Capital Gains are Labor Income
There is an idea, eminently plausible on its face, that to tax the results of investment is to, in effect, to double tax income. The idea is prosecuted with great vigor here by Scott Sumner; I am going to freely quote his illustration of the effect.
“I earn $100 wage income, and face a tax of 50% on wage income and 20% on capital income. I have two choices, spend the money today, or save it for 14 years, in which time (at 5% interest) my money will double. I pay 20% tax on the capital income. So let’s look at the two options:
A. Spend the money today: $50 in consumption, vs. $100 in a tax-free world.
B. Save the money for 14 years: $90 in consumption, vs. $200 in a tax free world.
In case A I face a 50% tax rate. In case B I face a 55% tax rate.
Thus a tax on capital gains is distortionary; it pushes us to consume now, rather than consume later. This leaves us poorer in the long term. Given this distortion against delaying consumption, Mr. Sumner favors the substantial reduction or abolition of capital gains tax. He does, however, believe that capital gains which are simply disguised labor earnings should be taxed as income. This is something I agree with; it is absurd to give a massive preference to the earnings of the quite well off. I am certain Mr. Sumner would agree that it can be difficult to tell when something is labor earnings, and when something is capital earnings. I go further; I think it is impossible. There is no difference between in nature between passive and active investing, because no investment is ever truly passive. All investments require analytical labor, and therefore should be taxed as we do labor.
This is clear if we consider a CEO. The CEO’s job is to allocate resources within the company, and to decide which ideas should be done and not done. For this, he is paid a salary by the company, which is taxed as income. If the company were to tie the CEO’s pay to agreed upon metrics, such as profit, or stock price, this too would be taxed as income (although the company would be able to deduct it from their taxes under Section 162(m)). However, if they were to be paid in stock, provided they do not sell the stocks within one year, they face a 20% tax on their earnings. The duties remain exactly the same; it is only the tax which changes. This inequity may be justified if corporate tax fell entirely upon shareholders; however, that is not so. This paper estimates that 31% of the costs fall upon consumers, and 38% on laborers. Thus, the gap between the two represents a large transfer to capital holders.
That a CEO is essentially laboring when they allocate resources may be obvious; less so is the hypothetical retail investor who places the whole of their savings into a Vanguard mutual fund. However, I believe the activities to differ in scope, not in nature. Investing is allocating resources to the most profitable ideas, just as a CEO does. The Vanguard investor is analyzing the track record of the mutual fund and who is managing it (just as the CEO judges the talent of others), and what the returns are to investment in the funds will be. The investor must have reason to believe that stock prices will on average continue to increase. This is not a certain event! Stock markets can and do fail to keep rising; the Nikkei 225 still hasn’t risen above its peak on December 29th, 1989, for example. Even something as seemingly riskless as putting money into treasury bonds requires analyzing whether the government is likely to default, or to inflate away its obligations. Given the recent increase in inflation to 8% per annum, this is no trivial danger. It is no surprise that the safest investments, FDIC or NCUA insured deposits, pay effectively negative rates - .05% annually, little different (if more convenient) than digging a hole in the ground and letting it sit. Finding which enterprises will succeed and fail - or simply finding who is better at picking that than you - is not passive income; it is labor, and so should not be granted special privileges in our tax code.
This is not to say we should raise the capital gains tax to the same as income immediately, or without further reform. While the corporate tax has a muddied impact, it should be repealed so as not to chase people away from organizing corporations. Additionally, while an evergreen reform which should be done under any circumstance, the step-up in basis (which allows for heirs to pay no tax on the appreciation of assets once the owner dies - the asset is revalued at the current price) should be repealed. The amount taxed should be tied to inflation. It is preposterous that someone pay tax on entirely fictional gains; if capital gains is to be tax like income, so too should its brackets be adjusted like income. However, neither should we grant it favors - and I believe that to tax at a lower rate is to reward certain forms of labor more than others.
After discussing this rough draft with a friend, and emailing Scott Sumner, there were some thoughts and objections, which I thought quite interesting and worthy of comment. The first is whether or not I intend to let capital losses be fully deductible. I must plead uncertainty on what the effects of such a reform would be; the combination of equalizing rates and giving loss deductions is so out of sample that it may be irresponsible to draw a straight line from the elasticity of small changes to large changes. However, what we do know is that the permanent elasticity in response to capital gains changes is small, closer to zero than to 1. I draw upon this for a survey of the literature - it is somewhat old, and will update if necessary. Further, as suggested here (twitter paper summary because the original is hard to access) the substitutability of capital for labor is low, suggesting that increased use of capital actually isn’t all that important for economic growth. If capital is abundant, adding more can’t substitute for labor at a one to one ratio - thus, the marginal return is lower, and stimulating more investment is less effective.
The other suggestion was to defer all taxes on investment. When you receive income, you are not taxed if you invest it, and investment is a deduction against what you paid in taxes. Whenever you eventually withdraw the money, only then do you pay the tax upon it. The effect is to essentially change the form of the tax into a progressive consumption tax; a goal which I heartily endorse, as I believe it is the best system out there (if difficult to administer; a fuller discussion of it will have to be another post).
However, I believe such a system of tax deferral would run into a rather severe definitional problem. What is an investment? Many items have both an intrinsic use, and utility as an investment. It is obvious that a stock is an investment - few people are inordinately gratified by a printed stock certificate - but what about a house? Buying a house is both investing, and consuming housing. If we give a tax deferral to a limited liability corporation buying houses and renting them, but tax an individual buying a house for both income and capital gains, we’ve advantaged forming an LLC to buy a house. Perhaps you could resolve this by taxing the implicit rent that someone is paying by living in an LLC house; however, that sounds really expensive, and hard to resolve. Goods are heterogenous in quality. It’s not reasonable, and seems terribly expensive, to assess what the rent would be for every single house and condo in America, because the condition of them all vary. Still less would I want to resolve the question of what the implicit rent of hanging a painting on a wall is, or the implicit rent of a used car. Any such shenanigans to evade taxes would also be predominantly utilized by the well-off. There are also questions of what happens when you get income, pay tax on it, and then invest it. Do you get the tax back? Far simpler it would be, I think, to tax labor income as labor income, and make the tax code less advantageous to the wealthy.