Fairness and the Capital Tax Fetish
Friday's weak employment report reminds us anew of the flagging U.S. economic recovery. While the Obama administration discusses additional stimulus packages, Treasury Secretary Tim Geithner is arguing that we should roll back key elements of the Bush tax cuts passed in 2001 and 2003. The administration is particularly skeptical about the benefits of today's lower rates on dividends and capital gains.</br></br>The tax on dividends, for example, is currently 15%, but it could increase to as high as 39.6% if the 2001 and 2003 tax cuts expire. On top of this, a new 3.8% tax on investment incomes for high-income earners begins in 2013 to help pay for ObamaCare. The administration's arguments for higher taxes on capital center on fairness and the need for deficit reduction.</br></br>These arguments are seriously mistaken. The relationship between investment, capital and wages is such that workers are better off if capital is not taxed at all.</br></br>Think of the economy as a pie split among workers, savers and the government, with the government's slice fixed. The savers' slice will equal the after-tax return on each unit of the capital stock, and what's left goes to workers as after-tax wages. The fairness advocates in effect claim that low tax rates on dividends and capital gains increase the share of the pie that goes to high-income savers. But the low tax rates increase the absolute size of the workers' slice by making the entire pie bigger. That's because low tax rates encourage capital accumulation, productivity and wage growth.</br></br>To understand how this works, it's worthwhile to return to President Bush's proposal, in January 2003, to substantially reduce the double taxation of corporate income by eliminating investor-level taxes on dividends. (The actual law reduced tax rates on dividends and capital gains to 15%.)