The Agenda

What Paul Krugman Misses About Taxing Capital Income

In “Wealth Over Work,” Paul Krugman of the New York Times praises Thomas Piketty’s Capital in the Twenty-First Century, a provocative and important book we will be addressing more than once. Piketty’s book is a careful work of scholarship, and Krugman could have done a lot of good by walking his readers through its central ideas. But instead Krugman uses his column as an opportunity for GOP-bashing:

Despite the frantic efforts of some Republicans to pretend otherwise, most people realize that today’s G.O.P. favors the interests of the rich over those of ordinary families. I suspect, however, that fewer people realize the extent to which the party favors returns on wealth over wages and salaries. And the dominance of income from capital, which can be inherited, over wages — the dominance of wealth over work — is what patrimonial capitalism is all about.

To see what I’m talking about, start with actual policies and policy proposals. It’s generally understood that George W. Bush did all he could to cut taxes on the very affluent, that the middle-class cuts he included were essentially political loss leaders. It’s less well understood that the biggest breaks went not to people paid high salaries but to coupon-clippers and heirs to large estates. True, the top tax bracket on earned income fell from 39.6 to 35 percent. But the top rate on dividends fell from 39.6 percent (because they were taxed as ordinary income) to 15 percent — and the estate tax was completely eliminated.

Some of these cuts were reversed under President Obama, but the point is that the great tax-cut push of the Bush years was mainly about reducing taxes on unearned income. And when Republicans retook one house of Congress, they promptly came up with a plan — Representative Paul Ryan’s “road map” — calling for the elimination of taxes on interest, dividends, capital gains and estates. Under this plan, someone living solely off inherited wealth would have owed no federal taxes at all.

What you’d never know from reading Krugman’s column is that there are actually are reasons to eliminate or reduce taxes on capital income other than protecting the interests of coupon-clippers and heirs to large estates, which are embraced not just by conservatives and libertarians, but also by left-of-center thinkers like Cornell economist Robert H. Frank, a leading advocate of a progressive consumed-income tax. Krugman has a readymade answer for those who’d elaborate on the case for taxing consumption rather than income:

Great wealth buys great political influence — and not just through campaign contributions. Many conservatives live inside an intellectual bubble of think tanks and captive media that is ultimately financed by a handful of megadonors. Not surprisingly, those inside the bubble tend to assume, instinctively, that what is good for oligarchs is good for America.

So Krugman is essentially giving his readers permission to ignore all contrary arguments. Fair enough. But if you’ll indulge me, let’s briefly consider the question of why we might want to reduce taxes on dividends. The tax code creates a strong incentive for firms to raise money by issuing debt rather than issuing equity. James Surowiecki of The New Yorker has detailed the problems caused by this debt bias:

Economies work best, generally speaking, when people are making decisions based on economic fundamentals, not on tax considerations. So, as much as possible, the tax system should be neutral between debt and equity, and between housing and other investments. It’s not, and, worse still, as we’ve seen in the past couple of years, debt magnifies risk: if companies or individuals rely on large amounts of leverage, it’s much easier for bad decisions to lead to insolvency, with significant ripple effects in the wider economy. A debt-ridden economy is inherently more fragile and more volatile. This doesn’t mean that the tax system caused the financial crisis; after all, the tax breaks have been around for a long time, and the crisis is new. But, as a recent I.M.F. study found, tax distortions likely made the total amount of debt that people and companies took on much bigger. And that made the bursting of the housing bubble especially damaging. So encouraging people to take on debt qualifies as a genuinely bad idea.

Cutting dividend taxes is one imperfect way to mitigate this debt bias, as Alex Brill and Alan Viard of the American Enterprise Institute (one of those think tanks!) have explained. When corporations borrow to finance new investment, they can write off their interest payments on their taxes. (See Robert Pozen and Lucas Goodman’s proposal to cap the deductibility of corporate interest expense.) But when they issue stock to finance new investment, taxes are paid at the level of the corporation (the corporate income tax) and at the level of individual shareholders (the dividend tax). One of Thomas Piketty’s colleagues, Emanuel Saez, has done important work documenting the impact of the dividend tax cut on the behavior of firms, as Brill and Viard report:

As economists Raj Chetty and Emanuel Saez have documented, the 2003 dividend tax cut induced firms to pay more of their earnings out to stockholders. After holding roughly constant near $25 billion from 1998 to 2002, annual dividend payouts rose following the 2003 rate reduction, reaching $33 billion a year by 2005. The number of corporations paying regular dividends surged after the tax cut. Increased dividend payments make it harder for management to hide a company’s true financial condition or divert corporate funds to their own pet projects.

It could be that Krugman believes that corporate debt bias is a good thing, or that it is vitally important that the managers of large business enterprises have more control over economic resources than equity investors. It could be that when the Obama administration observed that the lower tax rate on dividends “reduces the tax bias against equity investment and promotes a more efficient allocation of capital,” it did so at the behest of coupon-clippers and heirs to large estates. But this isn’t the only possible explanation.

The heart of the case against taxes on capital income is that they create a saving penalty. And if capital income taxes really do penalize saving, they don’t just hurt coupon-clippers and heirs to large estates, as Viard has argued:

Although some business investment in the United States is financed by foreigners’ savings and some Americans’ savings are used to finance investment abroad, the level of business investment in the United States is still linked to the amount Americans save. A reduction in the amount of Americans’ saving is therefore likely to shrink the US capital stock, reducing the long-run levels of output and wages.

Prominent economists’ simulation models indicate eliminating capital income taxes through a move to consumption taxation would increase long-run output by 2 to 9 percent. A significant part of the long-run gains come at the expense of short-run consumption. The size of the gains depends on economic assumptions, which are subject to considerable uncertainty, and on the design of the consumption tax reform. For example, long-run gains tend to be smaller if the consumption tax adopts the sensible and politically essential policy of offering some tax relief for consumption financed by assets accumulated before the consumption tax was adopted. The models also generally assume a closed economy, which magnifies the impact of Americans’ saving on domestic investment. Despite these limitations, the models usefully illustrate the potential gains from reducing or eliminating capital income taxes.

Serious people disagree on the severity of the saving penalty created by capital income taxes, as Viard goes on to observe. Some argue that the benefits associated with low taxes on wage income justify higher taxes on capital income, particularly if we view taxes on wages as taxes on investment in human capital. But is it really clear that people who want to move in the direction of a progressive consumption tax can can only be doing it out of a love for the plutocracy? Taxing capital income creates thorny problems that thoughtful people, of many different political affiliations, have devoted a lot of time and mental energy to addressing. To suggest otherwise is to misinform your readers.

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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