Improving capital gains taxes

As I’ve mentioned, I think the tax code could be improved. In a departure from my usual style, this post fleshes out some fairness-based arguments for one of my favorite changes.

(I think that this proposal, and many of the arguments in favor, is old. Wikipedia quotes Joseph Stieglitz making the basic point in Economics of the Public Sector.)

The policy

I’m advocating a package with 3 parts:

  1. We should significantly increase capital gains taxes by taxing it at the same rate as ordinary income.
  2. If an investor makes money one year then loses it later, we should give them their taxes back.
  3. We should only tax excess returns above what you get by putting your money in a savings account.

Justifications

1. Why have a higher tax rate?

The simple answer is “most Americans think rich people should pay higher capital gains taxes.” It looks unfair for Warren Buffet to pay a lower marginal rate on income than a working class family. But there are other great reasons.

One is that it can be really hard to distinguish “income” from “investment income,” and many rich people misclassify income to pay fewer taxes. Some of these egregious loopholes lose a lot of tax revenue. But if we tax capital gains at the same rate as other income then these loopholes disappear and the whole system gets simpler.

Another is that rich people do a good job of identifying profitable investment opportunities; normal people can’t participate effectively in those opportunities, and so the rich get richer faster. That feels like a fact of life, but it’s actually pretty easy to change. A capital gains tax effectively lets everyone benefit from every investment opportunity.

2. Why pay investors back when they lose money?

When an investor makes money they pay taxes. But when they lose money they never get a check back. The government effectively participates in the returns but not the risk.

(Investors do get tax deductions they can use once they’ve recouped all their losses, but much of the reason people are afraid to lose money is that they might never make it back.)

This discourages investors from taking on risk and encourages them to push the risk onto other people. Combined with the proposed increase in capital gains rates, it seriously discourages uncertain long-term investments and probably reduces growth.

In addition to sounding a lot like “Heads I win, tails you lose,” I think this policy probably loses the government money.

Why? The risk of going broke pushes investors to be more conservative and causes them to have much less taxable income—which is bad for both them and the government. But because very few investors actually end up going broke, the government doesn’t save much money at all. We’ve managed to get the worst of all worlds.

(That’s coming from a pretty rough BOTEC. If the intuitive case actually depends on that calculation, I should check more carefully.)

The new alternative effectively makes the government a non-voting partner in every investment, sharing in both risk and returns. That make the system more fair, puts us all on the same team with aligned incentives, and makes everyone richer. Instead of discouraging rich people from finding opportunities, it motivates them to make bigger bets so that they can give everyone a share.

3. Why adjust the initial investment using the risk-free rate?

When I put $1,000 in a savings account, I get $2,000 in 30 years because “money now” is worth twice as much as “money later.” Everyone—rich and poor, household or government—can make the substitution at that same rate. We should only tax your savings account if we specifically want you to spend your money immediately rather than later.

It’s actually worse than that: over the last few decades all of my “earnings” from a savings account are just keeping up with inflation, so I’m paying taxes without getting any richer at all. The market expects this to keep happening for the next 30 years, so this isn’t a weird corner case.

Instead, we should tax the difference between what you earned and what anyone could have made by just putting the same amount of money in a savings account. That is, we should tax the stuff that is actually income, i.e. when you are actually doing work, taking risks, or exploiting connections.

The best argument for taxing savings is that rich people save a higher percentage of their income and we want to spread the wealth. But if that’s our goal then we can just raise income taxes on the richest people—we don’t need to take a convoluted approach. Justifications about “keeping the money moving” are based on a misunderstanding—when I “save” money I’m lending it to someone else who will use it immediately.


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