Against capital gains taxes: Sumner edition

By Eric Crampton 12/03/2015

Capital gains taxes still do not make economic sense.

Here’s Scott Sumner explaining that while wage and consumption taxes can be equivalent, capital gains taxes are effectively a distortionary tax on future consumption relative to present consumption.

The biggest confusion is that people don’t understand why capital income should not be taxed, and why a wage tax is equivalent to a consumption tax. Consider someone with $100,000 in income, who can choose to consume, or invest in a fund that will double in value over 20 years. Suppose we want to raise revenue with a present value of $20,000, from this person. We could have a wage tax of 20%, and raise $20,000 right now. Let’s also assume that this person decided to spend 1/2 of his after-tax income—leading to $40,000 in consumption today, and save the other $40,000, leading to $80,000 in consumption in 20 years. Note that both current and future consumption are reduced by 20% relative to the no tax case.

Alternatively, we could directly tax consumption at the same rate (say with a VAT). Let’s assume the person saved $50,000 and spent $50,000 on consumer goods. After paying VAT they consume $40,000 today, and the government gets the other $10,000. After 20 years the $50,000 saved turns into $100,000, but you must pay $20,000 in VAT, leaving consumption of $80,000. Exactly the same as with a wage tax. The total revenue to the government looks bigger, but is the same in present value terms.

In contrast, an income tax doubles taxes the money saved, once as wages, and again as capital income. So now it’s $40,000 consumption this year, and only $72,000 in 20 years ($80,000 minus 20% tax on the $40,000 in investment income), an effective tax rate of 28% on future consumption. And of course with inflation the effective real tax rate is still higher. Income taxes make no sense at all; if you want progressivity, tax big consumption more than little consumption.

What’s a progressive consumption tax? A tax on income minus savings. In that set-up, you’d want to tax returns on investments (capital gains or interest or dividends) that were made in tax-preferred savings vehicles (and effectively then came from before-the-line pre-tax income). As Scott points out, that’s not a tax on capital gains or capital income, it’s a deferred tax on labour income.

Sumner proposes something pretty close to what New Zealand has. We get progressivity via the income tax rather than via a progressive consumption tax, but we don’t tax capital gains, and we doimpose a fringe benefit tax that helps in avoiding nonsense: he proposes that company cars that can be used in off-hours are consumption, not investment; I’m pretty sure those here would attract FBT. Capital income is taxed though, and investment yielding capital income coming out of wage earnings is then double-taxed.

And all of it is highly reminiscent of Seamus’s series of posts explaining how capital gains taxes are a bad idea. I get tired of commentators who point to National’s reluctance to impose capital gains taxes as evidence that they’re somehow bought out by moneyed interests when the economics on capital gains taxation are at best pretty iffy.