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

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

Reuters

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.

Throughout the campaign, you will no doubt hear one set of these arguments or the other, depending on which side is talking. But from a theoretical perspective, there is no ideal way to tax investment income.

NO PREFERENCE

Instead, we should look at the practical consequences of these tax preferences. What do we really care about? We want people to save money; we want the economy to grow; and we want to raise enough tax revenues to pay for the government's spending commitments (Social Security, Medicare, national defense, and all those other things that overwhelming majorities of Americans support).

Looking at the evidence, whether empirical studies or detailed macroeconomic simulations, the case for tax preferences is weak. Changes in capital gains tax rates have no real impact on savings and investment; instead, they affect when people sell their assets and how hard they work at avoiding taxes. (See Burman, The Labyrinth of Capital Gains Tax Policy, pp. 55-63. The same is true of changes in income tax rates in general; see Saez, Slemrod, and Giertz.)

At a high level, there is no correlation between capital gains tax rates and economic growth. Since 1947, in years when the capital gains tax rate was 25 percent or higher, real GDP growth has averaged 3.4 percent per year; in years when the rate was below 25 percent, annual growth has averaged 2.7 percent, or 3.2 percent if you exclude the recent recession. (Lower tax rates do not increase growth with a lag, either; see Burman, p. 81.)

It is true that, through most of the history of the income tax, we have had lower tax rates for capital gains. The exception is a brief period between the Reagan tax reform of 1986 and the Bush tax increase of 1990. Why? As in a stereotypical murder mystery, you have to follow the money. Of the total dollar value of tax preferences on investment income, 96 percent goes to households making more than $100,000 per year and 67 percent to households making more than $1 million.*** This shouldn't be surprising, since only the well-off have any taxable investments, and only the super-rich have a lot of taxable investments.****

If lower taxes on investment income don't increase savings and don't increase economic growth, then we're left with a purely distributional issue. Given the large deficits and growing national debt that politicians and ordinary people say they care about, does it make sense to have a special tax break for the rich that will cost the Treasury Department more than $50 billion next year? ($43 billion under 1997 law, another $13 billion if the Bush tax cuts are extended.) Obviously Mitt Romney and his hedge fund donors think it does.

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*  Zuckerberg will pay a higher rate for exercising options that he received in 2005, but those are a small proportion of his total holdings.

** I benefit from this provision as well, although on a much, much smaller scale. [I'm never sure if this kind of disclosure is necessary, since I'm arguing for a policy change that would hurt me, not one that would help me.]

***These figures are somewhat skewed by the fact that realizing capital gains in a given year makes you richer in that year. Even when you rank households by average income over a ten-year period, however, the majority of capital gains--and hence the majority of the benefits of lower capital gains tax rates--go to the richest households. (See CBO, p. 16.)

**** Profits from home sales are effectively tax-exempt for most households.