Why The Low Capital Gains Tax?

Former Fed vice chairman Alan Blinder doesn’t

get it, and neither, frankly, do I.

Why do we have a preference for capital gains in the first place? The main

argument is that lower taxes on capital gains boost investment. But the evidence

on that point is iffy at best, and there are better ways to spur investment,

like, say, the investment tax credit. Besides, lower taxes on capital gains

reduce the tax bills of the rich relative to the rest of us — after

all, they own most of the capital. But in this age of hyper-inequality, shouldn’t

we be making the tax code more progressive, not less?

A far more important objection is that the tax preference for capital gains

undermines capitalism — a system in which capitalists, not the state,

are supposed to make the investment decisions. When I discuss this issue with

my Economics 101 students, I show them an example of a proposed investment

that loses money before tax (and which, therefore, should be rejected) but

which actually turns a profit after tax because of the preferentially low

capital gains rate. (Accountants and tax lawyers live this example every day.)

The government thus induces people to make bad investments.

Justin Fox, on the other hand, says

that "In economic theory it’s pretty clear what a capital gain is and

why you would want to give favorable treatment to capital investment."

And Brad DeLong says

that he’s "’much more sympathetic to the capital gains tax preference

than Alan Blinder is".

The way I see it, when you’re rich enough, you can pretty much always structure

your income so that it turns into a capital gain. (In its simplest form, you

just found a company with a little bit of money, redirect your income into that

company, and then sell the company.) So having a capital gains tax rate much

lower than the income tax rate is tantamount to giving the rich a massive tax

break – even before accounting for the fact that it’s the rich who generally

have capital gains in the first place, and not the poor.

But I’m not an economist, so maybe one of them can explain to me how economic

theory, and/or economic practice, shows that capital gains should indeed be

taxed at a lower rate than income.

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