The Inconsistency of Taxing Investment Returns

Why are we taxing the benefits of investing but not the benefits of spending?

600 tax me bro Chris Fritz flickr.jpg

Apparently, defending billionaires is a controversial business. I'm glad to see my post yesterday that explained some arguments for why low taxes on investing make sense elicited so much interest and debate. In it, I asserted that non-professional investors should pay low or even zero taxes on long-term capital gains. I claimed this was sensible for two reasons. I wanted to take a moment to explain in better detail the theory behind the second reason I explain -- the idea that taxing investment returns is inconsistent policy.

The first argument I explained for why investment income shouldn't be taxed was a simple, practical reason: corporations are already taxed, so to tax investment gains is taxing the money twice. Any complaints in response that corporations have low effective tax rates is an argument for corporate tax reform, not an argument against low capital gains tax rates. My second reason, however, was more philosophical.

I argued that only income resulting from trading human capital for money should be taxed. By human capital here, I sort of just mean labor or work. So why not just tax all income instead? I view taxing investment returns as a somewhat arbitrary way to tax the returns on some forms of spending and not others. Let me explain through an analogy.

Economics is not so much the study of money as it is the study of utility maximizing behavior. That's part of what makes it so complicated. All individuals have different utility functions, so trying to figure out how a group of people will react to a particular scenario becomes very difficult. One person might find a hamburger delicious, but a vegetarian might find it repulsive.

But spending is voluntary. Presumably, few people (other than masochists) would willingly purchase something that they believe would provide no utility or negative utility. Instead, they'll buy something from which they will derive some utility.

Now let's outline two scenarios. Imagine there's a guy named Melvin. He likes video games, so he buys a Wii gaming console for $150. Let's say he derives some utility from his Wii each time he plays. So over the course of a decade, he would constantly be adding to his cumulative utility.

But what if, instead, he invested that money for ten years? It would be tied up for the length of the investment, so he would lose all of the utility that a Wii would have provided for that decade. The compensation for his lost utility, of course, is the investment's return. But that return is taxed -- unlike the utility that he had been enjoying while his investment was tied up.

The important question here is whether or not this capital gains tax would have an adverse effect on investing. I think it clearly would. Not only does this person have to delay obtaining utility from the fruits of his labor in order to invest, but the compensation for his wait -- the return -- is taxed. If you assume that this return would have brought approximately as much utility as what was derived over this time period by the Wii, then the tax would cause investing to provide less utility. A rational actor, in that case, would not invest.

In reality, however, we don't know whether spending would provide more utility than a long-term investment. This is a made-up example. In an alternate conception, you might argue that this person ultimately derived more cumulative utility by investing -- even if you account for the tax. Unfortunately, we don't know utility functions so we can't weigh these options in a meaningful way to determine a clear policy.

But doesn't this problem imply that we should seek a conservative outcome? If we want a world in which investing is on equal footing to spending, then the least we could do is try to minimize the loss of utility from having one's capital tied up in a long-term investment by allowing that person to reap those returns in full. Put simply: why are we taxing the return on investing but not the return on spending?

I hope this isn't now all more confusing than it was before. But the idea is really simple: investing is just another kind of spending. But the utility you derive from investing is delayed dependent upon the investment's return -- and I didn't even touch investment risk, which provides another headwind. If that potential return faces a tax, then it will often become a less desirable activity than spending, where utility is derived immediately and is not taxed.

What I'm looking for is a principle under which we have consistency in taxation. I think taxing capital gains is inconsistent, because we aren't taxing the utility derived from other spending. You might disagree and prefer to tax any income, no matter how it's obtained. That's your prerogative. I just believe that government policy should avoid discouraging behavior that will benefit economic growth more than its alternative.

Image Credit: Chris Fritz/flickr