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Feb 25 2013

Lower Capital Gains Taxes Drive Income Inequality

A new study from the Congressional Research Service concludes that keeping the tax rate on capital gains far lower than the taxes on regular income for the wealthiest taxpayers is the primary thing that is driving income inequality in this country. The abstract:

This paper examines changes in after-tax income inequality among tax filers between 1991 and 2006. In particular, how changes in wages, capital income, and tax policy contribute to changes in income inequality is investigated. To examine the role of these three possible contributors to the increase in income inequality, the Gini coefficient is decomposed by income source using the method developed by Lerman and Yitzhaki (1985). The Gini coefficient of after-tax income increased by 15 percent (0.071 points) between 1991 and 2006. By far, the largest contributor to this increase was changes in income from capital gains and dividends. Changes in wages had an equalizing effect over this period as did changes in taxes. Most of the equalizing effect of taxes took place after the 1993 tax hike; most of the equalizing effect, however, was reversed after the 2001 and 2003 Bush-era tax cuts. Similar results are obtained with other inequality measures.

And from the text of the study:

CBO (2011) has documented that income inequality has been increasing in the United States over the past 35 years. Several factors have been identified as possibly contributing to increasing income inequality. This paper examines changes in after-tax income inequality among tax filers between 1991 and 2006. In particular, how changes in wages, capital income, and tax policy contribute to changes in income inequality is investigated. During this period,
there were changes in the sources of income that differed by income category and there were many changes in tax policy…

Three potential causes of the increase in after-tax income inequality between 1991 and 2006 are examined in the analysis: changes in labor income (wages and salaries), changes in capital income (interest income, capital gains, dividends, and business income), and changes in taxes…

The role of capital income and capital gains has recently been thrust into the debate over increasing income inequality with the OccupyWall Street movement and proposed legislation to increase the tax rate on carried interests received by private equity managers. CBO (2011) documents the increased concentration of business income, capital income, and capital gains between 1979 and 2007.

Capital income has generally been concentrated among higher-income tax filers. Capital income can be capital gains, dividends, and business income from partnerships and S-corporations. The number of partnerships and S-corporations has steadily increased between 1991 and 2006. The number of partnerships increased by 1.4 million over this period and the number of S-corporations increased by 2.2 million.3 Income from these types of business is reported on an individual tax filer’s tax return and is not subject to the corporate income tax. An increasing share of income for high-income tax filers is from capital income, which could be part of the explanation for the rising income of this group of tax filers and rising income inequality.

And here’s the critical part. Because many forms of investment income are taxed as capital gains at 15% or, starting in 2013, at 20% for the top tax bracket — still half of what it would be if it were taxed as regular income — the wealthy investing class has arranged their finances so most of their income comes in the form that is taxed the least, as capital gains. In 1991, 92% of all income was taxable at the regular rate; in 2006, that was down to 77%.

A return to the tax pre-2011 tax rates would shift the burden and make our tax system ever so slightly more progressive. It would also reduce income inequality. But the most important thing we could do is tax capital gains at the same rate we tax other forms of income. That would make the tax code considerably more progressive, boost federal revenue, reduce the deficit and reduce income inequality.

19 comments

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  1. 1
    slc1

    But the most important thing we could do is tax capital gains at the same rate we tax other forms of income. That would make the tax code considerably more progressive, boost federal revenue, reduce the deficit and reduce income inequality.

    I”m sure that MH will be along to inform us as to why, in his considered opinion, this is a bad idea.

  2. 2
    daved

    I do have capital gains, at least fairly often, and in most cases, there really is no justification for taxing them at a lower rate than ordinary income. If I buy IBM at 120 and sell it at 140, this is no different from gambling winnings, really, though the odds may be better than a casino.

    I would consider an exception, taxing capital gains at a lower rate for those who finance ventures, like putting money into a new company — one of the few instances of “job creation,” even though the goal of the venture isn’t to create jobs, it’s to make money. It’s questionable whether this is worth doing, but you could at least make a case for it.

  3. 3
    snafu

    What are the economic justifications for treating capital gain income differently than other types of income? Are there any? Or is this simply an tax code game to benefit those who’s primary source of income is make from capital gains?

  4. 4
    Rob Monkey

    Michael Heath would do an infinitely better job of explaining it, but in regards to snafu @3: AFAIK it’s justified mainly by the idea that it encourages people to save money (so they can invest it and pay lower taxes on the investment) and it encourages investment in businesses by people who already have money. Personally I can’t really agree with the idea since I’m not sure what else you would do with lots of money laying around, I think any competent financial advisor would have you invest that money so why do we need to encourage something that will happen anyway? And while I can see giving people a nice tax break on say the first $5K of investment income that they make in a year (to encourage lower income people to save some money and invest it), I can’t understand the justification for allowing this tax break to apply to ANY amount of investment income. Especially when you consider the fact that hedge fund managers get to claim all their income is from capital gains even if it’s other people’s money they’re investing.

  5. 5
    eoraptor013

    Isn’t there also the notion that the money was already taxed at the corporate level? Or am I confusing that with something else?

    EoRaptor

  6. 6
    brucegee1962

    @3 snafu:

    I think the other justification for capital gains is that the money used for investment is at risk. If you invest in a company that ends up going bankrupt, then it isn’t like the government is going to reimburse you for your losses (unless you happen to be an enormous bank or something, which is a separate issue). So the profit you make when your investments are doing well are discounted by the fact that your principal could be reduced at any time if the stock price starts to sink, and could be wiped out entirely by a bankruptcy. Other forms of income might require more actual work, but they’re theoretically more reliable.

    I’m just stating the justification — I don’t necessarily agree with it. For instance, living off a paycheck is also risky, since you’re at risk of losing your job. So I agree with the OP that a higher CG rate would be a Good Thing.

  7. 7
    daved

    @eoraptor013 — I think you’re thinking of taxes on dividends.

  8. 8
    daved

    @brucegee1962 — Although it’s true that your investment could be wiped out, if it is, that’s a capital loss, which can be used on your taxes to offset your capital gains. Come to think of it, I think your gambling losses can be used on your taxes to offset your gambling winnings, so that’s a nice symmetry there. Ed Brayton would not know about the latter since he never loses :-)

  9. 9
    Michael Heath

    Ed writes:

    A return to the tax pre-2011 tax rates would shift the burden and make our tax system ever so slightly more progressive. It would also reduce income inequality. But the most important thing we could do is tax capital gains at the same rate we tax other forms of income. That would make the tax code considerably more progressive, boost federal revenue, reduce the deficit and reduce income inequality.
    [bold font by Heath]

    Not a word about the effect on economic growth rates. I’m also skeptical with the part I bold above relative to other tax reform options. How about cutting capital gains even more and start taxing the consumption of luxury goods to generate revenue even greater than what we collect from taxes on capital?

    There is no doubt optimal economic growth requires increased federal revenues by increasing the effective tax rates. A vibrant economy requires a government which complements private activity where we’ve gotten to the point we’re essentially an insurance company with an army (hat/tip to some unknown who pointed this out several years ago). But that doesn’t mean the paradigm of the old days remains as is today, we’re in a global economy where we continue to enjoy a competitive advantage when it comes to capital, but not labor. So let’s leverage our strengths, not tax them.

  10. 10
    lancifer

    How does making rich people poorer help poor people get richer?

  11. 11
    Michael Heath

    Re some prior posts about why we should even consider taxing capital different than income. We differentiate the utility of taxing various items for two valid reasons I can think of off the top of my head. The first and best is to optimize economic growth. We’ve learned its better to tax income and then imports as one example of our switching to a more sane scheme – only paleo-conservatives and perhaps conservative-libertarians continue to deny the factual premises that protectionism suppresses growth and therefore makes for a weaker labor market. The other is tax schemes as social engineering.

    These two motivations are not necessarily mutually exclusive. For example, once there was an argument that it was better to have more more homeowners than renters. Our current tax schemes subsequently came to favor homeowners over renters, even poor renters. E.g., in the state of Michigan, rental rates include their landlords being forced to pay far higher property tax rates – in my area the property tax rates landlords pay and pass onto their renters is 86% higher than what homeowners pay. This general bias towards homeowners was probably better from a societal perspective decades ago when it came to both growth and societal outcomes; however I’m not sure this paradigm still holds since people are much more mobile now, with far less loyalty towards employees than we once enjoyed.

    Taxing income and capital also has different impacts on the economy. Simplistically conflating the two is not sane in my opinion, nor is looking only to past trends when the economic environment is very different now than it once was. From my perspective many liberals love the idea of taxing capital because it makes them feel good. They therefore look for tidbits of facts to confirm their bias.

  12. 12
    slc1

    Re Michael Heath @ #11

    As predicted, MH has shown up with an argument favoring a different tax rate for capital gains. I am frankly surprised that he is also advocating taxing imports, otherwise known as tariffs. Why that’s protectionism!

    Interestingly enough, MH’s argument is identical to the one that former radio talk show host Bruce Williams used to use. Of course, according to MH, we shouldn’t pay any attention to Mr. Williams because he hosted a radio call in talk show, therefore what does he know?

  13. 13
    yak2

    While there is no need for the personal animus toward the views of Michael Heath on this matter — he represents the early-90′s republican views whcih were considerably less evil than the current “conservative” position — there is absolutely no actual evidence that low capital gain rates spur economic growth. We can, however, cite numerous instances of low capital gains rate being a disincentive to low-term growth. The best example being the current compensation system rampant in corporate america for our galtian overlords. Current CEO deals favor stock options over regular salary to take advantage of the capital gain rates. CEO’s then take short-term actions to maximize stock value in an attempt to personally profit, long-term implications be damned.

    Various US states have slashed tax rates on capital gains over the last 20 years, and not a single one can show a measurable increase in investment rate. They can show a measurable transfer of wealth to the 1%. Similarly, european governments that have cuts gains rates have not experienced surges in investment. This emperor has no clothes.

  14. 14
    Ichthyic

    How about cutting capital gains even more

    some people REALLY swallowed a lot of the Voodoo Koolaid in the 80s I see.

  15. 15
    Ichthyic

    While there is no need for the personal animus toward the views of Michael Heath on this matter

    actually, there is, since it’s hardly the first time he’s been corrected on the issue.

  16. 16
    Michael Heath

    slc1 writes:

    I am frankly surprised that he is also advocating taxing imports, otherwise known as tariffs. Why that’s protectionism!

    slc1′s rate of misrepresenting my positions when he references me in a post continues to approach 1. I did not and do not advocate taxing imports in general. I did have a clerical error in my post @ 11, but it should still be obvious (see italics below) I do not advocate for such policies. I fix what I wrote above here:

    We’ve learned its better to tax income and then [rather than] imports as one example of our switching to a more sane scheme – only paleo-conservatives and perhaps conservative-libertarians continue to deny the factual premises that protectionism suppresses growth and therefore makes for a weaker labor market.

  17. 17
    slc1

    Re Michael Heath @ #16

    I’m certainly glad that MH doesn’t support protectionist policies such as imposing taxes on imports, otherwise known as tariffs, and has clarified his position on the matter, and admitted that he misspoke. He doesn’t do that very often.

  18. 18
    Nick Gotts

    How does making rich people poorer help poor people get richer? – lancifer

    If you really can’t see how, your stupidity is even greater than I realised.

  19. 19
    daniellavine

    @lancifer

    How does making rich people poorer help poor people get richer?

    The two magic words they introduce you to on the first day of econ 101. If a few people have all the money goods are really expensive and most people can’t afford them — and are therefore poor. If the money is spread around more evenly everyone can afford what they need to get by.

    Money doesn’t have magical intrinsic value. Its value relative to particular goods results from supply and demand.

    @Michael Heath:

    Not a word about the effect on economic growth rates.

    Do you have any research to cite on the effect on economic growth rates? (Empirical research, not just an economic model.)

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