Economics, Taxes and Spending

Why taxing capital income is unfair

Image Credit: Carbon NYC (Flickr) (CC BY-SA 2.0)

Image Credit: Carbon NYC (Flickr) (CC BY-SA 2.0)

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.

10 thoughts on “Why taxing capital income is unfair

  1. I would guess that a 14% income tax is a higher tax rate t is paid by 75-80% of all income earners.

    And when you tax capital gains, you are also taxing money that has been taxed earlier.

    • Whilst there are good grounds for eliminating C G taxes, it is not the case that the “money” has been “taxed earlier.”

      Think about it.

      Take a simple case of a piece of land, bought and held, sans income produced.

      Of course there is the tax on gain thatr represents nothing but “inflation” (debased legal tender). So, if there is to be a tax on C G it should be indexed. The “money” is not a constant.

  2. The same argument applies to sweepstakes and gambling winnings. Both Mr. Spender and Ms. Saver had the same opportunity to buy a winning lottery ticket. So it is likewise entirely fair that Mrs. Gambler, who won $100 million at Powerball, pays not one dime of those winnings for the military that protects her and the other two people in our example.

    • That’s an interesting point of view, especially considering that lottery winnings are not taxed in Europe – where they are tax happy about everything else.

  3. What seems to be constantly missed in these discussions is the issue of “Public Ownership” of the vast majority of U S business and financial enterprises. True, beneficial ownership is often indirect, via funds, ETFs, etc.; but, a lot is direct.

    Has that beneficial ownership and the motivations to attain it been beneficial to the structure of the U S economy – is it still beneficial?

    If it is beneficial should constraints be placed on the benefits to those ultimate owners by taxation or otherwise?

    Do the benefits to the economy from “Public Ownership” deserve precedence over considerations of “fairness” or “equality?”

    Does taxation on the accrued values of beneficial ownership impede transfers amongst the “public ownership” that lowers the benefits of ownership and decreases public participation?

    Do we want the least possible strictures and deprecation of public ownership; or have we reached a point the public ownership no longer provides essential value to the structure of the U S economy?

  4. This makes no sense to me at all. Suppose Ms. Saver chose to spend Saturdays working a second job instead of going to the mall and spending what she made during the week. Under your logic, the extra $10 she earned working on Saturday should not be taxed, because after all she and Mr. Spender had “identical opportunities” and she shouldn’t be “punished” for a choice she made.

    • No Glen, under this logic that would be another $10 in INCOME FROM WAGES and would be taxed at 20% Like other INCOME FROM WAGES. This simply means that Ms Saver is working more, and earning more, to get ahead more. And Ms. Spender could have worked extra as well but opted to take more time off. So the opportunity is the same, the action is different.

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