Economics, Pethokoukis

Paul Ryan is making the wrong argument about investment taxes

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One of the worst aspects of the recent Obama tax hike was its treatment of investment income, raising capital gains and dividend tax rates by 60% (when you include the PPACA 3.8% surtax). The tax increase a) worsened further the tax code’s anti-growth bias against investment, and b) made the US even less globally competitive when it comes to taxing capital. Pro-growth tax reform should reverse those distortions, not exacerbate them. Studies suggest shifting to a consumption tax where households would be taxed only on their wages, not on any income from saving, such as interest, dividends or capital gains, would boost economic growth.

Keeping that in mind, read Rep. Paul Ryan’s answer to a question at a Wall Street Journal breakfast on Wednesday:

Joe Minarik, Committee for Economic Development: Number three, rates matter. OK, 1986 tax reform got you a 28 percent top rate by eliminating the preference for dividends and a much smaller preference at the time – (cross talk, inaudible) – yes, at eliminating the preference for capital gains. Are – if you don’t do dividends and capital gains, you are not going to get a top rate at that level. Are dividends and capital gains out of balance?

Rep. Paul Ryan: Yeah, I’ve never really – I mean, I think there is a good argument to have between ordinary income and capital income and how capital income is risk-based income and helps growth. But if your rates are getting low enough, then the difference between the two is not as severe with respect to growth effects. So I think that debate ought to be open with respect to tax reform.

Ryan’s answer sort of sounds like he’s open to the idea of eliminating the tax preference for capital gains and dividends, equalizing those rates with those on labor income. This has been a big tax reform goal of liberals. Now presumably Ryan would agree to this only if the top marginal rate on labor income were lowered substantially. But even if the top rate on labor income was lowered to 28%, it would still mean raising taxes on “risk-based income” even further.

About the only way to salvage this idea would be to do what innovation expert Clayton Christensen has recommended.Taxes on short-term investments would continue to be taxed at personal labor income rates. But that rate would come down the longer the investment is held, finally reaching zero after five years or so. As Christensen explains:

Federal tax receipts from capital gains comprise only a tiny percentage of all United States tax revenue. So the near-term impact on the budget will be minimal. But over the longer term, this policy change should have a positive impact on the federal deficit, from taxes paid by companies and their employees that make empowering innovations.

5 thoughts on “Paul Ryan is making the wrong argument about investment taxes

  1. Even if taxed at the same rate as ordinary income, capital gains still enjoys a tax advantage over other forms: the tax is deferred until the gain is realized. A savings account with a 5% yield taxed annually returns 42.4% net at a 28% marginal rate. A capital gain asset that grows at that rate for ten years has a cumulative after-tax yield of 45.3%, 6.7% more than the bank account. At a 39% tax rate, the advantage is 38.4% to 35%, a bonus of 9.5%.

    Also keep in mind that the more the tax rate on capital gains rises, the risk goes down. This is because the government reduces the tax on your other income by the marginal rate times the amount of your loss.

    • “Even if taxed at the same rate as ordinary income, capital gains still enjoys a tax advantage over other forms: the tax is deferred until the gain is realized”

      Isn’t that the case with all forms of income? There’s no tax until the taxpayer has put the cash into his or her pocket. The treatment of investment income is no different than it is for someone earning a bonus to be paid in the following year; the tax is due when the taxpayer gets the money and not merely when they have a piece of paper that says they have income.

      “Also keep in mind that the more the tax rate on capital gains rises, the risk goes down.”

      Again, wrong. The risk of losing one’s investment is related to the worthiness of the investment and not the tax treatment.

      Mind you, I think capital gains should be taxed as is other income, without a break, but I hate when people offer up such lame and easily discredited arguments.

  2. Proponents of raising taxes on capital need to answer the most fundamental economic question: When you raise taxes on something you get less of it. Why is it you want fewer capital gains?

    • It isn’t that I want less in capital gains, I see no justifiable reason for treating capital gains income differently than income from other forms. Income is income and a dollar of income ought to be taxed at the same rate as every other dollar of income… no matter whether it’s the first dollar of income you’ve earned or the millionth dollar you’ve earned, whether it comes from buying lottery tickets, getting up at 5 in the morning to lay bricks or sitting in an office trading stocks. To do otherwise is social engineering through the tax code, something every good conservative should be opposed to doing.

      As to whether that would result in smaller capital gains income, a revenue-neutral lowering of tax rates – per economic theory – would result in more of the other forms of income. Why should we worship investment income if doing so penalizes those who produce income through other means?

  3. “Isn’t that the case with all forms of income?”

    No, actually it isn’t. Zero-coupon bonds are taxed on the accumulated interest every year, even though the bondholder does not receive a penny until the bond reaches maturity or is sold. US savings bonds have a special exemption from the rule. Although EE and I bonds accrue interest periodically and may be redeemed at any time by the holder, the tax is deferred until redemption.

    “The risk of losing one’s investment is related to the worthiness of the investment and not the tax treatment.”

    I never meant to say that the probability of the investment going south is dependent of the tax treatment. I was thinking rather of the maximum downside – though I was still wrong for a different reason, namely that long-term capital losses are allowed to offset ordinary income (albeit to a limited extent), so changes to the long-term capital gains rate don’t change the tax savings generated by a capital loss. Rather, changes to the ordinary tax rate do.

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