Dollars and Jens
Thursday, April 26, 2007
marginal capital gains tax rates
The big supply-side economics idea was that marginal rates are what matter for creating incentives, and we should focus on lowering marginal income tax rates, getting rid of deductions and credits if we have to. I've been thinking for quite a while now about the idea of taxing capital gains as ordinary income, but indexing cost bases for ... well, for the time being, pretend I'm thinking about indexing them for inflation. Economic growth is particularly sensitive, it turns out, to marginal tax rates on capital, and it seems here as though I'm replacing a marginal rate of 15% with a marginal rate of 28%, so this seems like a bad idea from that standpoint. But — let's suppose this is approximately revenue-neutral — I'm not sure that's actually right. What are the incentive here?

It seems to me that the average dollar saved is likely to pay about the same amount in taxes, assuming the revenue neutrality, as currently. As far as creating an incentive to save and invest, this scheme should be just as good. Because of the higher marginal rate, I am reducing the incentive to make sure it's invested well; once I've decided to invest a dollar, it's worth more effort to make sure it's put to best use if I keep 85 cents of every dollar of outperformance generated than if I only get 72. I've increased the attractiveness of longer-term investments as compared to shorter-term ones, I assume. I've also eliminated the inflation tax risk that investors face, where, even if a project is fairly safe in terms of real returns, an investor is exposed indirectly to inflation risk because his taxes are higher if there's inflation than if there isn't. That would seem to be attractive to capital and reduce overall risk, which is the sort of thing that tends to promote efficiency, but it feels like a small effect. What else am I missing? What's the net result of all of this?

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