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Why Give Capital a Break?

By Chris Farrell Thanks to the Jobs & Growth Tax Relief Reconciliation Act of 2003, the tax rate on dividends was temporarily slashed from a high of 38% to 15%, and the tax rate on long-term capital gains dropped from 20% to 15%. These two measures were designed to encourage private savings by lowering the tax levy on capital.

The politics behind these tax cuts has been contentious. After a bruising battle, the Senate barely passed the 2003 bill on a vote of 51-50. The Administration has yet to buttonhole enough support on Capitol Hill to make the temporary cuts on capital income permanent.

Opponents charge that the cuts are giveaways to the rich, and making them permanent will only worsen the federal budget deficit. Supporters counter that the tax cuts boost entrepreneurship and that the tax initiative is the main reason the economy is averaging a 3.5% growth rate.

Yet fiery political rhetoric and tough legislative battles mask a remarkable economic consensus about tax policy: Taxes on capital should be extremely low -- if they must exist at all -- and ideally, eliminated altogether. The logic behind most political elites' and mainstream economists' support of freeing capital from Uncle Sam's grasp lies in an axiom of sound public policy.

Freeing capital of taxes encourages more savings. Greater savings funds higher rates of investment. Increased investment spurs faster economic growth. Rapid economic growth leads to higher living standards. And so on, in a self-reinforcing, virtuous circle.

HISTORY LESSONS. Based on that logic, there's a lot to be said for government policymakers creating incentives for more savings and investment. But the economic payoff is often exaggerated. For one thing, despite populist writings proclaiming savings and investment as the magical elixir of economic growth, most economists' academic research finds that incentives have a relatively small positive effect. And on the international front, the evidence is mixed.

A recent study from the Organization for Economic Cooperation & Development had Ireland as the fastest-growing nation among its members and Italy the slowest. Yet Ireland imposes steep taxes on capital and Italy a low one.

Still, what I find most disconcerting is the consensus about capital taxes. Dissenters have been pushed to the far fringes of the profession. Yet it wasn't always so.

In his 2005 paper "Does the United States Tax Capital Income?", University of Michigan tax economist Joel Slemrod notes that a hundred years ago it was taken for granted that capital and labor should be taxed differently, and that "capital income should be taxed at a higher rate than labor income." The reason lay with the distinction between earned and unearned income, says Slemrod, or what British Prime Minister William Gladstone more colorfully described as the difference between "industrious" and "lazy" income.

"MORAL DIMENSION." Indeed, the idea was so ingrained that Andrew Mellon, the financier, industrialist, and U.S. Treasury Secretary from 1921 to 1932, strongly supported the sentiment in his 1924 book, Taxation: The People's Business. "Mellon really believed in the moral dimension of tax policy," says Joseph Thorndike, director of the tax-history project at Tax Analysts, a nonpartisan tax consulting group.

It's worth quoting a key passage from Mellon at length on the difference between income from wages vs. income from investment:

"In the first case, the income is uncertain and limited in duration; sickness or death destroys it and old age diminishes it; in the other, the source of income continues; the income may be disposed of during a man's life and it descends to his heirs.

"Surely we can afford to make a distinction between the people whose only capital is their mental and physical energy and the people whose income is derived from investments. Such a distinction would mean much to millions of American workers and would be an added inspiration to the man who must provide a competence during his few productive years to care for himself and his family when his earnings capacity is at an end."

INCOME DISPARITY. Of course, it was a different era. The driving force behind the economic perspective on taxes at the time was the enormous income gap between workers toiling away in factories or fields and the scions of inherited wealth partying hard in the salons of New York City and the mansions of Newport. Sophisticated elites also believed that proposals to tax workers less than the coupon-clipping rich would diminish the attractiveness of socialist rhetoric and ultimately give capitalism a boost.

Today, socialism is a spent force. And the offspring of the rich tend to work rather than spend hours in a salon. "Even people who inherit a lot of money need an occupation," say Joel Mokyr, economic historian at Northwestern University. "Work defines your status in the modern world more than how much money you have."

So, is the idea of taxing labor less than capital anachronistic? I wonder. At the very least, I worry that the pendulum has swung too far. Wealth is still highly concentrated, with nearly a third of the nation's total net worth owned by the richest one percentile, and more than another third owned by the next nine percentiles, according to Slemrod.

CHALLENGING THE CONSENSUS. Even more important, we live an era when gains in living standards depend on improvements in human capital. Human capital consists of present and future earnings from investments in education, training, knowledge, skills, and health. Most people pay their bills from a salary or wage income, and any gains in their human capital largely show up as higher incomes. And most people, as Mellon noted, have only a few years to earn a peak income before their brains and bodies start to depreciate.

So, how about this proposal for giving a boost to a human capital economy? Let the temporary tax cuts on dividends and capital gains expire. Go back to the old rules, which certainly didn't impede investment spending in the 1990s. (No matter what, this part of the proposal passes for sound fiscal policy in Washington, D.C., anyway.)

Meanwhile, policymakers should focus on lowering the tax on labor income. The most sensible route might be to eliminate any difference between capital and wage income and ultimately tax them at the same rate, the route taken by President Ronald Reagan in the 1986 Tax Reform Act. Or maybe labor should be taxed at a slightly lower rate in a human capital economy.

Columnists love to proclaim solutions. It's part of the fun of the job. This is a case where I certainly don't have all the answers. But I'd like to see more of a challenge mounted to the economic consensus of capital taxation. Let the debate begin.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on Minnesota Public Radio's nationally syndicated finance program, Sound Money, as well as on public radio's business program Marketplace. Follow his Sound Money column, only on BusinessWeek Online

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