Last week, I reported UK plans to raise capital gains taxes from the minimal 10% rate currently applicable to an 18% rate. Not surprisingly, business organizations are organizing to lobby against the move. See Scots Firms Unite to Fight Capital Gains Tax Revamp, at Business Scotsman.com (Oct. 15, 2007). The argument being made by the Scots firms is that that taxing capital gains will discourage entrepreneurs "longer-term investment and risk-taking."
That sounds a lot like the arguments being made on this side of the Atlantic. Today's Wall Street Journal had a piece called "A Capital Gains Primer" that was intended to stifle the movement afoot, at least among a number of influential people discussing the US tax system, to increases the taxes on capital gains, which enjoy a markedly preferential rate compared to the taxes on labor. The Journal notes that "[t]axing capital gains at a lower rate than ordinary income is a long-established policy to encourage risk taking and investment."
I am sure that lower taxes make it easier for individuals to undertake the activities subject to taxation. But does that argument really distinguish adequately between labor and capital? Labor, one presumes, is something that can be done or not done, just as investment can be undertaken or not. Higher taxes on the returns to labor could discourage labor, just as higher taxes on the returns to capital could discourage capital investment. But while that may be true at the margins, I haven't yet seen convincing empirical evidence that suggests that people with capital will keep their money out of investments if the tax burden on investments increased to something closer to the tax burden on labor. Most investment decisions are made in terms of the expected returns, and tax is just one factor in that return. The need to diversify and many other considerations come into play.
Would entrepreneurs quit being entrepreneurs if they weren't rewarded with the preferential capital gains rate down the road for their risk-taking now, instead of the same rate that other people are rewarded with for their labor? This is the same question that has surfaced in the discussion of carried interests. The lobby for the managers who provide services to hedge funds and private equity funds seems to suggest that managing activity will decline if it is taxed like other service providers are taxed. Or that the managers will raise their fees so that they still get the same income even with the tax. Both doomsday scenarios are hard to accept as likely. As to the latter, if higher rates were feasible, managers would already be charging them, assuming an efficient market. As to the former, managers who have managing skills are not likely to retire to live in Florida just because they have to pay ordinary income rates on their income. They work partly for the thrill of it, not just for the money. And 65% of a really good thing is still a good thing, so they would still be making lots of money. I suspect it's just as true that the entrepreneurs--like Bill Gates when he started Microsoft--will keep working at making their dreams come true whether or not they expect low capital gains rates to apply. The argument that the Wall Street Journal and the Scots firms imply--that risk-taking won't take place without capital gains treatment--just isn't all that convincing.
What about the lower rate as a compensation for the inflation that is reflected in capital gains? That argument is also overstated, since the prevalence of shorter holding periods means there is less inflation of values reflected in gains. The increasingly preferential rates applied to capital gains also don't correlate with any empirical analysis of inflation--they are at best an exceedingly rough approach to adjusting tax for inflation, that overcompensates in many contexts.
And finally, what about the Wall Street Journal's emphasis on the fact that a majority of Americans now own stock in some form? The fact is, most ordinary Americans have very small amounts of stock and don't do many stock trades, so the capital gains preference is not a major factor in their taxation. Most of the stock is owned by the top quintile of the income distribution, and the ownership is particularly concentrated in the very top of the income distribution.
The Journal article is clearly intended to counter the increasing interest in a more equitable tax system that is reflected in the discussion of carried interest, the alternative minimum tax, tax shelters, and the capital gains rate. So it is rather interesting how the argument is made. In berating those who are arguing again for a tax system like the one set in place by the 1986 tax reforms, that solves many of the arbitrage problems inherit in categories that are difficult to distinguish by removing the category distinction and taxing all income equally, the Journal complains that tax discussions are talking about "'fairness,' inequality and income redistribution" and not about "economic growth."
That's funny for two reasons. First, the word 'fairness' (and none of the others) is put in quotes, as though the Journal finds it so suspect a reason for any tax decision that it has to be challenged when merely mentioned on the page. Is the Journal so far removed from ordinary Americans that it does not realize that fairness is the most important attribute of a tax system?
Second, the Journal seems to think that economic growth is supposed to be the sine qua non of the tax system, not fairness. Yet economic growth should follow as the result of a vibrant market system that is working; it should not have to be stimulated primarily by special tax programs that subsidize industry darlings. Maybe the Journal believes that a fair tax system stifles economic growth? Then one has to ask why that would be true. It would be so only, one would think, if the tax rates were so high that markets could not function as they should. But the US tax system is nowhere near that problem--in fact, our effective tax rates make us a rather low-taxed nation, compared to other countries.
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