Special Taxes for Special Wealth: Why Is Investment Income Different?

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Mitt Romney and Mark Zuckerberg's income is impressive and uncommon. But it doesn't necessarily deserve such uncommon treatment in our tax code.

Screen Shot 2012-02-09 at 12.40.42 PM.pngReuters

When Facebook goes public, Mark Zuckerberg will become one of the richest people in America, with shares that will probably be worth more than $20 billion. When he eventually sells those shares, his federal tax bill will only be 15 percent of the cash he receives.*

Zuckerberg and Mitt Romney (who, as everyone knows, paid a 13.9 percent tax rate for 2010) both benefit from tax preferences on investment income -- in this case, the 15 percent tax rate on capital gains.** Zuckerberg founded a company, so he's owned shares in that company since day one, which counts as an investment. Romney benefits from the carried interest provision, which says that even though the managers of private equity funds, venture capital funds, and hedge funds are investing other people's money, most of their fees are taxed as if they were investing their own money.

The carried interest provision is utter nonsense. If you are being paid to invest other people's money, you are working, and that's income from labor. It is a pure giveaway to small group of rich people who give huge amounts of money to politicians. For example, six of the ten millionaire donors to Mitt Romney's super PAC are from hedge funds or other investment firms. The bigger and more debatable issue is whether income from investments should be taxed at a lower rate than income from labor.

The short answer is that there is no perfect solution. There are valid theoretical reasons to give tax preferences to investment income and equally valid theoretical reasons not to.

THE CASE FOR SPECIAL TREATMENT

The conservative, supply-side argument for a tax break on investments is that we want people to save their money and invest it, so we shouldn't tax them for doing so. But we also want people to work, so it isn't obvious that investments should be taxed at a lower rate than labor.

There are more technical arguments against taxing capital gains (profits from selling an asset for more than you paid for it). One is that if you tax people when they sell assets, they will hold onto them longer than they would otherwise, which distorts their investment choices. The solution to this would be taxing people on the increase in value of their assets every year, but that might force them to sell assets simply because they need cash to pay their taxes. Another argument is that if you hold an asset for a long time, some of your profits are really just due to inflation. The solution there is inflation-adjusting your taxable profits, which is trivial in the computer age.

The argument against taxing dividends -- profits paid by corporations directly to their shareholders -- is that those corporations have already paid tax on those profits (assuming they pay corporate taxes, which can be a pretty flimsy assumption these days); this gives companies an incentive to issue debt instead of equity, increasing leverage. But there are better ways to solve that problem, like giving investors a credit for corporate taxes that have already been paid on their dividends.

THE CASE AGAINST SPECIAL TREATMENT

There are also technical arguments against tax preferences for investment income. The most important is that anytime you have two different income tax rates for the same person, she has an incentive to re-characterize income from one category (labor) to the other (investments). As a simple example, if you own a small business and receive income from it, you are better off calling it "dividends" as opposed to "salary" because they are taxed at different rates. In more complicated forms, this is one of the basic principles behind many tax shelters, which distort behavior and drain money out of productive uses and into the hands of accountants and lawyers who do nothing but design those shelters.

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James Kwak, an associate professor at the University of Connecticut School of Law, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.
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James Kwak is an associate professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. He blogs at The Baseline Scenario and tweets at @JamesYKwak.
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