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

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The carried interest provision is absolute nonsense. If you are being paid to make investments from different people’s money, you’re working, and that’s income from labor. It is a pure giveaway to a small group of rich folks that give huge quantities of money to politicians. For instance, six of the ten millionaire donors to Mitt Romney’s super PAC are from hedge funds or other investment companies. The larger and greater arguable issue is whether or not income from investments need to be taxed at a decreased rate than income from labor.

The quick answer is that there is no perfect solution. There are valid theoretical motives to offer tax preferences to investment income and equally legitimate theoretical reasons not to.

THE CASE FOR SPECIAL TREATMENT

The conservative, supply-aspect argument for a tax break on investments is that we want people to save their money and make investments, so we should not tax them for doing so. But we also need people to work, so it is not apparent that investments ought to be taxed at a lower rate than labor.

There are more technical arguments towards taxing capital gains (earnings from selling an asset for more than you paid for it). One is that in case you tax individuals once they sell assets, they may keep onto them longer than they would in any other case, which distorts their investment selections. The way to this would be taxing people on the increase in the value of their assets each year, but that might pressure them to sell assets merely because they need money to pay their taxes. Another argument is that if you maintain an asset for a long time, some of your earnings are surely just because of inflation. The solution there is inflation-adjusting your taxable profits, that is trivial in the computer age.

The argument towards taxing dividends — profits paid by way of corporations without delay to their shareholders — is that those have already paid tax on the one’s earnings (assuming they pay corporate taxes, which may be a quite flimsy assumption in recent times); this gives organizations an incentive to issue debt in place of equity, increasing leverage. But there are better methods to remedy that hassle, like giving investors credit for company taxes which 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 critical is that whenever you’ve got two one-of-a-kind income tax rates for the same individual, she has an incentive to re-represent income from one category (labor) to the opposite (investments). As a simple instance, if you own a small commercial business and acquire profits from it, you’re better off calling it “dividends” in preference to “earnings” because they’re taxed at distinct prices. In greater complex forms, this is one of the fundamental ideas behind many tax shelters, which distort conduct and drain money out of productive use of and into the hands of accountants and lawyers who do nothing but layout those shelters.

Throughout the marketing campaign, you will no doubt hear one set of these arguments or the opposite, depending on which aspect is speaking. But from a theoretical angle, there’s no faultless way to tax investment income.

Gains From Investments

NO PREFERENCE

Instead, we must observe the practical results of these tax possibilities. What do we truly care about? We need people to save money; we want the economy to develop; and we need to elevate sufficient tax revenues to pay for the government’s spending commitments (Social Security, Medicare, National defense, and all those other matters that overwhelming majorities of Americans support).

Looking at the proof, whether or not empirical studies or detailed macroeconomic simulations, the case for tax preferences is susceptible. Changes in capital gains tax rate haven’t any real effect on financial savings and investment; as an alternative, they affect when individuals sell their assets and how hard they work at warding off taxes. 

At a high level, there is no correlation between capital profits tax rates and economic boom. Since 1947, in years while the capital profits tax charge became 25 percent or higher, real GDP growth has averaged 3.4 percent per year; in years when the rate became beneath 25 percent, the annual increase has averaged 2.7 percentage, or 3.2 percent if you exclude the current recession. (Lower tax rates do not increase growth with a lag, both)

It is actually that, through the history of the income tax, we have had decreased tax rates for capital profits. The exception is a short period between the Reagan tax reform of 1986 and the Bush tax increase of 1990. Why? As in a stereotypical homicide mystery, you need to comply with the cash. Of the full dollar value of tax preferences on investment earnings, 96 percent goes to families making extra than $100,000 per year and 67 percent to households making more than $1 million.*** This should not be astonishing, considering that only the well-off have any taxable investments, and only the fantastic-rich have numerous taxable investments.****

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