Capital Offense

by Jonathan Chait | September 24, 2008

During a Democratic primary debate back in April, ABC News anchor Charlie Gibson took a brief respite from haranguing Barack Obama about his hatred for America to harangue him about his plan to increase the tax rate on capital gains. Gibson insisted that "one hundred million people in this country own stock and would be affected." He further declared, "History shows that, when you drop the capital gains tax, the revenues go up." Obama meekly insisted that he didn't really plan to raise the capital gains tax very much. And, indeed, he doesn't, proposing to raise the top rate to just 20 percent, or half his proposed level on ordinary income. You know how Warren Buffett has said he pays a lower tax rate than his secretary? Apparently, Obama isn't going to redress that.

Not that I can entirely blame him. The tax preference for capital gains is one of the most sacrosanct giveaways in the federal budget, zealously defended by a fearsome lobby. It's ethanol for millionaires. The only difference is that, when candidates come out against the ethanol subsidy, the news media gives them a pat on the head. If, on the other hand, you suggest trimming back the capital gains subsidy, the Charlie Gibsons of the world bite your head off.

One sustaining myth for the capital gains break is that it's a tax on the middle class. In fact, 60 percent of capital gains income goes to the .02 percent of Americans who earn more than $1 million a year. Yes, 100 million Americans own stock, but most of them have very little, and what little they have is mostly in pension plans that don't pay capital gains taxes anyway. In 2005, less than 14 million taxpayers had any capital gains at all.

More maddening is the constantly repeated claim that cutting capital gains tax rates makes revenue rise. Yes, capital gains revenues are higher than they were in 2003, when Republicans last cut the top rate to 15 percent. But they're still lower than they were in 2000, the last business cycle peak, when the rate was 20 percent.

And, even if capital gains revenues really did rise after a rate cut, it would prove nothing. Suppose you gave a big income tax cut to anybody who owns a Ferrari. Lots of people would go out and buy Ferraris to qualify for the lower rate. Hence, tax revenues from Ferrari-owners would rise, but not because Ferrari ownership had stimulated their entrepreneurial spirits. It would just reflect shifting income from one category to another.

Another justification for the capital gains break is that it rewards risk-taking or entrepreneurship. But the capital gains break rewards all kinds of capital investment, risky or otherwise. Anyway, why should the government favor risk? The risky new businesses that have a good potential for reward usually attract capital to finance them, so they don't need government help. Risky ones that don't have good potential usually don't get capital, but if they don't offer a good potential return, why should they? Allocating capital is exactly the kind of thing the invisible hand does well and government does poorly.

Some economists do favor lower capital gains rates, on the grounds that the income has already been taxed at the corporate level. But huge amounts of capital income escape taxation altogether. As Tax Policy Center director Leonard Burman writes, "the best response to that problem is a credit against individual income taxes for all taxes already paid at the company level, not capital gains taxes for private equity, land and oil wells, all of which are untouched by the corporate tax."

A basic axiom of economics holds that the tax code should be as neutral as possible--that is, it shouldn't encourage one kind of activity over another. The capital gains break introduces a distortion into the market. If I have $100 to invest, I can put it into the bank and pay a regular tax rate on the interest I earn, or I can put it into the stock market or real estate and pay the lower capital gains rate on my profits. If capital gains were taxed at the same rate as other kinds of income, then market signals would be the only factor behind my choice. By favoring capital gains, the government overrides the logic of the market.

The more common real-world result of the capital gains break is to encourage executives to turn their salary into capital gains via creative bookkeeping. My brother started a successful business creating custom software for the financial industry. He told me a while ago that he was spending an enormous amount of his time with lawyers and accountants, figuring out ways to have his salary come in the form of capital gains. All that time and money is an enormous waste.

The 1986 Tax Reform Act, a bipartisan deal between Democrats and Ronald Reagan hailed by economists, swept away the capital gains preference along with most of the other loopholes in the tax code. Since then, the capital gains rate has slowly crept down. In 1997, Bill Clinton agreed to a capital gains cut in return for more spending on children's health care. In 2003, President Bush cut the capital gains tax even lower. Now not even Obama is willing to end the capital gains preference.

Obama's leading economic advisers recently penned a Wall Street Journal op- ed rebutting the incessant accusation on that page that their candidate is a quasi-Bolshevik. In it, they boasted of their candidate's low capital gains rate. "A 20 percent rate," they noted, "is almost a third lower than the rate President Reagan set in 1986." Um, hurray?

One of the more Dada moments of the whole campaign came during Obama's triumphant convention speech. He promised to eliminate capital gains taxes on start-ups and small businesses, and 80,000 Democrats cheered. I booed my TV set.

Why has the capital gains preference become so unassailable? Obviously, the fact that it benefits the filthy rich doesn't hurt. But another factor is the terminology. "Capital gains tax" suggests some extra levy on capital gains. In reality, we don't have a capital gains tax. We have an income tax with special lower rates for income that comes from capital.

I'm thinking that we should start labeling income that journalists earn as a "journalism tax." It sounds like the Stamp Tax. Why are we being singled out? Imagine how much better we members of the Fourth Estate could do our vital work if we didn't have this oppressive tax. Take, say, network anchors. What incentive do they have to ask factual, non-self-interested questions if their success will be punished by a journalism tax?

Some powerful media figure needs to take up this cause. I think I know just the man for it.

Source URL: http://www.newrepublic.com//article/capital-offense