 20% of your income every April 15.

If you’re rich, you pay a tax equal to 20% of your income every March 15, and another tax equal to 10% of your income every April 15.

Now somebody writes a letter to the New Yorker pointing out that every April 15, the rich pay a lower tax rate than the poor.

I respond with a blog post saying, in essence, “It is not true in any important sense that the rich pay a lower tax rate than the poor. In fact, the rich pay a total of 30%”.

Now a commenter (let’s call him Paul) says I’ve got this all wrong because I am confusing April taxes with March taxes. The *April* tax *is* lower for rich people, and this is a fact I should acknowledge, quite independent of any other taxes those rich people might be paying.

I think I might respond that, yes, if anyone were silly enough to think that there’s anything interesting about singling out the April tax for special consideration, then I’d have to concede that the rich pay a lower April tax than the poor do. But that nobody with a serious interest in the consequences of tax policy would find this observation terribly interesting.

And our commenter might respond that this is just silly. The rich person is in no way being taxed at a higher rate. Instead, he’s being taxed twice, which is not the same thing at all.

To which I might respond that yes, I suppose that if you phrase the question in exactly the right way, you can defend this answer. But it’s an answer has absolutely nothing to do with the actual consequences of the tax code.

26. 26 26 Scott H.

When the difference in income tax and capital gains tax can be 25% there is a lot of incentive to define your income as capital instead of income.

This is not always possible, but when the incentive increases we should not be surprised to find that the incidence increases as well.

27. 27 27 Greg B

Steven,

I agree with Paul. At the risk of perpetuating this tangent, your initial claim was the letter to the editor was “wrong”. Perhaps like Paul, I infer “wrong” means inaccurate. If I understand correctly, the writer claimed the rich pay a smaller percentage of their income in taxes. Your example is consistent with the writer’s claim. Alice pays 50% (50/100) of her income in taxes, while Bob pays 36.67% (55/150) of his income in taxes. 36.67 is smaller than 50, so the writer’s claim remains accurate. We could avoid this tangent by choosing better terms. For example, you could suggest the writer’s claim is misleading or irrelevant.

More to the point, I’ll reiterate my earlier question. You disagree with the writer because you measure relative to consumption instead of income, and you’ve converted Bob’s \$1.50 of income into \$2.00 of “consumption”. Please elaborate on how one can legally get \$2.00 of consumption for \$1.50 of income. Then, perhaps we can have a legitimate discussion as to which measurement is more relevant.

28. 28 28 Morten

I agree with the gist of the argument.

However, in real life, it is often very difficult to decide what is capital gains/dividends and what is income. This suggest they both should be taxed.

For example, a partner in a law firm gets a big bonus every year. Capital income or ordinary income? A startup is sold by the founder. Capital income or ordinary income?

29. 29 29 Different Paul

GregB:

I think you need to reread Steve’s post.

“Alice pays 50% (50/100) of her income in taxes, while Bob pays 36.67% (55/150) of his income in taxes.”

You left out 50 cents Bob would have earned in interest income if it were not for taxes. Bob pays 52.5% (105/200).

“Please elaborate on how one can legally get \$2.00 of consumption for \$1.50 of income.”

I think you are confused. This is simple and the essence of the post.

30. 30 30 Pete

I for one am not rich (not yet, and perhaps never). I have used capital gains and, to a lesser extent, dividends to completely eradicate my student loans and go well into a positive amount of net worth in the past two and a half years. From this perspective, I would like to remind people of two things.

First, taxes on capital gains are not taxes on rich, they are taxes on not being short sighted and stupid. Capital gains are my reward for working hard and long enough the past three years to have extra money to save and to be very thrifty with my money after earning it. That extra tax (which in my case is often taxed as income due to the high turnover of my holdings) is a pretty big drag and to know that I have to pay it because people are jealous bitter towards a class I’m not even part of is really obnoxious.

Secondly, it is work to get returns on capital gains and dividends. I’ve personally seen people blow \$70k/year incomes and \$500k/year incomes and I’ve seen someone go through a \$150k inheritance in less than a year. The average lottery winnings are gone within two years. Just getting a big pile of money dumped in your lap isn’t going to set you up for life. If someone does inherit a lot of money and invests it properly from there, be grateful for the good they are doing. Don’t be upset for what they have and you don’t.

31. 31 31 Douglas Bennett

“Please elaborate on how one can legally get \$2.00 of consumption for \$1.50 of income. Then, perhaps we can have a legitimate discussion as to which measurement is more relevant.”

Greg B-

Could you first please point to where in the original post Bob’s income was ever stated as being \$1.50? His return was always referred to as ‘doubling’ his investment, meaning that he either had \$1.00 or \$2.00 available before capital gains taxes, depending on income taxes. Where is this \$1.50 coming from?

32. 32 32 Seth

I’m disappointed I’ve never thought about capital income taxes like this. Very nice.

33. 33 33 Thomas Bayes

I’m sure I won’t say it any better than Professor Landsburg already has, but maybe I can be a decoy for some of the criticisms.

Suppose the government administrators are just as smart as Bob, and they also invest ‘their’ 50 cent share of Bob’s income. When Bob’s investment doubles, so will theirs, and they can spend 1 dollar to improve roads. After Bob pays his 5 cent capital gain tax, he will have 95 cents because of his original dollar of income, but the government will have 1 dollar and 5 cents. So, the investment return on Bob’s original income will be \$2, of which the government will be able to spend \$1.05, or — you guessed it — 52.5%.

Before you object, ask yourself why it is okay to count the ‘time value of money’ against Bob, but not against the government’s take. It is not Bob’s fault that the government doesn’t use his money as wisely as does he.

34. 34 34 Neil

The capital gains tax is a surtax only if all income is taxed, but it is not. Say alice works hard and earns \$50K and pays \$10K tax (20%), while bob buys an asset (house, business) and works equally hard and increases its value by \$50K. If he sells it, and pays a reduced capital gains tax of only 10%, he consumes \$5K more than Alice even though both put out the same effort. Actually, Bob does better than that because he doesn’t have to realize his capital gain today–he can simply borrow against it and pay no tax. And if there is no estate tax, then he can leave the appreciated asset to his kids, and no tax is ever paid.

35. 35 35 Greg B

Douglas,

The example says Bob earns one dollar in wages, of which he pays fifty cents for the wage tax and invests the other fifty cents. Bob’s fifty cent investment doubles implying Bob has earned another fifty cents on his investment. One dollar of wages plus fifty cents in capital gains equals \$1.50.

So my question stands. According to the example, Bob starts with zero money, obtains \$1.50 from external sources, pays fifty-five cents in total taxes, spends the remaining ninety-five cents leaving him with zero money. How can one conclude Bob’s “consumption” is \$2.00? This is an important question, because obviously if Bob’s consumption is the more intuitive \$1.50, then the basis for Steven’s argument fails. In fact, Steven’s argument appears to be valid ONLY IF consumption exceeds income. Aren’t you curious how your consumption can exceed your total income without borrowing? I know I am.

36. 36 36 Greg B

Different Paul,

I appreciate your advice, but apparently I remain confused. I re-read Steve’s post and could not find a reference to the “50 cents Bob would have earned in interest income if it were not for taxes” that you mentioned. Further, I disagree with your assessment because the essence of the post is the capital gains tax, not the wage tax. It appears Steven will need to set us straight.

37. 37 37 mattmc

anon #1 nailed this- the dividend tax is already ridiculous because the corporate tax has already been paid on that profit.

I don’t even really understand rationale for the capital gains tax. It seems brutally unfair that it isn’t at least adjusted for inflation.

38. 38 38 Greg B

Different Paul,

My apologies. I wish to retract my preceding response to you. I’ve realized that the \$2.00 originates from the scenario where there aren’t any taxes which means you were correct to suggest that the phantom fifty cents is the fifty cents Bob didn’t earn because of the wage tax. This resolves my first question concerning why \$2.00 is used in the subsequent calculations.

Perhaps you or someone can further enlighten me on my second question, which attempts to dispute the premise that capital gains are always surtaxes over and above compensation:

Alice owns a business and pays herself one dollar in wages.
Bob owns a business, but in lieu of wages, pays himself a one dollar dividend.
Carl owns a business, but in lieu of wages, issues himself one dollar worth of stock.

Are Alice, Bob, and Carl taxed the same? If so, how, and if not, shouldn’t they be?

39. 39 39 Neil

Greg B.

If someone owns a business, they had to put up capital. If the income that was earned to put up that capital was taxed, and if the dividend or stock grant is just the interest on that capital, then there is higher (double) taxation of such income. The same is true when capital gains are just return on capital.

What Steve misses is that capital gains can simply be transformed earned income. In fact, there is a massive industry of tax accountants and tax lawyers whose job is simply to show people how to do this. When it happens, as in my example above, income is taxed differently and inequitably according to its form.

The perfect solution is NOT to tax capital gains like ordinary income; the perfect solution is to devise a tax system that does not leave the opportunity to transform earned income into capital gains income and tax only earned income (once). Such a tax system can be designed, but it might be simpler to do just what we do–tax capital gains, but a lower rate. By this method some capital gains are taxed too high, but at least the transformed income does not go untaxed.

40. 40 40 Steve Landsburg

Greg B: As Morten and Neil have pointed out, it is possible to disguise earned income as capital income and thereby avoid taxes. My argument does not apply to cases of skullduggery.

In the absence of that skullduggery, I think you and I are now on the same page regarding what you call the phantom 50 cents.

41. 41 41 Steve Landsburg

Thomas Bayes: Thanks for your excellent way of putting this.

42. 42 42 Babinich

This thread is exhibit A as to why you, Mr. Landsburg, are one of the most important bloggers on the planet.

43. 43 43 pk

By now, it should be clear through everyone’s opinions that the tax code distorts the choices that people make (regardless of one’s definition of “fair”) and results in unintended consequences in income (including creative compensation plans), savings, investment, and the resulting revenue. Attempts to “fix” this usually result in — a far more complicated tax code. Later, rinse, repeat. How about we tax “tax lawyers” income at 2x everyone else?

Notice we haven’t even brought up the issue of capital or ordinary losses, which (in general), can only be used to offset gains? Or that in order to “qualify” for capital gains (vs ordinary income), you must hold an investment for 12 months (giving preference to timing over the quality of investments)? Or the “exclusion” of capital gains in some circumstances if that gain was tied to your primary residence?

44. 44 44 DCLawyer68

Re Stock Options: in theory it’s correct that some income tax can be dodged by receiving certain types of stock options (those of speuclative future value as opposed to those with immediate redeemable monetary value). However, it’s my understanding this is subject to AMT, so a CEO will not likely be able to avoid this.

45. 45 45 The Last Profit

I am not a mathematician but it appears to me that there are some serious errors in the stylized example presented in the main article. At the point where Bob earns \$1, is taxed 50 cents, takes the remaining 50cents and turns it into \$1 thru his investment, the math seems to run astray. The authors claims the tax on consumption is 50% here (Bob made \$2 and is left with \$1 to spend). I may be overlooking something but it seems to me Bob only made \$1.50 (the \$1 of wages and 50cents in capital gains). This would result in a tax of .33% before capital gains(50 cent tax on \$1.50 income). Now if we add the capital gains into the equation we get a tax of 36% (50cents income tax + 5cents capital gains = 55cents tax on \$1.50 income). So, assuming I haven’t made some huge error, it seems that capital gains tax do not result in higher over-all taxes.
Feel free to correct me if I have made a mistake.

The Last Profit

46. 46 46 Steve Landsburg

The Last Profit: If you earn enough income to buy 100 apples, and the tax code reduces your income so that you have enough to buy 70 apples, we call that a 30% tax.

In the example, Bob earns enough income so that (without taxes), after saving it and letting it double, he can buy 200 apples at a penny apiece. The tax code reduces his income so that he can buy 95 apples. That’s a reduction of 105 apples. 105 is 52.5% of 200.

Or if the apples confuse you, just look at the dollars: With no taxes, Bob has \$2 after his capital gain comes in. With taxes, he has 95 cents after his capital gain comes in. That’s a 52.5% reduction.

47. 47 47 Greg B

Steven, Different Paul, Douglas, Neil:

I’m enjoying the discussion and appreciate your time. I’ve been enlightened. At the risk of wearing out my welcome, I wish to continue.

I agree Steven’s conclusion logically follows his premise, but I think we’ve agreed the premise is not entirely true. One reason is earned income can be disguised as capital income. This skulduggery, as Steven calls it, is what others might describe as legally maximizing one’s own consumption, which is the behavior I would have guessed economists expect. Neil has suggested the capital gains tax is not the best way to eliminate this flaw.

Further, I, and apparently several others, aren’t yet prepared to accept the premise due to gifting. The rebuttal is that the gift has already been taxed as ordinary income to someone else, thereby the recipient paying an implicit tax. This rebuttal is unsatisfying to me for at least two reasons. First, it dismisses the possibility that earned income has quite likely also been subject to this implicit tax. Second, the assumption that Carl would have received twice as much in lieu of the tax is by no means certain and is only one of a variety of scenarios. Carl’s grandma may have traveled more or given to additional beneficiaries. The following example illustrates the first of my concerns.

Carl’s grandma earns ten million dollars. She hires Alice and pays her five million in wages and gives five million to Carl, which he promptly doubles to ten million.

Add 50% wage tax. Carl’s grandma’s ten million is reduced to five million and therefore she pays Alice two and a half million and gives two and half million to Carl, which he promptly doubles to five million. How has the tax code affected everyone? Carl’s grandma’s consumption has been reduced by 50% (ten million down to five million). Alice’s consumption has been reduced by 75% (five million to two and a half million then to one and a quarter million). Carl’s consumption has been reduced by 50% (ten million to five million).

Add 10% capital gains tax. Carl’s grandma’s consumption has been reduced by 50% (ten million down to five million). Alice’s consumption has been reduced by 75% (five million to two and a half million then to one and a quarter million). Carl’s consumption has been reduced by 55% (ten million to four and a half million).

In summary, the capital gains tax does not cause Carl to reduce his consumption more than Alice. Clearly taxing gifts at the same rate as earned income restores Steven’s argument.

Has my thinking gone astray?

48. 48 48 Steve Landsburg

Greg B: The first place where I have a problem with your example is right here:

Alice’s consumption has been reduced by 75% (five million to two and a half million then to one and a quarter million).

Alice is working fewer hours for grandma, but this gives her either more hours to work for someone else or more hours of leisure. Since leisure is valuable, you have failed in either case to account for something Alice values.

So let’s leave Alice out of it for now. Carl’s grandma earns ten million dollars. She spends five million and gives five million to Carl.

Add a 50% wage tax. Carl’s grandma’s ten million is reduced to five million and therefore she spends two and a half million and gives two and a half million to Carl, which he promptly doubles to five million. Both Carl and grandma have had their consumption reduced by 50%.

Now add a 10% capital gains tax. Carl’s grandma’s consumption has been reduced by 50% (ten million down to five million). Carl’s consumption has been reduced by 55% (ten million down to four and a half million).

As for Alice, one of several things happens. Here are two of them: A) She works half time for Carl’s grandma, half time for someone else (quite possibly for the government, which now has five million dollars to spend), earns five million and has it reduced by 50% via the wage tax. Or B) She works half time for Carl’s grandma and enjoys a whole lot of leisure. Her compensation *per hour worked* is cut by 50%.

You could argue that Alice would have preferred more hours of work to all that valuable leisure and therefore suffers an additional blow. That could well be true. But the same is true for Carl’s grandma, who also might end up working a whole lot less because of the wage tax.

49. 49 49 Steve Landsburg

Greg B: Let me add to that last response:

Alice, because she faces a 50% tax, is discouraged from working. Carl’s grandma, because she faces both a 50% tax on her own spending and a 52.5% tax on what she leaves to Carl, is discouraged *even more* from working. (She presumably cares as much about Carl’s consumption as about her own; otherwise she wouldn’t be leaving him all that money.)

In this post, my only point was that those who are subject to capital gains taxes are hit harder by the tax code. One could go further and say: Therefore those who are subject to capital gains taxes (i.e. people who like to save) face greater tax-induced disincentives to work. One problem with taxing capital is that you end up disincentivizing some people more than others. Why that’s bad is a whole other story, but there *is* a standard story to tell.

50. 50 50 Rob

This is yet another reason to favor a flat tax. Yes, a flat tax is sometimes functionally regressive, but there are cultural/societal benefits to the poor who pay taxes: self-respect, work-ethic, decreased sense of entitlement, more honest involvement in civic society.

Two of the big benefits are: 1) we don’t waste more time arguing over how to tweak the tax system. Just make it flat and leave it. Change the culture to revere the flat tax and shun anyone who would dare to change it. 2) We don’t waste resources avoiding taxes or waste resources sequestering capital in places where it is less productive in avoidance of taxes. We don’t allow loopholes to create advantages for special interests to the determent of the society.

It’s really simple to fix these things. It’s also easy to forget that most of the voting public is near-sighted, self-centered, greedy and stupid. If I were rich and elite, I might look down on myself as likely to be one more asshole in amongst the rabble. Long live the virtues of mediocrity!

51. 51 51 Al V.

It appears to me that a point of confusion here is semantic. I think what Prof. L. is saying is that if there are no taxes, the Alice earns \$1 and spends \$1, while Bob earns \$1 in income, gets \$1 in gains, and spends \$2. With income taxes, Alice earns \$1 and spends \$0.50, so she has an effective tax rate of 50%, because she is spending half of what she would have spent without taxes Bob earns \$1, gets \$0.50 in gains, and spends \$1, so his effective tax rate is also 50%, because again he is able to spend half of what he would have spent without taxes.

Add in a capital gains tax, Bob now is able to spend only \$0.95, so his effective tax rate is 52.5%, because he is only able to spend 47.5% of what he would have been able to without taxes.

The key here is that Prof. L. is comparing what each person is able to spend to what he or she would have spent without taxes, and labelling the difference as the tax – which makes sense.

52. 52 52 Steve Landsburg

Al V.: Yes, what you’ve said is exactly right, and very well summed up.

53. 53 53 Benkyou Burito

So when Warren Buffet explained his situation in 2006 as having paid out about 16% of his total income in taxes, how does this happen?

I think that you are right but you are dismissing the preponderance of hereditary wealth.

I think people would be willing to eliminate a capital gains tax altogether if it were replaced with an estate tax like that proposed by Adam Smith and many of this country’s founders (Jefferson, Franklin, Paine inter alia). 100% tax on estates with a reasonable exclusion for those estates passed down to family heirs.

So estates over maybe \$5m at the time of death would revert to the state and the \$5m could be passed along completely tax free. Further removing the capital gains would provide a combined incentive for industrial investment and philanthropy since you can’t take it with you and the only way to keep the government from getting it is to put it back into the system.

Because, the examples of Alice and Bob… end even Carl (with his hard working Grandmother) are not the ones that strike many people as unfair. It is more so with examples like the Prescotts and MsCalls who earned vast wealth under a regime of practically zero taxes and have now a dynasty of wealth and its accompanying power and influence that passes effortlessly through the generations.

I would go a step further and reduce income tax a bit and replace it with an annual tax on the value of your capital, investment and real holdings, like a property tax. Set an exemption of \$10m for capital and investment holdings plus and additional \$5m for real property.

How equal would Alice and Bob and Carl be under this system?

54. 54 54 Benkyou Burito

I’m sorry, I suggested an anual holdings tax and included investment value. That should not be there. I meant to include only assets actually owned by the respective tax-payer.

55. 55 55 afan

It is not nearly as simple as dismissing as “skullduggery” people who take their compensation as capital gains rather than earned income. A more accurate term to characterize their behavior is “obeying the tax laws”. If, as the the case under current law, one can take a large share of income as capital gains, and pay tax at that rate, then the entire analysis fails. The initial income was taxed at 10%, then any REALIZED gains thereafter also at 10%, and “rich” Bob is really paying a far lower tax rate than Alice.

If you follow real life a bit further, the effect of the current tax law leads one to even lower rates for the “rich”. Suppose Karen is a successful business person, and a frugal consumer. Over time, in part by paying capital gains taxes at an effective rate much lower than 10% because she does not realize all her gains each year, instead leaving them to compound, she accumulates a sizeable fortune.

First, frugal Karen need not realize capital gains each year in an amount equal to her capital gains compensation. If she has a portfolio of \$100 million, an annual income of \$10 million in capital gains in lieu of salary, and realizes \$500,000 for spending money, she can leave the other \$9.5 million untaxed. So her tax rate on the \$10M of income is 10% of \$500,000= \$50,000, 0.5%. This is her real tax rate. It is a far cry from the 50% paid by Alice.

Now Karen, who has never in life received a paycheck, taking all her earned income in capital gains, takes the next step and stops realizing any gains for consumption. She realizes that, although the 10% rate on realized capital gains is much lower than the 50% rate working stiffs pay, it is still more than she needs to sacrifice to access her fortune for living expenses. So she borrows the money. She uses her investment portfolio as collateral. Her interest rate on the loan should be considerably less than the 10% capital gains rate, even lower if we adjust it down to reflect the unrealistically low CG rate assumed for this illustration.

If she is the timid type she simply spends the borrowed money (which is not income for tax purposes) and continues to increase her networth as her capital gains compensation increases the value of her investments. If she is more aggressive, she strucutures the loans so that the interest is tax deductible.

In this example where Karen has now driven her AGI to zero the deductions are not worth much. Now make a slightly more realistic assumption that Karen has some taxable income. This could be because she has some money in cash or bonds, is forced to realize some capital gains when companies are taken over and pay out in cash or new stock, or Karen takes a nominal amount of compensation as earned income. She can wipe out her taxable income with her interest deductions.

So Karen, BY HONESTLY FOLLOWING THE TAX LAW, can pay marginal and average tax rates that are far lower than Alice.

No “skullduggery”, simply behaving as a law abiding citizen.

56. 56 56 vivek

If the Govt. is doing something- providing the legal and other infrastructure necessary for markets and firms (which internalize externalities yielding a bonus)- then it makes sense for capital gains to be taxed even if arising out of earned income. This is because the worker/ivestor is getting more out of being a member of society than the worker/consumer. In any case the canons of taxation include the notion that tax should be related to ability to pay and should be cheap to collect relative to yield. The sale of a house or shares, etc, is a good time to be collecting the tax.
I don’t quite see the Proffessor’s point.
What we need to be looking at is the elasticities of supply of the various factors of production. Yes, at the margin there is a disincentive effect from C.G.T which ought to be discouraging market transactions or company formation- however the benefits far outweigh the marginal disincentive otherwise nobody would be fool enough to conduct their business through such entities. ‘Taxes are the price- not of civilization- but of getting access to the market, gaining legal personality for a corporation and so on.
Still the good Prof’s Marxist labour theory of value is kind of cute.

57. 57 57 Floccina

One might bring up the fact that if the capital gains are huge then it is more like income than like deferred consumption. Say you bought a tech stock in 1999 and sold it in 2000 for 10x what you paid for it. Then most of it is like labor income.

1. 1 Great Post on Income Taxes « Trader Wasteland
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