Is Mitt Romney’s federal income tax rate – 14% in 2011 – too low or too high? As most of Romney’s income comes from his investments, the answer depends largely on how capital income should be taxed.
Economists have made a number of arguments both in favor of and against taxing capital income. Many of these arguments rest on the impact of such a tax on investment, economic growth, and tax avoidance.
In my view, however, the most compelling argument made by opponents of taxing capital income is that it’s simply unfair.
Consider two individuals – call them Mr. Spender and Ms. Saver. They have the same job and the same qualifications, and they each earn $100 in wages today. They pay tax on that income – let’s say the tax rate on wages is 20%, so they’re left with $80 each after taxes. Both face the same choice: Spend the entire $80 today or put part of it in the bank and let it earn interest.
Notice that there’s no inequality here. Mr. Spender and Ms. Saver have the exact same opportunities available to them. They can spend $80 today, $80 plus interest in the future, or some combination of the two. They may end up in different places if they make different choices based on their preferences. But most of us probably wouldn’t consider that the kind of inequality that policy makers should worry about.
Let’s now assume that – true to their names – Mr. Spender spends his $80 today, and Ms. Saver puts her $80 in the bank. Let’s say the before-tax interest rate is 10%. If capital is not taxed at all, then Ms. Saver gets to spend $88 next year.
But wait, you might say. Ms. Saver just earned $8 in income and didn’t pay any taxes. Shouldn’t she pay 20% on the $8 and get to keep only $6.40? After all, the Mr. Spenders of the world are paying 20% on their wages.
But let’s step back and think about it with a longer-run perspective. Mr. Spender and Ms. Saver are identical in every respect except for the choices they made. Over his lifetime, Mr. Spender pays $20 in taxes. If we tax Ms. Saver on her interest, she ends up paying more than $20 over her lifetime – i.e., she pays $20 on her wages at the same time as Mr. Saver, plus she also pays $1.60 on her interest later.
Is it fair for two people with identical opportunities to pay different amounts in taxes over their lifetimes? Fairness is subjective, and economists don’t have any special expertise in deciding what is fair. So, I can’t answer that question for anyone else. But as a citizen, I certainly think it’s unfair – and I suspect many others would agree.
Could there be good reasons to tax capital income? Perhaps – but, at least in my view, fairness is not one of them.