Wednesday, August 10, 2011

Capital Gains Taxation: Contra Landsburg

Steve Landsburg has a recent post on capital gains taxation in which he makes one odd but arguably legitimate point while missing two other and, I think, more important ones. The result is that he gets the wrong answer to the question of how capital gains ought to be taxed. 

His central claim is that the tax rate on capital gains ought to be zero—more precisely, that if it is zero, taxpayers with capital gains will end up paying as taxes the same proportion of their income as those with other forms of income. It's not as screwy a claim as it seems at first; here is the argument, in my words not his. It assumes a 50% income tax, no capital gains tax.

Taxpayer A earns $1000, pays $500 in taxes, has $500 left to spend on her own consumption—half as much as she would have in a world without taxes.

Taxpayer B earns $1000, pays $500 in taxes, uses the remaining $500 to buy an asset which then appreciates at 5%/year for the next twenty years; for simplicity we ignore compounding. B then sells the asset for $1000, which he can spend on himself. 

In a world without taxes, B would have had $1000 to invest and so would have ended up with $2000. Hence A and B have both paid the same tax rate—50%. The only difference is that A chose to take her (taxed) income in the form of $500 of consumption in (say) 1990, B his (taxed) income in the form of $1000 of consumption in 2010. Each ended up with half the consumption he would have had in a world without taxes, so is really being taxed at 50% on all income. Hence, Steve argues, the fair capital gains tax rate, the rate that treats capital gains like other income, is zero.

What is being described here as capital gains looks an awful lot like interest. B could, after all, have deposited his $500 in a bank at 5% instead of buying an asset that appreciated at 5%. From an economic point of view, interest is what people are paid to postpone their consumption, making resources available for other people to use productively. It's not obvious why interest should not count as income and be taxable as such.

No doubt some of what shows up as capital gains is in fact implicit interest, but I don't think that is the natural way of looking at most of it. I think it is more accurately viewed as the return from a particular form of skilled labor. A speculator/investor spends time and effort figuring out what firms and what assets are going to increase in value and investing in them, improving the allocation of capital, nudging markets a little closer to efficiency, and being rewarded, assuming he does a good job, with income above and beyond the normal return on capital. I do not see why the income from that form of labor is a less suitable subject for taxation than income from digging ditches. And since the return is not a fixed proportion of the amount invested, as in Steve's case, but a function of the time and effort spent investing it, Steve's argument for implicit taxation does not apply.

There is, however, a serious problem with treating capital gains as ordinary income—much of it, perhaps most of it, is not income at all.

To see why, imagine that you buy a house for $100,000 and sell it, twenty years later, for $200,000. Over those twenty years, not only has the price of housing gone up, the price of practically everything has gone up, with the result that two dollars at the end of the period will buy about what one dollar bought at the beginning. Measured in nominal terms, by counting dollar bills, you have made a capital gain of $100,000 and will be taxed on it. Measured in real terms, by what those dollar bills will buy, you have made a capital gain of zero. Prices in our society trend up over time, so measured capital gains overstate—for long periods greatly overstate—actual capital gains.

Combine these two arguments and you have a simple conclusion. Capital gains ought to be indexed—measured in real rather than nominal terms, purchasing power not number of dollars. That done, they ought to be taxed as ordinary income.

27 Comments:

At 12:37 AM, August 10, 2011, Blogger Milhouse said...

Last I checked, that is indeed how Australia taxes capital gains.

 
At 12:54 AM, August 10, 2011, Anonymous Anonymous said...

A benefit of not indexing anything to inflation is that you get less inflation, because taxation (which withdraws spending power from the economy) automatically rises with inflation.

 
At 5:17 AM, August 10, 2011, Blogger Phil Birnbaum said...

That argument applies only to capital gains on non-productive assets, like, say, art or baseball cards.

Capital gains on stock are in large part the result of retained earnings. Corporation A is worth $100. It earns $10 in profit, pays $3 in taxes and $2 in dividends. It retains the last $5.

The corporation is now worth $105. The owner has paid his fair share of taxes (say, 30%). That extra $5 is his after-tax profit. But if you require him to pay capital gains tax when he sells the company for $105, you are double-taxing him on the profit.

 
At 5:23 AM, August 10, 2011, Blogger Phil Birnbaum said...

Here's another example where capital gains tax is not double taxation, but it's EARLY taxation.

Company A is worth $100. It then discovers a cure for cancer. However, the cure needs lots of work, and FDA approval. It won't be ready for 20 years. In 20 years, it'll start making a stream of huge profits until the patent expires. The present value of those profits is $1000. When those profits are realized, there will be corporate tax of $300. Therefore, the present value to investors is only $700.

As soon as the discovery is announced, the stock goes from $100 to $800. If you sell the stock, you have to pay tax on a capital gain of $700.

But that $700 isn't real money. It's the present value of future after-tax earnings. Since it's the present value of AFTER-TAX earnings, it should itself be considered an after-tax gain. To tax it is, again, double taxation.

Actually, it's not really double taxation. In 40 years, after all the profits are realized, the value of the stock will go back down to $100, and the holder will incur a capital loss of $700. If that is tax-deductible, then it's a break-even ... but only in nominal terms. By taxing the immediate capital gain, the tax system has demanded its tax on $700 forty years too early.

If tax deferred is tax saved, the opposite applies too. The tax system has double taxed the owner of company A by 40 years worth of time value on the tax paid in advance.

 
At 6:06 AM, August 10, 2011, Blogger J Storrs Hall said...

Actually, none of these people should be taxed at all. The vast majority of tax receipts are wasted, in the sense of being used primarily to buy votes. Furthermore, the way this is done contributes largely to social pathologies, including the destruction of the cultural values such as individual industry and responsibility.

Morally, discussing the details of taxation without referring to its greater evil is like discussing whether a rapist should wear a condom, without etc.

 
At 9:11 AM, August 10, 2011, Blogger David Friedman said...

Anonymous has it backwards. If you don't index capital gains, or for that matter ordinary income tax, you get more inflation--because inflation increases tax revenue without requiring an explicit tax increase, which governments like. If you do index your tax system, then inflation doesn't change the real value of taxation.

 
At 9:15 AM, August 10, 2011, Blogger Æternitatis said...

@anonymous at 12:54 AM "A benefit of not indexing anything to inflation is that you get less inflation, because taxation (which withdraws spending power from the economy) automatically rises with inflation."

I do not understand this argument. How is not indexing capital gains (or anything) to inflation going "to "get less inflation"? I think someone once said that "Inflation is always and everywhere a monetary phenomenon." If inflation is a monetary phenomenon, it is within the control of the monetary authority, i.e., the Fed. Given that (1) without indexation inflation will lead to increased tax revenues, (2) the interest of the political branches (i.e., the President and Congress) in increased tax revenue, and (3) the considerable (if fortunately these days somewhat limited) influence of the political branches over fed policy, it seems to me that if you are either anti-inflation--which I generally am--or anti-tax/spending--and I'm most definitely am--one would favor indexation.

@ Prof. Friedman:

I am inclined to think that you are right about indexing and taxation. But doesn't your/our position imply that interest income should also be indexed to inflation (or perhaps more elegantly, but equivalently, there should be a deduction for the inflationary, real depreciation of nominal assets held, such as bank accounts or bonds)? That implication hardly defeats the argument, but I've never heard or read it.

 
At 10:45 AM, August 10, 2011, Blogger Julien Couvreur said...

If you tax capital gains (indexed) as income, what is the impact on risk-taking?

It is important to separate multiple factors in capital gains: interest rate (which reflects time preference and deferred returns), profits/losses (which reflect entrepreneurial risk), money supply changes.

Which of those three are you trying to tax? How do you separate them? Where do you get the signals to tell them apart (in particular, the interest rate is polluted by central bank intervention)?

If you tax profits, what happens to losses?

 
At 11:24 AM, August 10, 2011, Anonymous Anonymous said...

"If you don't index capital gains, or for that matter ordinary income tax, you get more inflation--because inflation increases tax revenue without requiring an explicit tax increase, which governments like."

You mean to say you get more spending.

"I think someone once said that "Inflation is always and everywhere a monetary phenomenon.""

Someone was wrong. If the government is overspending/undertaxing, inflation is inevitable.

 
At 11:26 AM, August 10, 2011, Blogger $9,000,000,000 Write Off said...

Its odd that you see capital gains as the wages of services and not the return on capital, the return on risk, and inflation (the last is an old complaint about CG taxes).

Most people actively involved in exploiting their own capital live year to year off the profits (distributed or salaried) taxed as OI, not from selling chunks of cap gain assets, I imagine.


Also, the realization requirement means that 5% annual appreciation in an asset will far exceed 5% interest paid by a bank even if taxed at the same rate.

 
At 11:28 AM, August 10, 2011, Blogger Gordon said...

This matter quite interesting because it seems to pit economists with similar free-market sympathies against each other. For example, Scott Sumner, in his TheMoneyIllusion blog, has made the same point as Landsburg; yet David seems convinced that it is incorrect. David says "it is not obvious" that interest should not be taxed as income, but that is indeed what Landsburg seems to believe, based on another post of his that is linked to in the post David discusses. The point that Landsburg and Sumner are making (I think) is that consumption of future goods should not be more highly taxed than that of present goods. I don't quite see what David's response to that would be.

I am skeptical of David's argument about capital gains reflecting some sort of labor. I suspect that the majority of capital gains are paid by persons who engage in no such labor, but hire others to do it for them. Those others earn an income from that labor that is taxed to *them*. If a person decides to engage in his own "capital-goods" labor, why should he not be taxed on the market wage for that labor, rather than the gain produced?

 
At 1:17 PM, August 10, 2011, Blogger Glen said...

Don't investors as a class - by definition - end up getting "the normal return on capital"? Any added value of the work people do to try to get "above average returns" is positive for the ones who do manage that but negative for those that don't, netting out to zero, so shouldn't the taxes on their "income" from that activity also net out to zero?

And what about investments for which the return is a fixed proportion of the amount invested? Does your argument suggest that at least they shouldn't be taxed?

 
At 3:19 PM, August 10, 2011, Blogger David Friedman said...

"If you tax profits, what happens to losses?"

If you tax capital gains, it should be the net capital gain. That eliminates, on average, the tax on gambling winnings, since they cancel with gambling losses.

 
At 4:10 PM, August 10, 2011, Anonymous Steven E Landsburg said...

David: A large part of your argument seems to be that my argument applies to interest as well as capital gains, and it's "not obvious" why interest shouldn't be taxed as ordinary income.

I agree that my argument applies to interest as capital gains, and have said so many times, in other blog posts and in print.

Because that argument applies to interest, I reject the assertion that it's not obvious why interest shouldn't be taxed.

You do have a point when you observe that some capital income is a reward to the labor of seeking out good investments, but then at the very least the "interest portion" of the gains should be untaxable.

I should also mention that while I might have contributed something by finding new ways to express these arguments, the arguments themselves are not new. They permeate the modern literature on public finance; Chris Chamley and Ken Judd are key figures here.

 
At 7:36 PM, August 10, 2011, Anonymous Anonymous said...

Here's a rationale for not taxing capital gains. Let's say I have a security that pays me $100 per year in dividends. But then the dividend rate is increased to $200 per year. The value of the security therefore would double ("other things being equal"). (Assume we are talking about inflation-adjusted values, so that inflation does not come into the discussion.)

If I hang on to this security, the govt will continue to tax its income, meaning that the govt will also benefit from the higher dividend rate.

If I sell this security, I'll earn a paper profit, to which the govt will want to apply a capital gains tax. However, I make no gain by selling it, because I get some funds, but I forfeit the future dividends.

In this way, the capital gains tax is a pure tax on exchange. Warren Buffett is aware of this, which is why his preferred holding period is "forever."

My actual gain came from the improvement in the security, which caused a doubling of the dividend. This is an event that the govt can't tax, so they use the crummy approximation of taxing the "realization" of this gain at the time of the next transaction.

This "crummy approximation" is unnecessary. The people who serially own the security (through buying and selling) benefit from it, as a group, only through its dividends. The money received by any seller is offset by the money paid by the buyer.

Therefore, a more rational method of taxation is to tax just the dividends from the security. By doing this, the govt's benefit will be in exact proportion to the benefit accruing collectively to the various, serial owners of the security.

 
At 8:33 PM, August 10, 2011, Blogger econtiger said...

@ Prof. Friedman:

Glad to stumble on your blog, I should of checked it out a while ago.

Regarding Capital Gains, I enjoyed the post, that's a new perspective I haven't thought about before.

I would mention a commonly touted benefit of having lower capital gains, interest and dividend tax rates (to be clear, inflation-indexing them, but having still lower rates) compared to income taxes: it shifts taxation onto consumption and less on savings, thus shifting behavior and the national rate of consumption and savings.

A higher savings rate would likely lead to higher investment rates, in turn leading to higher productivity rates and thus a higher standard of living growth over time.

In terms of the fairness issue of treating capital gains as "labor-like" since it can be due to skill, for example of stock traders going closer to tax free, that is a tricky issue to me. I see a difference between a full-time stock trader versus a doctor who invests 10% of their income into an index fund, or who perhaps passively invests in a local venture capital fund.

One advantage of a national retail sales tax / VAT is it appears to deal with these issues. In the sales tax scenario, you can still reward savings and penalize consumption, and also avoid giving the stock trader a free ride so to speak.

I realize not everyone is on board with the goal of increasing US's savings rate (Bernanke: Global Savings Glut), and even if it is a goal, there are other ways to get there such as eliminating the home mortgage interest deduction.

 
At 11:50 PM, August 10, 2011, Anonymous Anonymous said...

"Someone was wrong. If the government is overspending/undertaxing, inflation is inevitable."

And why is that?

 
At 12:21 AM, August 11, 2011, Anonymous Anonymous said...

> Prices in our society trend up over time, so measured capital gains overstate—for long periods greatly overstate—actual capital gains.

The real prices for the consumption bucket trend lower, not higher. That is how we avoid Malthusian limit, duh!

 
At 12:52 AM, August 11, 2011, Anonymous Anonymous said...

"And why is that?"

Spending injects financial assets into the economy and taxes withdraw them. A mistake that monetarists make is thinking that money (especially base money) is a limiting factor. You can always borrow against assets, or sell to someone who can, so money doesn't matter. Contrary to popular belief, issuing bonds is no less inflationary than crediting bank accounts (commonly if inaccurately called "printing money").

 
At 1:39 PM, August 11, 2011, Anonymous Anonymous said...

"Spending injects financial assets into the economy and taxes withdraw them."

Do you're saying "dollars" == "financial assets".

 
At 1:40 PM, August 11, 2011, Anonymous Anonymous said...

* "So" not "Do".

 
At 4:01 PM, August 11, 2011, Blogger Glen Whitman said...

"You do have a point when you observe that some capital income is a reward to the labor of seeking out good investments, but then at the very least the 'interest portion' of the gains should be untaxable."

Is it possible, then, that the status quo has it approximately right? Exempting the "interest portion" while taxing the "labor portion" would imply that we should have a capital gains tax rate lower than the marginal income tax rate, but greater than zero. Given the current top marginal tax rate of 35%, the current capital gains tax rate of 15% could be justified on the assumption that labor contributes 3/7 (or about 42%) of capital gains.

 
At 10:43 PM, August 11, 2011, Blogger SheetWise said...

This is the absurdity of taxing income in a calendar year -- as if we are still living in an agrarian society, paying our tribute in wheat and corn that are subject to the seasons. If you accept the concept of a progressive tax on earnings within a calendar year, then any earnings that are not subject to the progressive tax appear to be a dodge. How can you have a capital gain if selling something for dollars will cost you the exact same number of dollars if you want to buy it back? The government even recognizes this in real estate transactions (to a limited degree, but obviously out of necessity). It's the dollars that are an abstraction, not the goods.

 
At 3:22 AM, August 12, 2011, Anonymous Andy said...

In Friedman's case the capital gains taxes would still have an advantage over regular income. Since the taxes are only paid upon realization of the gain they can still be far lower than income taxes over the same period even if they are at the same nominal rate.

 
At 2:00 PM, August 12, 2011, Blogger dWj said...

I agree with you and Steven Landsburg: we should index the cost basis for capital gains, but not at some proxy for the rate of inflation, but at a proxy for the "risk-free" rate of interest. Returns earned at that rate are simply, in any relevant sense, "interest", while returns earned in excess of that rate are attributable to skilled labor. (Inflation, in fact, is irrelevant.)

 
At 2:37 PM, August 12, 2011, Anonymous Anonymous said...

Skilled labor, that's a hoot. Someone who is comatose is the perfect capitalist since he isn't bothered by market risk. The actual capital allocation decisions are made by corporate management.

 
At 5:45 PM, August 18, 2011, Blogger Eric Rasmusen said...

There are a couple of very good comments above:

"Don't investors as a class - by definition - end up getting "the normal return on capital"? Any added value of the work people do to try to get "above average returns" is positive for the ones who do manage that but negative for those that don't, netting out to zero, so shouldn't the taxes on their "income" from that activity also net out to zero?"

and

"Is it possible, then, that the status quo has it approximately right? Exempting the "interest portion" while taxing the "labor portion" would imply that we should have a capital gains tax rate lower than the marginal income tax rate, but greater than zero."

For securities, capital gains are labor income for hardly anyone. They're just returns to saving and risktaking, and shouldn't be taxed. The number of Warren Buffets is small enough that we can ignore them. And, actually, those few are providng a public good by improving the accuracy of prices, so maybe the subsidy they should get balances their lack of taxation on their labor.

On the other hand, in real estate and non-publicly traded business, there's a lot of labor income masquerading as capital income.

Think about Schumpeter's Capitalist and his Entrepreneur. Oddly enough, it's the heroic Entrepreneur that we should tax more.

 

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