Capital Gains

Interesting conversation today between Felix Salmon and Evan Soltas over the proper way to tax “investment income.” Both authors make good points: Soltas argues that the definition of investment income should be narrowed, but that investment income should be taxed at a lower rate because 1) inflation is a huge problem if we tax investment income like ordinary income, and 2) “Taxing consumption tomorrow at a higher rate than consumption today — which is what a tax on investment income does — encourages people to shift consumption forward in time, and that’s inefficient.”

Felix responds by arguing that:

1) Investment really isn’t deferred consumption. The amount of money invested, in the world, is going up over the long term, not down — which means that once you look past the natural tidal movements of money in and out of various investment vehicles, it’s reasonable to say that money, once it gets invested, stays invested. Pretty much forever.

And  2) If I earn money and spend it today, my spending is going to become someone else’s income. If that person then pays tax on that income and spends the remainder, we’ll get yet another round of income tax out of it. And so on and so forth. It’s a constant high-velocity money-go-round, which is driving tax revenues all the way. By contrast, if my money is tied up in savings for a decade, it’s not generating any tax revenues at all. As a result, saved money generates much lower tax revenues than spent money. At the very least, then, it should be taxed at the same rate as spent money.

On the whole, I found Felix more convincing. But I think he brushed over a couple of important points that could have strengthened his argument. First, I think the relevancy of this whole debate basically boils down to ‘what is an acceptable level of income inequality in the United States.’ The problem that I have with Soltas’ argument is that the vast majority of people benefitting from the lower capital gains tax rate are wealthy individuals with surplus income. That is, they aren’t making tradeoffs between consumption today and consumption down the line because their consumption budgets are not constrained by income. Only half of the country is currently invested—and the likelihood that an individual is invested correlates significantly with that individual’s income level (rising with income). There is one notable exception to trend group, and that is lower and middle income individuals saving for their retirement—however, the total amount of money that these individuals invest pales significantly when compared to the invested assets of the upper 10% of households (measured by net worth)—the top 10% of households “accounted for about 85 to 90 percent of stock shares, bonds, trusts, business equity, and non-home real estate” and “accounted for 81 percent of the total value of these stocks.”   Furthermore, tax-deferred and tax-free savings vehicles already exist for lower-income investors. 401(k) accounts, Roth IRAs, and other retirement savings vehicles exempt (in one form or another) these savers from the sort of taxes to which Soltas refers.

With that said, I do think a couple caveats should be in place before we start taxing capital gains like real income. First, I do think that inflation should be taken into account when calculating capital gains; that is, I would support taxing real capital gains (as opposed to nominal capital gains) at the level of ordinary income. Second, I was surprised that neither author really acknowledged the role that capital gains plays as a form of compensation—maybe I am just sympathetic to this idea because I am writing from Silicon Valley, but I think that stock options and other forms of investment type compensation work effectively as a talent motivator and driver of innovation and entrepreneurship.  I would be partial to a system that instituted a progressive form of capital gains taxation whereby maybe the first $100,000 is exempt from taxation or could be taxed at a low rate of 10-15%, and then steadily move upward from there. I would actually be interested in seeing the top rates for ‘investment income’ move significantly higher than the rates for ordinary income—I don’t see any reason why an individual with $100 million in the bank should pay only  39% on the unearned millions that he/she is accruing in dividends/capital gains every year [let along the current 15%]. The money isn’t going anywhere—soak it! (I guess there is a fair bit of empirical evidence that soaking the rich/investment income at high rates incentivizes tax avoidance, but that seems to be a problem more with execution than with the theory to me.)

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