Wednesday, February 15, 2012

Why Not a Progressive, and Separate, Tax on Capital?

This idea is the result of a curious mashup of reading about the Ming Dynasty, industrial revolution, state collapse, and poverty, but it seems to me ideal to tax capital and labor separately, and progressively, at the same rates.  It baffles me that this isn't suggested more often.  Why not treat capital income completely separately from labor income, each with equal progressive rates (corporate taxes are already nominally taxed at progressive rates, I have individual investors and sole proprietors in mind here)?

There are numerous benefits from this.  First of all, it would encourage people to diversify their assets.  An individual receiving most of their capital gains from illiquid assets like housing is severely disadvantaged relative to someone that receives a portion of their gains in smaller amounts through dividends and stocks.  Divesting illiquid assets such as housing would be disadvantaged since this would lead to high tax liability in one year relative to a regular income stream from other capital assets.  This would encourage money being put to work in productive enterprises rather than tied up in bidding land prices up.

It would encourage low income households to invest at least some of their money since this would enjoy a separate tax schedule and presumably standard deduction.  While a poorer person may not gain much tax advantage from the 15% capital gains rate, they gain a significant advantage if interest income from stocks and bonds as well as capital gains would be effectively untaxed due to existing on a separate rate.  They would face an effective marginal rate of 0.  This also avoids the perverse incentive of the current tax system that encourages the already well off to invest ever more of their wealth, gaining a greater tax advantage with each step, allowing them to pull ahead of the less well off.

In addition it would avoid the current bias of our system towards capital.  Currently, someone that enjoys a high labor income due to investment in their own human capital faces much higher tax rates than someone that primarily invested in capital.  The reasoning behind this looks increasingly thin to me as we gain better knowledge of how the economy worked during the industrial revolution, it increasingly seems that capitalism is a misnomer and that higher incomes among the labor force and linked small scale investment was a larger driver of change than large scale investors and capitalists, including the bourgeoisie (incomes were higher for industrial workers than for artisans, the earlier assumption was that wages were driven down by people being driven off the land which the records don't back up).  This makes a lot of the classical assumptions questionable, the evidence increasingly seems to be that the important competition is that of new firms originated with small investors rather than the Schumpterian sense of competition for outsize returns by a few powerful firms and large investors.  The policy implication is that it is more important to favor labor and new capital formation and that capital shortages are exceedingly unlikely to exist in the real world. 

Separating capital income from labor income means that someone that gets a higher wage will face a comparable tax rate as someone that receives their income from capital.  In addition, a successful wage earner will have an incentive to invest in capital as well since this would be taxed on a separate schedule (and vice versa).  It would also mean that large concentrations of capital face higher marginal rates advantaging hungry new start ups (to some small degree).

That's all I have time for.  I have no doubt there are many complications, there are some big problems with being able to label one form of income another.  However, these problems would mostly exist for new firm start-ups still operating as sole proprietors, not for very high incomes.  Some shrinking of existing brackets would also be necessary since most high earners are currently being taxed on both labor and capital income under current income taxes.  As a separate issue, current tax rules with their myriad deductions would likely interact poorly with this which would require trimming some of these deductions (which we need to do anyway, but it's a separate topic).  Of course, more narrowly we could just make the cap gains tax progressive, but I have a big problem with favoring cap gains over dividends.  There are also some housing issues that I'm aware of.

Anyway, this is a half thought through idea but multiple lines of evidence are converging to make me think that our current system is fairly ruinous from a long term economic standpoint.  Capital needs to be taxed at much higher rates than it is today but it also seems important to encourage capital formation among lower incomes and among people who are currently primarily invested in labor.  The current system disadvantages groups such as doctors and other professionals too much relative to groups like bankers, separating income into two separate schedules would eliminate many of the disparities in current tax rates between nominally equal income groups.

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