Taxing the Returns to Financial Capital vs. Human Capital

Sen. Max Baucus (D-MT) and Rep. Dave Camp (R-MI) have stated that they are shooting for base-broadening, rate-lowering reform. And per their recent Wall Street Journal op-ed, they have established that the want to maintain the progressivity of the current tax code while also ensuring that low-income and middle-income Americans are shielded from a tax increase. One model for tax reform that meets these objectives is the “Modified Zero Plan,” devised by Paul Weinstein Jr. and Marc Goldwein for the center-left Progressive Policy Institute. Drawing on the illustrative “Zero Plan” tax reform proposal included in the Bowles-Simpson fiscal commission’s chairmen’s mark, the Modified Zero Plan replacing the six-bracket individual tax rate schedule with a three-bracket tax rate schedule (12, 22, and 28 percent), it eliminates all tax expenditures but the earned income tax credit (EITC) and the child tax credit (CTC), and it treats capital gains and dividends as ordinary income. 

Among conservatives, this last aspect of the Modified Zero Plan is likely to prove particularly unattractive, as there is a broad consensus on the center-right that while the capital gains tax preference is not an ideal policy, it is useful in that it counteracts other provisions of the tax code that discourage savings and investment. There are, however, a few other issues that merit consideration. First, the political momentum is against a robust capital gains tax preference. Preferential rates for long-term capital gains and qualified dividends were worth $36 billion and $31 billion respectively in 2010. ATRA raised capital income taxes for high-earners by a substantial amount relative to Bush-era rates, though the increase was smaller than it would have been in ATRA’s absence. The Affordable Care Act also imposes a new 3.8 percent tax on investment income for households earning $250,000. Even after these increases, the capital gains tax preference a tempting target. That is why the Obama administration continues to promote the “Buffett Rule,” which would raise effective taxes on long-term capital gains and qualified dividends above 28 percent. The Buffett Rule is bad policy, particularly when contrasted against the Modified Zero Plan. 

It is also possible that champions of the capital gains tax preference are underestimating the harm that flows from high labor income taxes. As Chris Sanchirico of the Tax Policy Center recently observed, capital income taxes aren’t set in a vacuum. Lower capital income taxes will mean higher labor income taxes or higher borrowing levels or lower spending, though of course lower spending could also allow lower labor income taxes. Sanchirico suggests that we ought to be more concerned about the possibility that labor income taxes reduce savings as much as capital income taxes.

And then there is the question of human capital. The capital gains tax preference is designed, among other things, to shield investment income from double taxation. One conceptual challenge, as Steve Randy Waldman explains, is that returns to human capital are impossible to distinguish from wages. “If human capital accumulation is as or more important than other forms of capital accumulation, and if the quality of effort that people devote to building human capital is wage-sensitive,” Waldman writes, “then taxing wages in preference to financial capital may be quite perverse.” Waldman writes from an idiosyncratic left-of-center perspective. Yet his argument resonates in interesting ways with a right-of-center argument that Gary Becker and Kevin Murphy made in 2007 in The American. Becker and Murphy observe that the widening gap in incomes can be attributed at least in part to the rising payoff from investment in human capital. Moreover, they provocatively argue that calls for raising labor income taxes on high-income individuals and cutting them for low-income individuals can be understood as “a tax on going to college and a subsidy for dropping out of high school.” It’s a safe bet that Becker and Murphy believe that capital income taxes should be low, but they do end their article by identifying human capital as “the most productive and precious form of capital.” 

I don’t think taxing capital income more heavily to cut taxes on labor income is obviously the right thing to do. The case for progressive consumption taxation, as made by Alan Viard and Robert Carroll, is very attractive, and I have generally favored Graetz-like approaches that move us closer to consumption taxation. But the difficulty of distinguishing wage income from returns to human capital really does complicate matters.

Garett Jones has more on this subject.

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute Policy Fellow. He is a contributing editor at The Atlantic and National Affairs, a member of the ...