Capital Income and Effective Tax Rates for the Rich

by Reihan Salam

One of the big reasons effective tax rates droop a bit as we hit the highest earners is that we treat capital income and other forms of income differently, and not always coherently. Many believe that in an ideal world, we wouldn’t tax capital income at all. In a chapter on “Tax Policy and Growth,” Alan Viard offers a simple explanation for why we might want to move towards a progressive consumption tax:

The fundamental difference between income taxation and consumption taxation is that consumption taxation provides morefavorable treatment of capital accumulation. Unlike consumption taxation, income taxation imposes a penalty on saving.

To illustrate this point, consider two individuals, Patient and Impatient, each of whom earns $100 of wages today. Impatientwishes to consume only today, while Patient wishes to consumeonly at a future date. Savings can be invested by firms in machines that yield a 100 percent rate of return between now andthe (potentially distant) future date. In a world with no taxes, Impatient consumes $100 today. Patient lends the $100 to a firm,which builds a machine that yields a $200 payoff in the future; thefirm then pays Patient back her $100 loan and $100 interest, allowing her to consume $200 in the future.

What happens in a world with a 20 percent income tax? Impatient pays $20 tax on his wages when they are earned and consumes the remaining $80, which is 20 percent less than in the no-tax world. Patient also pays a $20 wage tax and lends the remaining $80 to the firm. On her $80 loan, she earns $80 interest and is repaid $160 by the firm, reflecting the payoff on machines. However, a $16 tax is imposed on the $80 interest. Patient is left with $144, which is 28 percent less than in the no-tax world, compared to a mere 20 percent reduction in Impatient’s consumption. Under the income tax, Patient faces a higher percentage tax burden solely because she consumes later.

Consumption taxation yields a more neutral outcome, at least ifthe tax rate remains constant over time. Consider a consumptiontax imposed directly on individuals at a 25 percent rate, which means that the tax is 20 percent of the combined amount devoted to consumption and the tax. (For example, a taxpayer who consumes $100 pays $25 tax, which is 20 percent of the $125 total spent on consumption and the tax.) After earning $100 of wages, Impatient consumes $80 and pays $20 tax. Patient lends her entire $100 to the firm; she owes no tax because she has not yet consumed. On her $100 loan, she earns $100 interest and accumulates $200, reflecting the payoff on machines. She consumes $160 in thefuture and pays $40 tax. Each worker’s consumption is reducedby 20 percent, relative to a world with no taxes. Because both workers face the same percentage tax burden, the consumption tax does not penalize saving.

A consumption tax would be much friendlier to new investment. It would, however, reduce the effective tax rate on the rich, as the rich are in a much better position to save and invest a larger portion of their income.

Though I’d like to see an eventual transition to a consumption tax, I favor half-way measures in the near-term, like the Bush tax reform panel’s Growth and Investment Plan, which imposes a flat 15 percent tax on dividends, capital gains, and interest received.  

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.