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.)
