Feldstein: Taxes on Investment Income Are High and Distortionary

June 21, 2006

Download Taxes on Investment Income Remain Too High and Lead to Multiple Distortions

Harvard economist Martin Feldstein has published an excellent new non-technical article on the economic costs of taxing investment income in the new issue of Economists’ Voice. The piece argues forcefully for reduced taxation of capital income on efficiency grounds. From the piece:

Thanks to recent tax reforms, the marginal tax rates on investment income in the United States are significantly lower today than in the past, which correspondingly reduces the economic losses caused by the tax system. That’s the good news. But there is also bad news.

The first piece of bad news is that tax rates on the income from saving and investment remain much higher than they would be in any rational system of taxation. The second piece of bad news is that these taxes continue to seriously distort the economy with a large resulting loss of real income. The third piece of bad news is that many economists grossly underestimate the efficiency cost of our system of taxing capital income because they think that if the taxation of capital income does not cause a big reduction in saving, it is not a problem. They are wrong, as I will explain.

A Little Tax HistoryBack in 1963 the highest marginal rate of personal income tax was 93 percent. A taxpayer in the top bracket got to keep only seven cents out of every extra dollar that he earned. I used to work for one of those taxpayers: Ronald Reagan. His experience of the adverse effects of such high tax rates on his decisions and on those of his Hollywood friends is an important reason that we have much lower marginal tax rates today.

Even as recently as 1980 the top income tax rate was 70 percent on interest and dividends, and 50 percent on wages and other personal services income. Today the top statutory federal marginal income tax rate is 35 percent, although the effective marginal tax rate for many high income taxpayers is over 40 percent when the Medicare payroll tax, the phase-out of deductions, and state tax systems are taken into account. In many well-off two-earner families, at least one of the two faces a marginal social security payroll tax as well, bringing that individual’s total marginal tax rate above 50 percent.

Today’s statutory tax rates on capital income consist of: a corporate tax rate that is down from 46 percent in 1980 to 35 percent now; a 15 percent maximum tax rate on capital gains (which in 1980 could reach more than 40 percent as a result of tax add-ons and offsets); a 15 percent tax rate on dividend income; and a 35 percent maximum rate on interest income. Recent legislation extended the lower rates on dividends and capital gains until 2010, after which they could revert to 35-plus percent if Congress does not pass new legislation…

But it would be wrong to conclude from the recently reduced tax rates on dividends and capital gains and today’s much more modest rate of inflation that the tax on capital income is now low. The full tax on capital income includes not only the taxes paid by the individual investors but also the corporate income tax. When these taxes are combined, the result is still a marginal tax rate that is high—albeit not as high as in the 60s and 70s—and that is thus capable of doing a great deal of economic harm.

Read the full piece here (PDF).

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