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Capital Income Taxes: A Bad Idea

Recent research suggests that capital income should not be taxed, despite conventional wisdom to the contrary.

David Fettig - Editor

Published December 1, 1999  |  December 1999 issue

The following article is based on a paper in the Summer 1999 Quarterly Review, published by the Minneapolis Fed's Research Department. The paper was authored by Andrew Atkeson, bank economist and associate professor of economics at the University of Minnesota; V.V. Chari, bank adviser and professor and chair of the economics department at the University of Minnesota; and Patrick J. Kehoe, monetary adviser at the bank and professor of economics at the University of Pennsylvania.

For years, policymakers with a proclivity for taxing capital income had their views buttressed by the conventional wisdom of public finance research, which suggested that capital income should not only be taxed, but taxed heavily. But the conventional wisdom is changing, according to the authors cited above, and research now suggests that far from taxing capital income at a high rate—or at all—lawmakers should reduce taxes on all capital income to zero.

The debate has shifted, the authors suggest, and policymakers should stop concerning themselves with trying to determine the proper rate of taxation, and begin debating the merits of taxing capital income at all. "Those responsible for shaping the best possible tax system for the nation would be wise to give serious attention to the relatively new principle of public finance demonstrated here: taxing capital income is a bad idea."

Minimize distortions to maximize fairness

When economists think of tax policy, they think about minimizing distortions. For example, let's say the government is trying to determine what level of taxes should be applied to apples and oranges, and let's also say that Americans insist on eating one apple a day, regardless of cost, but are much less devoted to oranges and will only eat them when the price is right. In this case, it would make sense to tax apples more heavily than oranges because Americans would continue to eat their apple regardless of the level of taxation, and their behavior wouldn't be greatly affected; that is, they would continue to eat their apple a day and respond to the price of oranges, just as before. There is minimal distortion of consumer behavior. If, on the other hand, oranges were taxed heavily, people would have a strong response and would alter their behavior accordingly.

In the past, researchers—and, hence, policymakers—have thought of capital income as the apples described above, and have assumed that Americans, for example, would continue to save at a fixed rate, regardless of taxation on capital income. If true, then capital income taxes are desirable because they do not distort behavior, and if they don't distort behavior, it follows that they can be taxed heavily. Indeed, in 1978, the maximum tax rate on one form of capital income—capital gains—was 49.1 percent; after fluctuating in the following years it was set at a maximum rate of 28 percent in the 1990 Budget Agreement.

Beginning in the mid-1980s, economic theory began to use models in which the saving rate is not fixed, but rather is chosen by consumers who want to make the best use of their money. If the goal of saving is to have more money to consume at a later date, then taxing capital income at a constant rate works against that goal and becomes an ever-increasing tax on consumption. In his 1986 research, Christophe Chamley showed that over the long run, the optimal tax rate on capital income is zero because such a rate will minimize distortion and optimize consumption.

Let's go back to our apples-as-capital analogy: If you slice off a quarter of an apple at one point in time, then slice off a quarter from the same apple at the next "taxing" interval, then another quarter at the next, and so on, there eventually won't be much left to consume. You could keep adding apples to the bin to save for the future, but why would you? Over time, they are all essentially doomed to the same fate. You would save many fewer apples than you would otherwise; your behavior has been distorted big-time, and for an economist this is a bad thing.

But what about for a policymaker? If economists think about distortion when they think about taxes, policymakers worry about fairness. So what if capital income is taxed heavily, a policymaker might say—if people are wealthy enough to accrue a lot of capital income, it's little skin off their noses to pass a chunk to the Treasury. But it turns out that it is considerably more than a little skin, and not only for the individual saver but also for the economy as a whole. If capital savings are discouraged there are fewer funds to invest, and fewer investments mean less economic growth, and less economic growth affects everyone—not just the wealthy. Some economists might ask: Is it fair to drag down the economy and everyone in it because of a misguided tax policy? The best way to tax the wealthy is to tax their consumption or income, these economists might say, and not their investments: Minimize distortions and you maximize fairness. Besides, it's not just the wealthy who are impacted by capital income taxes—more and more of Americans' future income is tied up in those very capital investments that are the subject of this debate.

New research = new policymaking

Of course, the debate—both on the economic and political level—is much more complex than described here, and the authors of the Quarterly Review article concede that Chamley's views—and the views of others who have done supporting research—are not universally accepted. But the authors show that those concerns are not well grounded and that it is time to begin incorporating the new research into policymaking. In the end, they maintain: "Tax policy [should] be left to do what it should be doing: minimizing tax distortions by not taxing capital income."

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