Romney's 15% average income tax rate is all over the news, with the usual "tax the rich" outrage.
Romney pays little income tax because, hold on...Romney has little income. The guy doesn't work. He lives on his investments and campaigns for President. If I took a year off of teaching to go on a round-the-world gliding tour, I wouldn't have much income either, and would pay little income tax.
(We're all guessing here, of course -- maybe it's all crafty shelters. But who cares about Romney anyway; the issue at stake is whether the US should substantially raise rates on everyone else's interest, dividends, capital gains, or wealth itself, in addition to estate and property taxes.)
Yes, from an economic perspective, interest, dividends and capital gains are not "income." Romney should pay taxes, and at least at the same rate as everyone else. He should pay taxes on his consumption, not the returns on his investments.
A central proposition in the economics of optimal taxation is that the tax rate on capital should be zero or close to it. Like anything else in economics, there is a huge literature of ifs ands and buts, yet the result seems fairly robust. (Google "optimal taxation of capital." This is not a political statement, there are thousands of pages of equations behind it. There is a separate "optimal taxation" literature on "optimal redistribution," with some equally surprising results that I'll write about some other day.)
Intuitively, this is related to the theorem that you shouldn't tax intermediate goods, or have tariffs for moving goods around the country. Romney's income was taxed once, when he made it. It's not efficient to tax it again, because he chose to save it rather than spend it immediately on an orgy of houses, private jets, and a big vacation for his extended family.
If you made money in dollars, paid taxes, then went to Canada and got $1.20 Canadian, it would make no sense to say "you made 20 cents of income, we'll tax it." It makes no more sense to pay taxes again on money that is moved over time. We decry that Americans don't save enough, the Chinese, the trade deficit and so on. Well, if you want people to save more, stop taxing it.
For this reason, the U.S. Tax code has been slowly reducing the taxation of rates of return. Capital gains and dividends are now taxed less than ordinary income. IRAs, 401(k), 526, and a welter of other devices allow people to save and invest without paying taxes on the rates of return. (It would be much simpler to just eliminate taxes on rates of return, but then the lawyers and accountants would have nothing to do.) Dividends are finally taxed at the same rate as capital gains. Estate taxes have been slowly and chaotically lowered.
Taxes on capital and wealth also are singularly unproductive of income, and very productive of tax shelters.
It's been a slow and painful process. And now, about to be undone, for no good economic reason.
Obviously, economists need to communicate better. Economists in general need to keep reminding everyone to look at tax rates, distortions and incentives first and foremost, not taxes. Opinion writiers like Paul Krugman's post on the subject don't do the world a favor by deliberately forgetting this basic principle when it is politically convenient.
Wednesday, January 18, 2012
16 comments:
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Is currency speculation not a taxable activity?
ReplyDeleteCalivancouver, don't be silly. Short term capital gains are taxed as ordinary income. (Except for gains an losses from section 1256 contracts and straddles - form 6781). Everyone knows that.
ReplyDeleteThe U.S. is made up of a majority of Greeks so the country is at risk of their philosopy of drawing down capital for consumpiton. Life style is what the liberal main stream media promotes to them. As does Hollywood and the music industry. Life style vs. money in the bank. Two kinds of people. Consumptionists vs. Capital Accumulationists. Greeks vs. Americans.
Taxing consumption has long been my battle cry; Milton Friedman advocated progressive consumption taxes to finance military outlays.
ReplyDeleteBut today, I am beginning to wonder. The globe has capital gluts, and people save for reasons unrelated to interest rates. They save for retirement, college for kids, etc. Globally. Too much of it.
Unlike 20 years ago or before, there is no shortage of capital today (indeed, "too much money chasing too few deals" is a commonplace sentiment among all types of money managers, from private equity, to real estate, to money managers).
Seemingly no matter how large and wasteful the federal government becomes, it cannot obtain "crowding out." Indeed, US Treasury auctions are routinely and heavily oversubscribed, at rock-bottom interest rates. Capital is cheap and abundant.
I would hate to say "tax capital," but I have not heard anyone seriously address the issue that what we suffer from today is a lack of demand. Taxing consumption now? Really? How about taxing pollution instead (another Friedmanite idea)?
I like the approach of Market Monetarists. I hope Cochrane gives serious thought to the promise of Market Monetarism. Being against federal deficits is obvious. But that alone will not bring growth.
John, 2 things.
ReplyDelete1) you say that interest and dividends are not considered income. According to the Haig-Simons definition (discussed in every Public Finance book) they are part of income (I think...). It is true that the IRS sets them apart for reasons you discuss, but since in Economics the Haig-Simons definition rules, I mention it.
2) you mention the optimal tax on capital is zero (referencing the Judd Chamley Kocherlakota style of results). Fine. But there are people who vehemently disagree. Two names: Emmanuel Saez and Peter Diamond, and I would throw Thomas Piketty in there, too (thus, 3 names). These people are heavy-weights, not little "Joe Blows" walking around. No, Saez is Bates Clark winner, Diamond is Nobel winner. Thus, it is not clear to me that there is consensus about the zero taxation on capital in the profession.
Yes of course -- I tried to say "ifs ands buts" to acknowledge the literature without going on and on in a blog post. But in any case, the academic literature is way more sophisticated than just "the rich pay capital gains taxes, so we should tax the rich more by raising the capital gains tax rate." Even those who disagree have models that consider margins and incentives!
DeleteJohn
Manfred,
DeleteFunny you should mention Diamond. I'd considered him to present some of the stronger cases for lower rates of tax on capital---especially in his work on the interaction between pension systems and tax systems. Here's what he said in 2009:
"Comparing the table to a tax on labor earnings makes several points. A 30% tax on earnings puts a 30% wedge between contemporaneous earnings and consumption. ...[A] 30% tax on capital income puts only a 3% wedge between consumption today and consumption in a year (when the rate of return is 10%). But it puts a 67% wedge between consumption today and consumption in 40 years. The difference comes from the shifting relative importance of principal and interest in the financing of future consumption as we look further into the future. Table 5 makes it clear that the intertemporal consumption tax wedge depends on whether nominal or real incomes are being taxed."
Sorry, my bad. I'd not read the paper you referenced. Sure, taxing individual income from investments makes more sense than corporate income taxation. Though the arguments the prof makes are important: double taxation is a problem.
DeleteJavage, I was thinking of the Diamond Saez paper in the Journal of Economic Perspectives, published in the last JEP (I think).
DeleteYep! Went and searched it right after commenting. Should reverse the order I do things! Thanks for the pointer.
DeleteIf Romney's income is "carried interest" that is clearly fee for service income and should be taxed at full rates.
ReplyDeletePretty much all earned income is the result of investment - in education, in skills, in reputation, in contacts. An argument that we should not tax income from capital is an argument that we should not tax the income of doctors or University professors.
One problem with not taxing income and just taxing consumption (although I support moderate sales taxes and a carbon tax) is that it would lead to the run away concentration of wealth which is bad for social stability / health of the Republic reasons.
I believe you're making a mistake and Prof. Cochrane can correct me if I'm wrong: The problem with taxes on investment income is that they tax future consumption at a higher rate than present consumption. This asymmetry can be solved by directly taxing consumption instead of income. In other words, the ultimate use of all income is consumption; the issue is the distortion toward present consumption at the expense of investment (future consumption).
DeleteUnder a flat consumption tax, the future consumption of a medical student is taxed at the same rate as his present consumption. Therefore, what lowers the return on human capital is the PROGRESSIVITY of income tax, not its mere existence.
To argue that the rewards of putting different factors of production to use should be taxed differently seems like a weird base for making policy decisions. The whole idea of taxing production factors is flawed to begin with, as you note.
ReplyDeleteBut the notion that the gains - whether one calls them income or something else should be of merely legal concern - from the factor "work" should be taxed unequally compared to those from the factor "capital" makes little sense other than to avoid capital from being flushed to somewhere else, essentially due to a simple prisoner's dilemma situation. Taxing work higher than capital gains just because it is at a disadvantage when it comes to mobility seems at best like a really lazy solution.
I never really understood the argument with regards to getting rid of estate taxes. Sure, taxes have been paid on it once, but by someone else. For the one getting the estate, it's basically like manna from heaven.
What I want to know is whether there is an observed correlation between A) tax rates on estates, dividends, and capital gains, and B) savings rates. My intuition says we've been lowering these taxes steadily, but saving decreased until 2008. Am I wrong?
ReplyDeleteEarned income is taxed only once for income tax purposes. If Romney was taxed on his earnings and chose to invest the entire net after tax amount, this establishes his cost basis. If the net investment grows in value, only the increase in value is taxed as a capital gain. A "second" tax is only applicable when the wealth is transferred either through a gift or upon death. Double income taxation applies when corporations pay dividends. The dividend is not deductible by the corporation (therefore taxable at the corporate level as earnings) and taxable at the individual level upon receipt.
ReplyDelete"interest, dividends and capital gains are not "income.""
ReplyDeleteAlso, rain is not water.
Okay John, I think what you (and others) say with respect to capital gains taxes makes sense in the framework in which economists typically analyze these things (and excluding a number of important costs).
ReplyDeleteLet's step out of the framework:
Premise 1: Social institutions (i.e. confidence in contract enforcement mechanisms, respect for the law) are necessary for value-adding transactions in the presence of information asymmetries and information costs
Premise 2: There exist information asymmetries and information costs
Premise 3 (in summary): Social institutions must maintain the trust/confidence of the economic actors in order to function as designed
Conclusion: Social institutions must maintain the trust/confidence of economic actors for value-adding transactions to take place
Now, introduce Premise 4: Institutions can only inspire trust if they satisfy certain intangible standards of social justice/fairness
Premise 5: Income inequality and low taxes on the wealthy are perceived as unjust/unfair
Conclusion 2: Income inequality and low taxes on the wealthy can inhibit value-adding transactions
We can expand these arguments a great deal, but the jist is that there ARE costs associated with low capital gains taxes and inequality that many economic analyses outright ignore.
We cannot ignore them. They are real, if hard to measure.