Agnosticism to Capitalist Religion

Since the time of Adam Smith, market-oriented economists have devoutly argued that capital accumulation is the path to ever-greater wealth (actually, Smith believed perpetual growth was limited by the division of labor). The “religion of accumulation” is the mother of tax-preferences for capital income. (The current tax system is a far cry from a land and resource oriented program, which I prefer, but that’s not likely to change).

In light of the recent Munk Debate, where odd couple Paul Krugman and Art Laffer agreed that the capital gains tax preference was inefficient, Evan Soltas refutes that “investment is really deferred consumption” and this preference actually dampens distortion in our tax code by encouraging people not to switch consumption forward in time. It’s worthwhile pointing out that there’s nothing inherently “left” or “right” about this debate. We can end the preference (though, technically, not the loophole) for capital income as much by decreasing top income tax rates as increasing capital rates.

Contra Soltas, Felix Salmon notes:

Investment really isn’t deferred consumption. The amount of money invested, in the world, is going up over the long term, not down — which means that once you look past the natural tidal movements of money in and out of various investment vehicles, it’s reasonable to say that money, once it gets invested, stays invested.

Felix’ ultimate point – that capital gains preference is clogging up money in a slow-moving investment vehicle – may be correct. But to say that investment is not deferred consumption because it’s never disinvested is roughly similar to arguing that deficits aren’t borrowing if we just roll them over and our growth rate exceeds the interest rate.

At the margin, an increase in the capital gains tax would decrease my investment in the stock market and increase my current propensity to consume. More importantly, it’s not necessarily the quantity of fixed investment that’s important (just like, in a rough analogy, the rolled-over debt in absolute is not important) but its relation to national income. Here’s a graph of net fixed capital formation as a % of output:

By the way, investment’s share of output is up-and-around 16%, well-below the 40% threshold suggested by the Ramsey Model (at which point fast depreciation makes further capital investment unprofitable). This per se is not an argument for the tax preference, but does suggest the marginal investment is not welfare-defeating, as Salmon implies.

However, as the title suggests, I am rather agnostic about about this big loophole. Capital accumulation hasn’t done wonders for the median American. Sure, we have a lot more unrealized utility from consumer surplus than we used to, but most of that comes from the technology revolution which isn’t capitally-intensive. Most of it is software derived from human capital (which is relegated to an afterthought in Soltas’ piece).

The mobility of capital ownership is dead, and that makes this loophole all the more damning. But the crux of Soltas’ argument can be applied to progressive ends. Preferably, the $161 billion in budget shortfall from the capital gains preference can be closed, financing government investment in deteriorating bridges, power grids, and airports.

Theorists will tell us that government is less efficient at allocating capital, and that might be true, but ignores a government mandate and competitive advantage in ultra-large scale projects like power grids, nuclear plants, and road systems. These are investments that increase net capital formation to the benefit of society as a whole. The latter is something our capital gains preference ignores completely.

More importantly, removing all loopholes simplifies the tax code and would allow a more efficient allocation of resources, which are currently tied up in the “tax industry” (lawyers, TurboTax coders, accountants, advisers, launderers, etc.)

As a footnote, when Soltas’ suggests “subsidizing human capital” it’s very important to point out that almost all incomes over 250,000 (before which capital gains are both irrelevant and untaxed) are human capital gains. Almost none of it is natural, but created through long investments learning a trade, going to grad school, and just being an engaged person. (Bill Gates might have dropped out of Harvard, but all the time he spent coding in high school is an investment in human capital).

The answer, perhaps, is a lower tax rate at the top that is applicable to all incomes, and the implementation of a land value tax to make up for any lost revenue… But now I’m getting too close to my ideal plan.

Some afterthoughts: Actually, everything else equal, I’d rather just run a higher deficit and cut taxes. But I’d rather the marginal deficit finance government spending than loopholes for the rich. Also worth noting that the progressive tenor of this post changes if capital ownership was more equitable, and I’d prefer a secular trend to that effect, but can’t detect any perfect policy so far. Further note that Soltas’ isn’t necessarily to the “right”, and Salmon to the “left”. I’m sure Art Laffer would like equal treatment at the current capital gains tax rate.