Why should investment income be taxed lower than wage income?

[RgrF]

This one's easy. Give those over a certain age or income level the lower rate and tax those under that age/ income level, Mr. Romney for example, at the earned income rate all other wage earners pay.

What's unfair about that?

[Ted King]

RgrF wrote:
This one's easy. Give those over a certain age or income level the lower rate and tax those under that age/ income level, Mr. Romney for example, at the earned income rate all other wage earners pay.

What's unfair about that?

You could do that, but what it would end up doing is primarily benefitting retirees with incomes significantly greater than that of a median income household -as I showed above: a married retired couple would have to have an income of over $70,000 before they would pay more than 15% for their income tax even if capital gains were taxed at the same rate as wage income, and that $70,000 is $25,000 more than the median household income (IOW, they would be earning $25,000 more than half the households in the U.S. and still only paying 15% income tax. Surely if they made more than $70,000 and had to pay a 10% higher tax rate because capital gains were taxed at the same rate as wage income, the hit to their disposable income shouldn't be too onerous since half the people in the country would be living on greater than $25,000 less than that couple.

The more I look at this, the more I'm convinced that there is not a good reason to tax capital gains at a lower rate - except if someone can convince me that investment income in general should be rewarded with a lower rate because they carry a greater risk than wage income does.

[mattkime]

i think the reason why investment is taxed at a lower rate is because its taxed on the sale of the item, rather than on withdrawal of the money. this lowers the friction involved in selling and buying stocks which initially seems like a good idea. the idea breaks down once people figure out a way to earn the majority of their income this way

[davester]

samintx wrote:
Div income taxed at 15% BUT your other income min of 28%?? that is how I'm taxed. Not all div are qualified.

That statement is bogus. Only the part of your income over $85k is taxed at that rate. If you have to worry that the 28% is a large fraction of your income then you are living on easy street. I often wonder if folks who make statements like this have no idea what the difference is between a marginal tax rate and an effective tax rate.

Actually, the whole retiree income argument is bogus. I think it is dredged up because it conjures visions of little old ladies barely able to make ends meet. That is false. The retirees that are in high tax brackets purely due to unearned income are rolling in money. The capital gains special tax breaks are aimed 100% at the rich. Also, the huge break on capital gains was originally intended to incentivize investment in the US economy. It never had anything to do with retirees. The problem with that tax break is that it has been proven not to work for this purpose. The definition of capital gain is so broad as to render the term almost meaningless. It basically amounts to "if you work hard for your money you get taxed at standard rates, but if you use financial speculation to earn your money you get preferential treatment. This is the most regressive tax structure that exists.

[Ted King]

mattkime wrote:
i think the reason why investment is taxed at a lower rate is because its taxed on the sale of the item, rather than on withdrawal of the money. this lowers the friction involved in selling and buying stocks which initially seems like a good idea. the idea breaks down once people figure out a way to earn the majority of their income this way

I don't mean to be critical of your comment in any personal way, but "friction" in this context sounds like a euphemism that a securities trader would use to sort of hide the fact that what he's really only talking about is that it costs him more money. I can't believe there is logistically more involved in selling investment and getting the capital gains if the rate is 15% compared to 28%. But maybe what you are getting at is that people would be less likely to invest in the first place if the return was reduced by higher taxes. But savings have to go someplace, so I'm not convinced on the surface of that argument if that is indeed what is being alluded to by "friction" here. What does a lower rate on capital gains do for the economy as a whole that makes up for the inequality in tax rates between investment income and wage income?

[JoeH]

Well "friction" is a term a theoretical economist would use. They model the flow of money using some of the same formulas as physical scientists and engineers use to model fluid flows. It is part of their attempts to make economics more quantitative. On a broad level it works, in practice the results of this kind of modeling are qualitative. Where it breaks down is when used to justify various economic policies such as taxes. It is not a simple thing like opening a valve and therefore improving flow of water.

For this specific case, "friction" can describe the difference in how the money involved in the investment "flows" through the economy compared to other uses of money. In someone's wallet, it might get spent on something at a store, the store uses that to pay staff or a supplier, and so on. In the process it "flows" from one point in the economy to other places. An investment stays in one place for a while, it only flows to somewhere else when cashed in. In the economic models this can be simulated by a higher "friction" coefficient representing an average of multiple investments being made, held, and then sold over a period of time. Changing that value is what tax changes are intended to do in the real economy, but there is no exact equation that describes if that will work or be the best way to accomplish the goal.

[Ted King]

Deleted this post after realizing something after rereading JoeH's post.

Last edit, I hope: Oops, I deleted thanking JoeH. for his explanation.

[Ted King]

JoeH wrote:

An investment stays in one place for a while, it only flows to somewhere else when cashed in. In the economic models this can be simulated by a higher "friction" coefficient representing an average of multiple investments being made, held, and then sold over a period of time. Changing that value is what tax changes are intended to do in the real economy, but there is no exact equation that describes if that will work or be the best way to accomplish the goal.

One thing I definitely do not see in this rational for lower capital gains taxes is that it would justify the lower rate for equity managers getting a lower rate on their labor.

It seems like the effort to keep capital gains flowing rather than stay locked up as investment has the affect of discouraging long term investment. That is, investors are more likely to look for short term gain, pull the money out and look for the next short term gain. It seems like it encourages investors to go into riskier investments in a manner that is more likely to lead to bubbles in markets. Does the modeling take that into account? Is there empirical evidence that reduced capital gains taxes actually have an overall beneficial effect on economic activity?

[JoeH]

That is where it starts to get tricky. You have to check the source of material used to justify a position for or against a policy, the models created to support one often incorporate a bias of the economist.

Basically, lobbyists successfully argued that equity managers should get the same treatment. As far as I can tell there is no economic research that supports this rationale, they just managed to convince enough lawmakers that it should.

As for the impact on the low capital gains rate on long term investment, the ones who argue for it also seem to be in the same camp that believe in the Laffer Curve applying. Yes, that works on a qualitative level when marginal tax rates of 70%, 80% or more are involved, but there is little empirical or theoretical evidence as to when it no longer applies. The benefits from empirical research also appear to fall off after a while once investors adjust their strategies. In any case, the proponents argue that the greater mobility of money in the economy provides benefits that outweigh the negatives of reduced long term investment.

There are models showing this approach leading to market bubbles, and of course ones from the other side showing that is doesn't. Empirical evidence seems to be showing that at current tax levels decision making by many investors is not influenced much by the difference between regular tax rates and the 15% special rate for capital gains. As large investors at that level will just reinvest most gains, the proceeds usually don't actually get into the higher money velocity consumer market, so it is not clear just how much benefit the low capital gains rate does have on the overall economy.

Now speculators as a sub-class of investors are a different breed. They want to cash in on small changes in value frequently. Up to a certain level economic models do show a benefit in stabilizing prices over a period of time at a slight extra cost to the economy. But models do show if speculation becomes predominant, it can definitely lead to bubbles. What the models don't show is how to determine what level of speculation in a market is good, and when it is too much. At an empirical level we can see an example of this in the oil and related markets. Years ago most buyers and sellers in these markets were suppliers and end-users, with an estimated 20-30% speculators. Prices were relatively stable. Now it is estimated that speculators comprise 70-80% of the market, prices are volatile and currently high and rising. How this all works out will provide researchers lots to argue over, in the meantime we get to go along for the ride.

[Ted King]

Rewarding inventors with patent protection for creating devices that enrich most people's lives significantly is something I'm pragmatic enough to say is okay - even to the point of the inventor amassing a fair bit of wealth (at least for a number of years). I'm generally pragmatic about things; if it were a crystal clear case that lower taxes on capital gains income than on wage income generally has a beneficial affect, then I wouldn't be against it even if there were some - not extreme - accumulation of wealth for some individuals because of it. If everybody is clearly better off for it and some people get a bit better off than others because of the economic mechanism involved, then I guess I can pragmatically accept the inequity of someone getting a lower tax rate for "pushing money around" compared to some guy pushing asphalt around to make our roads.

But... it sounds like the empirical evidence is murky - that the interpretation of the evidence depends a lot on assumptions that are made and fed into the models and the assumptions may be overly influenced by ideology. In that case, the pragmatic justification for the lower rate on capital gains isn't at all clearly made to my way of thinking.

And there is a kind of non-monetary "cost" that I imagine the economic models don't include because it's a judgment that is probably intrinsically nearly impossible to quantify. That is the social/moral "cost" of inequality between the rate that someone getting income from labor may have to pay compared to someone who gets their income much more heavily from capital gains. If there isn't a clear pragmatic justification for that disparity then I think the social/moral cost tilts the table in favor of not taxing the two different kinds of income at a different rate. I suppose that someone could argue that it is the highest income earners who are favored by the lower tax rate on capital gains, but that it is still fair for them to pay a lower rate because they pay such a high percent of the income taxes taking all income into account. I would say that that is an argument for something like a flat income tax rate rather than a good rationale for carving out an "exemption" of sorts in the form of capital gains tax rates. (A flat tax being something I would reject on other grounds.)

I suppose that I don't have much business going on about this since you, JoeH, clearly have a much deeper understanding than me. But it bothers me that so many discussions take place in the forum about economic matters without delving into the underlying assumptions for the positions people take. Not doing so just seems like asking for people to talk past each other or just spout whatever ideology that strikes their fancy.

I really don't like thinking about money and economics, but it's so central to our political lives - I think now more than usual - so I don't feel like I can avoid it. I appreciate your (JoeH) input and hope that you will continue to bring some light into these discussions. I'm sure I'll make mistakes, but I have a big enough ego that I'll probably keep blabbing on sometimes anyway. But I do try to be willing to accept and acknowledge when someone shows me that I'm wrong, so keep bringing it on!