Forget The Wealthy. How Do We Tax The Lucky?
September 30, 2011, 7:08 pm
Filed under: Corporations, Economics | Tags:

A few weeks ago, the Washington Post ran a lengthy, above-the-fold piece looking into what impact capital gains tax rates were having on wealth inequality in America. “Most of the richest Americans pay lower overall tax rates than middle-class Americans do,” the reporters noted, adding that during the past two decades, “more than 80 percent of the capital gains income realized in the United States has gone to 5 percent of the people; about half of all the capital gains have gone to the wealthiest 0.1 percent.”

The primary reason for this is that wages and capital gains are taxed at different rates. (The other reason, of course, is that many in the middle class simply don’t realize capital gains because they really don’t invest in securities.) In 1986, as part of a compromise tax bill between President Reagan and Democrats, capital gains and wages were taxed at an equal rate: 28 percent. Since that time, lobbyists have doggedly worked to lower the rate to where it is now: 15 percent on capital gains and dividends, which is a full 20 percent lower than the top rate on wages. Members of Congress, many of whom are very wealthy and who own lots of stocks and bonds also were keen to do what was in their economic interest.

Effectively, the disparity means that hedge fund managers and others who derive a disproportionate amount of their income from investments, pay  a lower effective tax rates than firefighters, police officers, and teachers. As the Post article explains, “Anyone making more than $34,500 a year in wages and salary is taxed at a higher rate than a billionaire is taxed on untold millions in capital gains.” This growing inequality has prompted many, including billionaire businessman and philanthropist Warren Buffet, to urge lawmakers to raise the capital gains rate. As Buffet explained in a New York Times op-ed last month, because most of his income is derived from investments and not wages, he ends up paying taxes at a much lower effective rate than his secretary. “My friends and I have been coddled long enough by a billionaire-friendly Congress,” he wrote.

But the candidates vying for the Republican presidential nomination don’t seem to be at all concerned about these startling trends in inequality. Many, in fact, have vowed to lower capital gains rates even more if elected. And they have powerful allies in Congress, including Rep. Paul Ryan (R-WI), the chairman of the House Budget Committee, who has proposed eliminating capital gains taxes altogether. The argument from them is that capital gains taxes are a form of double taxation and more importantly, that they curtail economic growth, which is bad anytime but especially during a recession. Both claims, however, are not supported by the evidence.

The “double taxation” argument is disingenuous for several reasons. In the case of capital gains related to buying and selling securities for instance, the tax only applies to the gain (or profit) an investor sees, not the original amount he or she has invested. What about the tax on dividends that some corporations give to shareholders? Corporations have to pay taxes on their profit and then again on dividends that they issue. That sure seems like we’re taxing the same money twice. Not only is that inefficient and unfair, but it might also discourage firms from issuing dividends. “A double tax is a destructive and unfair way for the government to gain additional revenue,” longshot presidential hopeful Newt Gingrich wrote in 2009.

This too oversimplifies things. As economist Leonard Burman explained to Washington Post readers recently, “lots of corporations manage to avoid much of their corporate tax and many capital gains are on assets other than corporate stock.” More and more, many large corporations are getting away with paying almost nothing in taxes. A recent study by the Institute for Policy Studies shows that some companies pay more to their chief executives than they do to Uncle Sam. And as the Tax Policy Center’s William Gale has explained, “While the emphasis and public discussion has been on the so-called double taxation of corporate income, the non-taxation of corporate income is probably even bigger.” So yeah, it’s double taxation … but only if these companies were paying their fair share in taxes to begin with.

Nevertheless, the idea of double taxation intuitively seems unfair to most people. But it’s central to our tax collection system. All wage-earning Americans pay income and payroll taxes. (Eventually, when we make a purchase, we also pay a sales tax. That’s a lot of different taxes to be paying on the same amount of wages.)

But what about the impact on investment? As another unlikely presidential contender, Herman Cain, has said, “The capital gains tax represents a wall between people with money and people with ideas.” Lowering the rate, or eliminating it entirely as Cain and others would like to do, will spur unparalleled investment and job creation. Or so the argument goes.

The argument makes sense until you consider that everyday trading in the securities market does not have much of an impact on investment or jobs. If Warren Buffet buys, say, 1 million shares of Bank of America stock, and sells the shares when the price is higher, none of that money goes to the Bank of America because such securities transactions almost always occur in the secondary market and therefore have little impact on a company’s ability to grow and hire additional workers.

In fact, the connection between jobs and capital gains taxes seems to go in the opposite direction. Ultimately, any tax cut that is not offset by spending reductions or revenue increases elsewhere has the effect of growing the deficit. “As the government borrows to finance the deficit, it shrinks the pool of saving available for investment,” notes the Center for Budget and Policy Priorities. The more the government borrows, then, the less investment capital available to business looking to expand and hire additional workers. Lowering the rate that millionaires and billionaires pay without having a way to pay for it will actually do more than increase inequality. It will stymie job creation.

That does not mean that we should arbitrarily raise rates on capital gains. We have to encourage investment and so, perhaps, we should treat different sorts of investment differently. A person who invests in a plant should have his or her gains taxed differently than someone who runs a hedge fund. But something should be done to address to issue in a way that will have the greatest impact on the middle class and not just benefit those fortunate few who owe some of their wealth and success to, as Burman argues, luck.