Tax Policy Center Ignores the Most Basic Reasons for Reduced Taxes on Investment

Following on this week’s depressing news that investment has failed to recover even to levels it was at 7 or 8 years ago, Chris Sanchirico at the Tax Policy Center tells us we should tax it more:

House Ways and Means Committee Chairman Dave Camp (R-MI) has proposed requiring most derivatives investors to pay tax on their annual returns even if they don’t realize their gains by selling their securities. This proposal, which requires investors to mark-to-market the value of financial derivatives, has ramifications far beyond the heady world of high-tech finance. It implicitly challenges our most basic and firmly held beliefs about why we tax investment gains the way we do.

Camp’s plan raises two key questions: First, should mark-to-market be required for all investment assets, not just derivatives? Second, does his proposal fracture one of the main justifications for taxing long term capital gains at roughly half the rate on ordinary income?

Ask most tax experts why, in a nutshell, rates should be lower for capital gains, and you’re liable to get a mini-lesson on the “lock-in effect.” There’ll be other reasons too. But the lock-in effect is going to be pulling some serious weight. ….

Start with the fact that investors “get as much time as they need” to pay tax on their accrued gains. Investment gains are taxed, not as they accrue, but only when they are “realized”—by, for example, selling the asset. This is a tax advantage because the unpaid tax stays on the taxpayer’s balance sheet and continues to earn income.

The lock-in argument then comes back for more: given that gains aren’t taxed until realized, it says, realized gains should be taxed at lower rates. Because investors can delay the tax until they sell the asset, they’ll be tempted to delay selling for an inordinate amount of time. That’s inefficient because better investments might crop up in the meantime. Keeping rates low reduces this tax-borne inertia.

What about investors who are tempted to delay buying for an “inordinate amount of time” because taxes on capital gains and dividends are too high? The biggest inefficiencies associated with taxing investment income are a) that it double, triple, or quadruple taxes the returns to saving, when considering the corporate income tax, the ordinary income tax, and the estate tax, b) it taxes gains from inflation as well as real returns, and c) it taxes a key input to long run economic growth. We, and hundreds of other “tax experts” over the decades, have made this case repeatedly, and that is why the U.S. and virtually every country on earth has zero or preferential rates on capital gains and dividends.

Follow William McBride on Twitter @EconoWill