Does the Low Capital Gains Tax Harm the Poor?

An article in the Washington Post makes this assertion, but provides little to no evidence to back up its claim

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Should the rich pay more in taxes? Most Americans think so, and they do face higher income tax brackets. But they also benefit from a relatively low capital gains tax, which can result in some wealthy individuals having a relatively lower effective tax rate than poorer people.

This situation inspired Billionaire investor Warren Buffett to pen an op-ed piece about a month ago, calling on regulators to take a hard look at the capital gains tax. Today, the Washington Post has a sprawling front-page story about how the capital gains tax hurts the poor by feeding the inequality gap. Unfortunately, its authors provide no credible evidence that this is the case.

Why Capital Gains Taxes Are So Low

For starters, simple math can show that if rich people invest their money and face a relatively low tax rate on their profits then wealth inequality will grow. Indeed, unless you make investing illegal, the gap between rich and poor would widen no matter how high the tax rate: those who are have more money to invest would boost their incomes more than those who don't. Lower tax rates just cause the gap to grow faster.

But why have a relatively low capital gains tax rate? Doing so encourages investment. Obviously, the poor, along with everybody else, would benefit from investment and the growth that follows. If capital gains taxes are very high, then wealthy people would prefer to spend more of their money instead of investing it. Taxing worker income doesn't run into this problem: people have no choice but to work, unless they intend to rely on the welfare system. But those with extra capital always have a choice about how to use it: enjoy the money now through consumption or invest it to have more money to spend in the future. For this reason, the decision to generate income through investment should be more sensitive to tax rates than the decision to generate income from work.

Will More Tax Revenue Necessarily Benefit the Less Affluent?

Now let's look at the WaPo article. Its authors Steven Mufson and Jia Lynn Yang argue that the capital gains tax should be raised because doing so will help to close the income gap. This could only help if it makes the poor better off. But this assertion relies on the assumption that the poor aren't actually better off with additional opportunities for better employment provided by more investment. Here's the first argument they provide to support that assumption.

Many tax experts contest the benefits of a low capital gains rate.

Jane Gravelle, a tax expert at the Congressional Research Service, says a [capital gains] rate cut could generate more government revenue for a year or two as investors take advantage of lower rates or a rising stock market, but she says that initial bump in tax revenue would fade. And the government, over time, would collect more overall if it kept the rate higher.

If we assume that Gravelle is right, then this means that a low capital gains tax doesn't provide additional capital gains tax revenue in the long run. So what? Lower wage earners are only necessarily better off when more tax income is generated if you assume that transfer payments are the only way to create a thriving lower- and middle-class. Instead, less affluent workers could still ultimately benefit from a lower capital gains tax if the additional investment it provides creates better job opportunities. And higher paying jobs could, in turn, provide more overall tax revenue for the government.

Do Low Capital Gains Taxes Create Jobs?

But do lower capital gains taxes really create jobs? The article takes a shot at that possibility too:

"Lower capital gains [taxes] are a mixed bag even if you're just looking at efficiency," said Leonard Burman, a professor at Syracuse University and former head of tax analysis at the Treasury Department. "It might encourage more risk-taking, but it also creates huge opportunities for tax shelters aimed at converting ordinary income to capital gains. People would make investments only because of the tax benefits."

Moreover, he notes, given the recent financial crisis, it's not clear that an absence of risk-taking is what's ailing the economy.

This comment is bizarre for a couple of reasons. For starters, stating that increased "risk-taking" is the purpose of a low capital gains tax is a loaded way to express its objective. If you want to define startups and business expansion as "risk-taking," then you'll find this explanation sensible. But risk is really just an inescapable feature of investing. More accurately stated, a low capital gains tax should produce more investment generally, since it would discourage consumption and encourage saving (via investment). Such investment will create jobs.

And for people to make investments "only because of the tax benefits" is kind of the point. What would we, prefer: for Warren Buffett to purchase a new speed boat or for him to invest that money in a young firm's equity? It's pretty obvious that the latter would better serve the growth of the U.S. and by extension anyone who might get a job from that new company, which includes less affluent Americans. Do we really care if we only push him in the right direction through tax benefits? Of course, dishonest individuals who create fictitious investments to enjoy the low capital gains tax rate should face criminal penalties. That's a different story.

Burman's comment about the recent financial crisis is an unbelievable cheap shot as well. The housing bubble was not caused by excessive risk taking due to the low capital gains rate on business investment: it was caused by overinvestment in housing. In fact, the housing market has far more favorable tax treatment than business investment. Married couples selling a home are exempt from paying any capital gains tax up to a $500,000 gain on sale. They also benefit from the super-lucrative mortgage interest deduction. Finally, they do not need to pay taxes on the imputed income of their home (the effective return they obtain by living in the home instead of paying for rent). That same luxury is not afforded to business investors.

The housing bubble occurred in large part because investment dollars poured into the housing market due to its ridiculously preferential tax treatment compared to business investment. If Burman here means to say that the playing field for business and housing investment should be leveled, then he's absolutely correct. But that's probably not what he means.

Other Ways to Narrow the Wealth Gap

You could argue that the wealth gap isn't actually that meaningful: if the citizens of a nation are sufficiently free from poverty, then it might not be so important if it has some very rich people and some relatively less rich people. If almost everybody's living fairly comfortably and a government safety net exists to aid the few who aren't, then that sounds like a pretty decent place to live.

But let's say that you are concerned with the wealth gap anyway, because you think that money is great and some people shouldn't have a lot more than others. There are still better ways to try to close it through the tax code than ways which might hamper investment.

One way would be to create a big value-added tax on luxury goods. Maybe you could tax the rich 25% on private jet purchases. Maybe homes worth more than $1 million could include a 30% tax. It would be far better to tax the wealthy on consumption than investment.

Even a more aggressive estate tax could make sense. Those who accumulate significant wealth during their lifetime may more effectively invest it for future growth than their children. An exception here could be made for family businesses, however.

Another possibility was already hinted at: begin to level the playing field between real estate investment and business investment. Get rid of the mortgage interest deduction and other favorable tax treatment provided to homeowners. Such benefits exclude poorer individuals who generally rent.

The article's implication that the capital gains tax is so low that it adversely affects poor people could very well be true. Some economist could use data to prove that investment would shift by a statistically insignificant amount if the tax was, say, 40% instead of 20%. But the WaPo article provides no such evidence. Instead, it relies on the extremely weak, qualitative assertions of two experts.

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