***The Omnibus Tax Policy Thread*** (1 Viewer)

[Wrighteous Ray]

Some reasons why capital gains should be taxed at a lower rate than ordinary income:

1. On average, about half of capital gains are only nominal, not real. If I buy a house for $100,000 and sell it twenty years later for $200,000, there's a good chance that my real income on that set of transactions is zero. The purchasing power of $100,000 in 1980 is roughly equal to the purchasing power of $200,000 in 2000 because of inflation. (I'm making that up, but if it's inaccurate, feel free to substitute numbers that are accurate.) People should arguably pay tax only on real income, not on strictly nominal income. On average, inflation is about 3% annually, and returns on capital investments are about 6% annually. (Some people make a lot more than 6% on their capital investments, which is part of why Warren Buffet's true tax rate may really be lower than his secretary's. But he's the exception rather than the rule.) Therefore, on average, about half of all capital gains are strictly nominal; and the true tax rate on capital gains is about double the nominal rate. It would make a lot of sense for taxes on capital gains to be indexed to inflation. Barring that, just figure that a nominal 15% tax rate on capital gains generally equates to a real rate of about 30 percent. (I think this is a very strong argument.)

I like that the approach in all three of your points is "fairness" because that's an easy subject to debate as compared to something like "it helps the economy."Using an example like you buying a house for $100K seems misleading to me if we're talking about fairness. For one thing, the tax code doesn't generally tax you on appreciation of your home value, so your tax rate there would probably actually be zero. But even if you had used an example like stock rather than a home I think using an ordinary Joe for the example is misleading, because capital gains make up only a teeny fraction of most people's income, but make up a huge percentage of other people's income. In 2007, the top 400 filers derived 66 percent of their income from capital gains and dividends, compared to 22 percent for filers making between $500,000 and $1 million and just 2 percent for those making under $50,000.

So I think a more appropriate example would be a guy like Romney and his $20 million in capital gains this year, because that's really the sort of person who would be most impacted by a change. Would it be unfair to Romney to tax him 30% on his capital gains? If you're a believer in progressive taxation, I'm not sure how easy it is to characterize the current situation as most fair. Especially because there's something that feels very different about money that you earned by working versus money you earned simply by already having a lot of money. What did Romney actually do this year to get that $20 million? With respect to Romney, we can't even say he made wise investments with it -- he's got his money in a blind trust.

People like Romney also have the opportunity to, say, earn lots of capital gains income in years where they have offsetting losses or when tax rates are lower for some reason, and then earn less in other years, just by timing when they sell off assets. Working people can't do that. So capital gains income is "better" in that sense than regular income from working because it's more flexible.

This was sort of a rambling response that didn't directly answer your point. I guess it's reasonable for you to say that inflation makes it seem like capital gains tax rates are lower than they actually are. But I'm not sure that makes raising them unfair.

2. "It's already been taxed." As silly as it can be in certain other contexts, I think this argument has some merit when talking about earnings on capital that was taxed when it was acquired. If you want to know what Mitt Romney's effective tax rate is, I don't think you should just look at the amount he pays in taxes in a given year as a percentage of his income that year. I think you should compare his earnings in the real world to his would-be earnings in a fictional world without taxes. If Romney makes $100 in 1980, pays $25 in taxes, uses $50 to live on, and invests the remaining $25 . . . his original $25 investment will eventually be worth $250 when he cashes out a few decades later. If he pays 15% on his $225 gain, he'll be left with after-tax income of about $191. In a world with no taxes, he'd have been able to invest $50 instead of $25, and his investment would have eventually been worth $500 instead of $250. Comparing his after-tax income in a tax-free world with his after-tax income in the real world, it appears that Romney's effective tax rate is way higher than 15 percent even in years when his income is limited to capital gains. (I don't think this is a strong argument, but some economists smarter than me do. And even though I don't think it's a strong argument in itself, I do think it helps counteract certain objections to point #3.)

I don't understand how this distinguishes a guy like Romney from other people. If there were no taxes, that would free up the $25 for everyone back in 1980. So everyone would be able to invest it and make the $250.

3. Why favor consumption over savings? Arnold Kling puts it simply: "If A and B earn the same income, but A saves and B spends more, then A should not have to pay higher lifetime taxes." If we want to distort behavior less, we should tax alternative activities at similar rates. Sales tax is usually around 7% or so. If we want our tax policy to be neutral with regard to spending versus saving, the tax on capital gains should be no higher than the tax on sales. (Arguably it should be zero, but we don't have to go that far here.) After all, when people resent the rich, it's usually for their lavish spending rather than for their lavish saving. Or at least it should be. (I think this is a fairly strong argument, but it's at least partially offset by the fact that capital gains taxes don't have to be paid on assets donated to charity. So Bill Gates can donate shares of MSFT to the Bill & Melinda Gates Foundation without either Bill or the Foundation having to pay taxes on the gains. At least I think that's how it works.)

I like the concept of "lifetime taxes" but doesn't this analysis ignore some important relevant stuff? For one thing, Romney knows that he can transfer a bunch of his wealth to his kids tax-free. It's not like he's saving it all to spend on a huge 100th birthday party. So on the money Romney places into trusts for his kids he's effectively paying a 0% rate.I guess I also object to the notion that the hypothetical in any way resembles the real world. As I noted in my response to the first post, poor and middle income people for the most part have very little capital gains income. Wealthy people have lots of it. Yes, you can find examples of people like "A & B" who earn similar incomes and one of them saves a lot and one spends a lot. But by far the most important factor in how much you save is how much you have. People that have a lot can afford to save a lot.

I also think the "resent the rich" thing is a red herring. We've had lots of discussions here about taxing the rich more. I can't really remember anyone saying that they favor higher taxes on the wealthy because they resent their lavish lifestyle. For me at least, progressive taxation is more about the marginal utility of money rather than resentment.

 

[oso diablo]

what if cap gains are taxed at a lower rate, up to the amount of cap gains that equals your ordinary income for the year? And then any cap gains over that are taxed as ordinary income?

p.s. would still keep ALL short-term cap gains at ordinary income rate (as it is today).

 

[Wrighteous Ray]

Here's a blurb in Slate today that sort of elaborates on my sloppy attempt to argue capital gains taxes should be raised

I found the piece confusing, but I think the study gets at an important point I was trying to make that low capital gains rates undermines progressivity in the tax structure. I think it's worth considering why we have chosen to tax income in particular, and why we have a progressive tax structure. In my view, it's largely a rough attempt to tax wealth so that sacrifices are shared more equitably. Low capital gains taxes seem to do the exact opposite by diminishing tax liabilities for the very wealthy at the expense of others.

 

[Tom Hagen]

Some reasons why capital gains should be taxed at a lower rate than ordinary income:

1. On average, about half of capital gains are only nominal, not real. If I buy a house for $100,000 and sell it twenty years later for $200,000, there's a good chance that my real income on that set of transactions is zero. The purchasing power of $100,000 in 1980 is roughly equal to the purchasing power of $200,000 in 2000 because of inflation. (I'm making that up, but if it's inaccurate, feel free to substitute numbers that are accurate.) People should arguably pay tax only on real income, not on strictly nominal income. On average, inflation is about 3% annually, and returns on capital investments are about 6% annually. (Some people make a lot more than 6% on their capital investments, which is part of why Warren Buffet's true tax rate may really be lower than his secretary's. But he's the exception rather than the rule.) Therefore, on average, about half of all capital gains are strictly nominal; and the true tax rate on capital gains is about double the nominal rate. It would make a lot of sense for taxes on capital gains to be indexed to inflation. Barring that, just figure that a nominal 15% tax rate on capital gains generally equates to a real rate of about 30 percent. (I think this is a very strong argument.)

This is an interesting argument that may have some merit. However, if I buy a stock for $100,000, hold it for 366 days and then sell it for $200,000 I'm getting the same tax advantage as if I had held it for 30 years. If inflation adjusted returns are the goal I think we would need different holding periods at different capital gain rates.

 

[Maurile Tremblay]

I like that the approach in all three of your points is "fairness" because that's an easy subject to debate as compared to something like "it helps the economy."

That's true only because I mis-introduced my post. My arguments didn't really show why capital gains should be taxed at a lower rate than ordinary income; they instead tried to show why simplistic fairness-based arguments in favor raising taxes on capital gains miss the mark.People are naturally offended that a multi-millionaire can have an income tax rate of only around 15% while nine-to-fivers have to pay higher rates than that. My arguments attempted to show that the "only 15%" rhetoric is misleading. After accounting for inflation, the nominal 15% rate is more like a real rate of 30%. Also, Earning a 10% return on a $100 investment is like earning a 5% return on a $200 investment; so the fact that the amount of a given investment was already reduced by income taxes means that any income from that investment is correspondingly reduced because of taxes as well. The reduction is real, but it doesn't show up in the "only 15%" figure.Ultimately, any argument I make that capital gains should be taxed at lower rates than ordinary income would focus on something like "it helps the economy" rather than on "fairness." That's because I believe that (a) any improvements in fairness that can be achieved by raising capital gains tax rates can be achieved just as effectively by raising the highest marginal rates on ordinary income instead, and (b) from any point to the left of the inflection point on the Laffer curve, any given improvement in fairness gained by the first method will do more harm to the economy than the same improvement made by the second method. (I'm not entirely convinced of either point (a) or point (b), but I think they are probably correct as generalizations — though it might be easy to come up with particular hypothetical situations where they'd be incorrect.)My argument for (a) relies on the fact that we can effectively increase taxes on Romney's 2012 investment income either by raising 2012 capital gains tax rates or by using a time machine to raise ordinary income tax rates from 1942—1972 (or whenever the invested capital was originally earned). In the first universe, Romney earns $200, pays $20 in taxes, invests $180, earns $18 a year on it, pays $3 of that in taxes, and lives off of the remaining $15 per year. In the second universe, Romney earns $200, pays $40 in taxes, invests $160, earns $16 a year on it, pays $1 of that in taxes, and lives off the remaining $15 per year. We can get to the same point — turning the original $200 in earnings into a stream of $15/yr for Romney with the rest going to the government — with lower ordinary income tax rates and higher capital gains tax rates, or with higher ordinary income tax rates and lower capital gains rates. Either way works. Raising taxes on capital gains is not necessary for achieving any desired level of progressiveness. So if the current tax system is not progressive enough for your liking, it doesn't follow that you should necessarily want to raise taxes on capital gains.My argument for (b) I'll save for when I respond to Matthias.

Using an example like you buying a house for $100K seems misleading to me if we're talking about fairness. For one thing, the tax code doesn't generally tax you on appreciation of your home value, so your tax rate there would probably actually be zero.

This is like the kicker exception to AVT. We need 1031 exchanges to be exempt from ordinary capital gains tax rules because the ordinary rules are so blatantly unfair. It's less blatant with many other investments than with buying a house (in part because a greater proportion of the typical appreciation of real property is only nominal), but the needed exception shows that the underlying principle is whack.

 

[Wrighteous Ray]

My argument for (a) relies on the fact that we can effectively increase taxes on Romney's 2012 investment income either by raising 2012 capital gains tax rates or by using a time machine to raise ordinary income tax rates from 1942—1972 (or whenever the invested capital was originally earned). In the first universe, Romney earns $200, pays $20 in taxes, invests $180, earns $18 a year on it, pays $3 of that in taxes, and lives off of the remaining $15 per year. In the second universe, Romney earns $200, pays $40 in taxes, invests $160, earns $16 a year on it, pays $1 of that in taxes, and lives off the remaining $15 per year. We can get to the same point — turning the original $200 in earnings into a stream of $15/yr for Romney with the rest going to the government — with lower ordinary income tax rates and higher capital gains tax rates, or with higher ordinary income tax rates and lower capital gains rates. Either way works. Raising taxes on capital gains is not necessary for achieving any desired level of progressiveness. So if the current tax system is not progressiveness enough for your liking, it doesn't follow that you should necessarily want to raise taxes on capital gains.

This assumes that the wealth was earned in that person's lifetime from ordinary income. Isn't a big part of the controversy that hedge fund folks and Warren Buffett are only paying capital gains rates on the money they earn from their regular jobs? Do we know what Mitt Romney's tax rate was at the time he was first accumulating his wealth? I suspect he didn't just earn a regular salary at Bain -- it was probably some sort of stock thingamajig. But I don't know.There are also some people that pay capital gains taxes on wealth that they inherited or received from a trust or otherwise obtained without paying income taxes on it. Your example doesn't really work for them.

We need 1031 exchanges to be exempt from ordinary capital gains tax rules because the ordinary rules are so blatantly unfair. It's less blatant with many other investments than with buying a house (in part because a greater proportion of the typical appreciation of real property is only nominal), but the needed exception shows that the underlying principle is whack.

I don't think houses are treated differently because they appreciate more slowly. I think it's because for millions of people, the equity in their home represents a huge percentage of their wealth. And unlike stock, it's tough to sell a house a little bit at a time.

 

[Maurile Tremblay]

I just came across this paper. I've read only the first few paragraphs. It seems quite relevant to this thread.

 

[cstu]

Capital gains taxes impede growth. If you want small businesses to expand and hire more people, you are not helping them to do so. This is not by itself a reason not to do it- our situation is so dire that we may very well need to consider this and all other means of additional taxation. But it's important to recognize the heavy cost.

This is the standard line but since taxes are only paid on profits I don't buy it. Investments are made based on the option that presents the best ROI. Even if taxes, assuming a reasonable amount, lower the ROI the business is still going to choose the most profitable investment.

 

[Sand]

Capital gains taxes impede growth. If you want small businesses to expand and hire more people, you are not helping them to do so. This is not by itself a reason not to do it- our situation is so dire that we may very well need to consider this and all other means of additional taxation. But it's important to recognize the heavy cost.

This is the standard line but since taxes are only paid on profits I don't buy it. Investments are made based on the option that presents the best ROI. Even if taxes, assuming a reasonable amount, lower the ROI the business is still going to choose the most profitable investment.

Investments are made on the probability of the best ROI. There are no guaranteed returns around (USTs excluded). When ROI changes and risk remains the same decision making changes.

 

[cstu]

Capital gains taxes impede growth. If you want small businesses to expand and hire more people, you are not helping them to do so. This is not by itself a reason not to do it- our situation is so dire that we may very well need to consider this and all other means of additional taxation. But it's important to recognize the heavy cost.

This is the standard line but since taxes are only paid on profits I don't buy it. Investments are made based on the option that presents the best ROI. Even if taxes, assuming a reasonable amount, lower the ROI the business is still going to choose the most profitable investment.

Investments are made on the probability of the best ROI. There are no guaranteed returns around (USTs excluded). When ROI changes and risk remains the same decision making changes.

First of all, let me be clear - I don't support taxing capital gains as income since I do think too high of a rate discourages investment. However 25% is a reasonable historical capital gains rate. Take an investment with an expected ROI of 10% before taxes. With a capital gains rate of 15% the effective ROI is 8.5% but at 25% it is 7.5%. That's a 1% difference in ROI, hardly enough to discourage the investment if it's the best one available.

 

[Wrighteous Ray]

I just came across this paper. I've read only the first few paragraphs. It seems quite relevant to this thread.

This is way over my head. What is meant by an "optimal tax rate"?

 

[Maurile Tremblay]

I just came across this paper. I've read only the first few paragraphs. It seems quite relevant to this thread.

This is way over my head. What is meant by an "optimal tax rate"?

The details are over my head as well, but I think I understand the gist. An optimal tax rate is one that inefficiently distorts behavior the least.Since nearly all taxes distort behavior, it may seem obvious to the point of being stupid to say that the optimal tax rate on capital income is zero. The optimal tax rate on nearly anything would be zero if we considered it in isolation.

But that's not what the authors are saying.

The authors are instead saying that, if we want to remain revenue-neutral, it is preferable (in the sense of causing less behavioral distortion) to shift taxes away from capital income and towards either consumption or income from labor.

The short version is that when you tax consumption or income from labor, you will distort behavior by causing people to substitute leisure for labor (or vice versa, depending on their current wealth). When you tax income from capital, you will cause the exact same distortion as before, and in addition you will cause people to substitute consumption for savings.

So if you want to tax John a total of $100 through a combination of labor-income tax, capital-income tax, and consumption tax, it is preferable (in the sense of causing less behavioral distortion) to adjust labor-income tax or consumption tax up and capital-income tax down until capital-income tax is at zero.

I know from our previous discussions that whether you'll consider Tax Policy A preferable to Tax Policy B will depend not only on their relative distortive effects, but also on their distributive effects.

The authors address this with a lot of fancy math I couldn't follow precisely. (See the section with the subheading: Heterogeneous Consumers.) But I believe their conclusion is that, just as you can be revenue-neutral by adjusting labor-income tax and/or consumption tax up while adjusting capital-income tax down to zero, you can also be distribution-neutral over the long run (though not during a temporary adjustment period) by doing the same, while remaining optimal w/r/t distortion. (Technically what they're doing is not showing that distributive effects can be held constant by reducing capital income taxes to zero, but rather that utility can be maximized by reducing capital income taxes to zero, where people's utility per dollar can differ among individuals in any arbitrary way you like. I believe that's functionally the same thing, since the argument for redistribution is that we can increase total utility by transferring the tax burden from people who get more utility per dollar to people who get less utility per dollar at their current levels of wealth.)

This part relies on several extra assumptions, and holds only if those assumptions do not depend on the population's total wealth. Or something like that.

 

[Wrighteous Ray]

I just came across this paper. I've read only the first few paragraphs. It seems quite relevant to this thread.

This is way over my head. What is meant by an "optimal tax rate"?

The details are over my head as well, but I think I understand the gist. An optimal tax rate is one that inefficiently distorts behavior the least.Since nearly all taxes distort behavior, it may seem obvious to the point of being stupid to say that the optimal tax rate on capital income is zero. The optimal tax rate on nearly anything would be zero if we considered it in isolation.

But that's not what the authors are saying.

The authors are instead saying that, if we want to remain revenue-neutral, it is preferable (in the sense of causing less behavioral distortion) to shift taxes away from capital income and towards either consumption or income from labor.

The short version is that when you tax consumption or income from labor, you will distort behavior by causing people to substitute leisure for labor (or vice versa, depending on their current wealth). When you tax income from capital, you will cause the exact same distortion as before, and in addition you will cause people to substitute consumption for savings.

So if you want to tax John a total of $100 through a combination of labor-income tax, capital-income tax, and consumption tax, it is preferable (in the sense of causing less behavioral distortion) to adjust labor-income tax or consumption tax up and capital-income tax down until capital-income tax is at zero.

I know from our previous discussions that whether you'll consider Tax Policy A preferable to Tax Policy B will depend not only on their relative distortive effects, but also on their distributive effects.

The authors address this with a lot of fancy math I couldn't follow precisely. (See the section with the subheading: Heterogeneous Consumers.) But I believe their conclusion is that, just as you can be revenue-neutral by adjusting labor-income tax and/or consumption tax up while adjusting capital-income tax down to zero, you can also be distribution-neutral over the long run (though not during a temporary adjustment period) by doing the same, while remaining optimal w/r/t distortion. (Technically what they're doing is not showing that distributive effects can be held constant by reducing capital income taxes to zero, but rather that utility can be maximized by reducing capital income taxes to zero, where people's utility per dollar can differ among individuals in any arbitrary way you like. I believe that's functionally the same thing, since the argument for redistribution is that we can increase total utility by transferring the tax burden from people who get more utility per dollar to people who get less utility per dollar at their current levels of wealth.)

This part relies on several extra assumptions, and holds only if those assumptions do not depend on the population's total wealth. Or something like that.

This was helpful, thanks. I guess I'm unclear how dropping capital gains taxes to zero wouldn't have serious distributive effects given that the wealthy pay lots of capital gains taxes but the poor pay virtually none. If the answer is "substantially raise the top marginal tax rates" or "substantially raise estate taxes", those don't seem politically plausible.

 

[Maurile Tremblay]

This was helpful, thanks. I guess I'm unclear how dropping capital gains taxes to zero wouldn't have serious distributive effects given that the wealthy pay lots of capital gains taxes but the poor pay virtually none. If the answer is "substantially raise the top marginal tax rates" or "substantially raise estate taxes", those don't seem politically plausible.

The authors acknowledge that the steps that would need to be taken in conjunction with eliminating taxes on capital income may be politically unrealistic. (The problem that they specifically mention is that, for a tax policy to be optimal in the sense that they mean, not only must capital income be untaxed, but everybody must believe that capital income will remain untaxed for the duration of their planning horizons. There's no good way to get everybody to believe that, since whenever there's a pile of money within reach, the government can resist taxing it for only so long.)

 

[Maurile Tremblay]

This paper on moral philosophy has some pretty fun thought experiments relevant to considerations regarding trade-offs between fairness and efficiency.

 

[Wrighteous Ray]

This paper on moral philosophy has some pretty fun thought experiments relevant to considerations regarding trade-offs between fairness and efficiency.

I'm trying really hard to read through this thing but I think it needs pictures or something. Keep getting distracted.

 

[Maurile Tremblay]

I just came across this paper. I've read only the first few paragraphs. It seems quite relevant to this thread.

This is way over my head. What is meant by an "optimal tax rate"?

Here's an easier read, though it's necessarily a rather incomplete explanation.

 

[fatguyinalittlecoat]

I just came across this paper. I've read only the first few paragraphs. It seems quite relevant to this thread.

This is way over my head. What is meant by an "optimal tax rate"?

Here's an easier read, though it's necessarily a rather incomplete explanation.

I just saw this bump. The link was understandable but unsatisfying because we just had to trust the author's assumptions. There was no intuitive explanation that made it obvious that 0% tax on capital was optimal. I'm left with a bunch of questions that I can't really answer from the link. Anyway, thanks.

 

[Slapdash]

I just came across this paper. I've read only the first few paragraphs. It seems quite relevant to this thread.

This is way over my head. What is meant by an "optimal tax rate"?

Here's an easier read, though it's necessarily a rather incomplete explanation.

I just saw this bump. The link was understandable but unsatisfying because we just had to trust the author's assumptions. There was no intuitive explanation that made it obvious that 0% tax on capital was optimal. I'm left with a bunch of questions that I can't really answer from the link. Anyway, thanks.

Optimal is this case just means the tax that raises the most revenue with the least amount of deadweight loss. Sounds like that post from Garett Jones is saying that the deadweight loss of taxes on capital are so large it overwhelmes any gain to the well-being of workings through transfers. That strikes me a bit extreme.

 

[Maurile Tremblay]

Sounds like that post from Garett Jones is saying that the deadweight loss of taxes on capital are so large it overwhelmes any gain to the well-being of workings through transfers.

He's saying that, under certain assumptions he considers standard, a tax on capital (including interest, rent, and capital gains) will cause wages to decrease by an amount greater than the tax, so that even if 100% of the tax that is collected is transferred to wage-earners, the wage-earners will come out behind. In order for that result not to hold, we need to substitute some exotic assumptions for the standard ones.The mathematical arguments for his position are too opaque for me to spend the time required to completely understand them. But I feel like I understand the gist well enough to offer the following comments.

1. There is no universal agreement on which assumptions are "standard" and which are "exotic." One of the assumptions that Jones makes, for example, is that everybody has an infinitely long life. This doesn't seem like a terrible assumption for most policy-related purposes when it's not the inter-generational effects we're interested in; but by removing this assumption, the proof no longer holds: it is possible to make some generations of wage-earners better off by transferring to them the revenues from taxes on capital when inter-generational effects are taken into account, and the capital-tax rate can rise or fall over different generations. (The assumption is there because if people don't live infinitely long lives, they'll save for retirement for a while and then live off of their savings for a while, which really makes everything a lot more complicated than if they'd just work and live with the same, constant savings-and-consumption patterns all their lives. Also, if people die, there will be inheritances, which also complicate everything.)

2. Money isn't the same as happiness. The Chamley-Judd theorem says that we can't make laborers richer by transferring capital-tax revenues to them; it doesn't say we can't make them happier. It's not out of the question that a world in which half the people have $10 and the other half have $14 is better, happiness-wise, than a world in which half the people have $11 and the other half have $20. (And I'm not just talking about nominal dollars, obviously; I'm talking about real wealth, like the quality of a person's car.)

3. I've been using words like "wage-earners" and "laborers," but the Chamley-Judd theorem is about labor, not laborers. It says that we can't transfer wealth from capital to labor by taxing capital and transferring it to labor. But people aren't neatly divided into "capital" and "labor." Most people are capitalists, laborers, both, and neither at various times in their lives. The Chamley-Judd theorem says that a tax on capital will cause a fall in wages that, in the aggregate, will exceed the revenues from the tax — so that even if we transfer the whole of the revenues to laborers, the laborers will be financially worse off. But that's not true of every specific laborer. I'm a laborer, and if all the capital-tax revenues were transferred to me, I'd be better off. More generally, we don't need to transfer all the revenues to laborers: we can transfer some to the unemployed, and they will be better off.

4. With those criticisms of the theorem out of the way, here's my attempt at explaining the basic point of the Chamley-Judd theorem in a way that can be grasped more intuitively:

Suppose that you, as King, decide that you want to transfer wealth from producers of bread to consumers of bread. You might think that a tax on the sale of bread (paid by the sellers) could be used to finance a subsidy for the purchase of bread (paid to the buyers), and that would do the trick. A minute's reflection, however, would show the impossibility of that plan. The price of bread would simply increase to offset the effects of the tax and subsidy.

Chamley-Judd says that what's true of bread is also true of capital and labor. Capital and labor are both inputs into business activities: capital hires labor to do a job. You can think of a laborer as a consumer of capital; he uses capital to accomplish a task and get himself paid, and he pays the provider of the capital a price for its use. Let's say that Tim, a laborer, uses $100 of capital borrowed from or invested by Jane, a capitalist, to buy a hammer. He uses the hammer for a year to earn $1,000, which he uses in part to repay $110 to Jane. The use of the capital cost him 10% per year, which in this case was $10.

Chamley-Judd says that when you tax capital to subsidize labor, the cost of the capital will increase — just the same as when you tax the sale of bread to subsidize the purchase of bread, the price of the bread will increase. Not only that, but by increasing the cost of capital, you're affecting the investment-versus-consumption decision of capitalists in a way that reduces the overall stock of invested capital. Wage rates are very largely determined by capital investment. The reason that most American laborers make so much more money than most Asian laborers is not that Americans are inherently superior at laboring; it's that there's been much more capital investment in America — more and better factories and equipment, etc. — which makes American labor more productive.

So when you tax Jane to fund a transfer to Tim, Tim's wages will go down for two reasons. First, Jane will require a higher return on her investment to make up for the tax; and as Jane's share (in the form of her ROI) of the overall profit goes up, Tim's share (in the form of wages) will go down. And second, less capital investment means that the quality of the hammer Tim can afford will go down, which means that Tim won't be able to hammer as productively, and won't be able to charge as much for his hammering. The cumulative effect makes Tim financially worse off even if 100% of the tax on Jane is transferred to him.

 

[Maurile Tremblay]

My argument for (a) relies on the fact that we can effectively increase taxes on Romney's 2012 investment income either by raising 2012 capital gains tax rates or by using a time machine to raise ordinary income tax rates from 1942—1972 (or whenever the invested capital was originally earned). In the first universe, Romney earns $200, pays $20 in taxes, invests $180, earns $18 a year on it, pays $3 of that in taxes, and lives off of the remaining $15 per year. In the second universe, Romney earns $200, pays $40 in taxes, invests $160, earns $16 a year on it, pays $1 of that in taxes, and lives off the remaining $15 per year. We can get to the same point — turning the original $200 in earnings into a stream of $15/yr for Romney with the rest going to the government — with lower ordinary income tax rates and higher capital gains tax rates, or with higher ordinary income tax rates and lower capital gains rates. Either way works. Raising taxes on capital gains is not necessary for achieving any desired level of progressiveness. So if the current tax system is not progressiveness enough for your liking, it doesn't follow that you should necessarily want to raise taxes on capital gains.

This assumes that the wealth was earned in that person's lifetime from ordinary income. Isn't a big part of the controversy that hedge fund folks and Warren Buffett are only paying capital gains rates on the money they earn from their regular jobs? Do we know what Mitt Romney's tax rate was at the time he was first accumulating his wealth? I suspect he didn't just earn a regular salary at Bain -- it was probably some sort of stock thingamajig. But I don't know.

Yeah, and that's relevant to the assumptions that go into Chamley-Judd. As I understand it, one of the assumptions of Chamley-Judd is the efficient capital markets hypothesis, which says that you can't earn higher rates of return on capital (invested on publicly traded exchanges) by trying harder or being smarter or putting in more hours. It treats all capital gains as the capital doing the work, and not as the investor doing the work. If, however, the efficient capital markets hypothesis is wrong (which I believe it is), then there isn't such a tidy distinction between labor and capital. If I spend eight hours a day finding particularly good stocks to invest in, and thereby increase my returns, why should those increased returns not be taxed as if they are the product of my labor — i.e., as ordinary income, and not as capital gains? I've never heard a good answer to that.A lot of the issues concerning tax policy on capital gains are too complicated for me to have very strong opinions about one way or the other. But the two principles that I think I'm pretty comfortable with are:

1. Capital gains should be indexed to inflation so that taxes are paid only on real (as opposed to nominal) gains.

2. To the extent that real capital gains above the risk-free interest rate are the product of diligent effort by the investor, they should be taxed as ordinary income.

The first principle seems straightforward to apply. The second principle might be prohibitively complicated to apply as long as we tax capital gains and ordinary income at different rates — but doing so (taxing them at different rates) becomes much less critical if we adopt the first principle.

 

[Slapdash]

3. I've been using words like "wage-earners" and "laborers," but the Chamley-Judd theorem is about labor, not laborers. It says that we can't transfer wealth from capital to labor by taxing capital and transferring it to labor. But people aren't neatly divided into "capital" and "labor." Most people are capitalists, laborers, both, and neither at various times in their lives. The Chamley-Judd theorem says that a tax on capital will cause a fall in wages that, in the aggregate, will exceed the revenues from the tax — so that even if we transfer the whole of the revenues to laborers, the laborers will be financially worse off. But that's not true of every specific laborer. I'm a laborer, and if all the capital-tax revenues were transferred to me, I'd be better off. More generally, we don't need to transfer all the revenues to laborers: we can transfer some to the unemployed, and they will be better off.

Read a counterpoint to this today, interesting throughout:K is not captial, L is not labor

Like physical capital, and unlike hours of the day, the collective stock of human capital grows over time, without obvious bound. Yet, at least under existing arrangements, we have no means of distinguishing between “returns to human capital” and “wages”. “Capital taxation”, in conventional use, refers to levies on capital gains, dividends, and interest. As a political matter, results like Chamley-Judd are often used to support setting these to zero. But eliminating conventional capital taxes shifts the cost of government to wages, which include returns to human capital. If human capital accumulation is as or more important than other forms of capital accumulation, and if the quality of effort that people devote to building human capital is wage-sensitive, then taxing wages in preference to financial capital may be quite perverse. Further, while physical capital grows by virtue of nonconsumption, it seems plausible that human capital development is proportionate to its use, which would render a tax penalty on “wages” particularly destructive. Fundamentally, Chamley-Judd logic suggests that we should tax least the factor most capable of expanding to engender economic growth. You don’t have to be a new-age nut to believe that human and institutional development, which yield return in the form of wages, may well be that factor. It is perfectly possible, under this logic, that the roles of capital and labor are reversed, that the optimal tax on labor should be zero or even negative, because returns to physical and financial capital are so enhanced by human talent that even capitalists are better off paying a tax to cajole it.

...

But more fundamentally, what we mean in life and politics by “capital” and “labor” are simply not the phenomena that Chamley or Judd (or Ramsey) model. It is wonderful for Jones to remind his students that, especially in a context of full employment, “capital helps workers”. Stories of what a worker can accomplish with a bulldozer versus a shovel are important and on-point. Students should inquire into the process by which in some times and places construction workers get bulldozers and live well, while in other times and places they work much harder with shovels yet barely subsist.

But Chamley-Judd tells us very little about the tax rate appropriate to income from dividends, interest, or “capital gains” in the real world. How and whether an incremental purchase of financial claims contributes to growth or helps workers is a complicated question, one that a Ramsey model can’t resolve. Models that are more realistic about finance, whether Keynesian or monetarist, predict states of the world where financial capital formation is harmful to real economic performance. To the degree that human and institutional capital grow with use rather than disuse, shifting the burden of taxation from financial claims to labor may be harmful over a very long-term. In the asymptotic steady state, who knows? We have as much reason to believe that you will like strawberries as we have to believe that the capital gains tax should be zero.

 

[Maurile Tremblay]

Read a counterpoint to this today, interesting throughout:

K is not captial, L is not labor

Thanks for the link. I'm unfamiliar with the interfluidity blog, but I'm adding it to my must-reads. That was a really good blog post.

 

[fatguyinalittlecoat]

So can I still advocate for high capital gains taxes as a means of redistributing wealth? It's getting too jargony in here.

 

[Maurile Tremblay]

So can I still advocate for high capital gains taxes as a means of redistributing wealth? It's getting too jargony in here.

You can certainly advocate for high capital gains taxes as a means of reducing wealth-inequality. Even those who believe that high capital gains taxes will reduce the poor's wealth would stipulate that they'd reduce the well-to-do's wealth at a faster rate.It's uncertain whether high capital gains taxes to fund a transfer to the poor can increase the (working) poor's wealth in absolute terms. All the models that weigh in with an answer are greatly oversimplified. The intuitive result, I think, is that increasing capital gains taxes while similarly reducing taxes on wages should make the working poor better off. Some models show the opposite result. The models are oversimplified, but so is our intuition, so who knows?

 

[Slapdash]

Read a counterpoint to this today, interesting throughout:

K is not captial, L is not labor

Thanks for the link. I'm unfamiliar with the interfluidity blog, but I'm adding it to my must-reads. That was a really good blog post.

He doesn't post frequently but they are always very thought-provoking. I think I found him through this post on MR.

 

[fatguyinalittlecoat]

Hey all,  I’ve noticed a bunch of tax policy discussions breaking out in the Trump thread and the Biden thread and the American Jobs Act thread.  Seems like it might be a good idea to centralize the content into one thread and I remember this one having some good stuff from way back in the day.

Anyway, I’m going to try to get some good discussion going in here a little later, but if anyone has thoughts about corporate taxes and estate taxes and capital gains taxes and step up basis and wealth taxes or anything else tax-related like additional funding for IRS enforcement, this might be a good thread to share them in.  It looks like Biden is pushing to make somewhat significant changes to the tax code, lots to talk about.

 

[the moops]

Seems like a good place to put this

Reuters: YELLEN: SAYS UNCOLLECTED TAXES AMOUNT TO $7 TRILLION OVER A DECADE

https://twitter.com/kylegriffin1/status/1389625873138126849?s=20

 

[The Commish]

Seems like a good place to put this

Reuters: YELLEN: SAYS UNCOLLECTED TAXES AMOUNT TO $7 TRILLION OVER A DECADE

https://twitter.com/kylegriffin1/status/1389625873138126849?s=20

That seems low  

 

[kface]

Seems like a good place to put this

Reuters: YELLEN: SAYS UNCOLLECTED TAXES AMOUNT TO $7 TRILLION OVER A DECADE

https://twitter.com/kylegriffin1/status/1389625873138126849?s=20

This is such a big deal.  I would celebrate any government that chases this stuff down

 

[fatguyinalittlecoat]

Global minimum corporate tax a little closer to reality

If Biden makes this happen I think it will be a huge accomplishment.

 

[Sand]

Global minimum corporate tax a little closer to reality

If Biden makes this happen I think it will be a huge accomplishment.

They'll have to get G7 to G193.  

 

[fatguyinalittlecoat]

They'll have to get G7 to G193.  

I don't think they have to get everyone on board because I believe part of the agreement is to change the ways corporations are taxed in general.  Also, I don't think any corporations are going to set up headquarters in Somalia no matter what their tax rate is, so it's mostly about using international pressure to get a handful of low-tax but stable nations like Ireland to go along.  But I have to admit I don't entirely understand all the details.  I'm just excited that they're at least trying to end the practice.

 

[Sand]

I don't think they have to get everyone on board because I believe part of the agreement is to change the ways corporations are taxed in general.  Also, I don't think any corporations are going to set up headquarters in Somalia no matter what their tax rate is, so it's mostly about using international pressure to get a handful of low-tax but stable nations like Ireland to go along.  But I have to admit I don't entirely understand all the details.  I'm just excited that they're at least trying to end the practice.

It will be interesting to see if it works out well for all.  Not really worried about Somalia or Yemen, true, but it will be interesting to see how places like Ireland and Gibraltar, etc., go along with this.

(IMO, the US should have gone to zero corporate taxes.)