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Sunday, March 18, 2012

NY Times: Capital Gains vs. Ordinary Income

New York Times, Capital Gains vs. Ordinary Income, by Uwe E. Reinhardt (Princeton University):

In a column etitled Capital Gains, Ordinary Income and Shades of Gray, the Harvard economist N. Gregory Mankiw, who advises Mitt Romney in his presidential campaign, offers a fine teaching piece on the tenuous and often confusing line between ordinary income and capital gains under our tax code. As Professor Mankiw reminds us, the highest tax rate on ordinary income is now 35% while that on capital gains is only 15%. ...

Professor Mankiw touches in passing what for me is the crux of the issue. He writes:

Critics of current law think it is unfair that these private equity partners are taxed at capital-gains rates, whereas other high-income individuals like doctors and lawyers pay the much higher tax rates for ordinary income. It is a reasonable point, and some reform may well be appropriate. But ... it is not obvious what the best approach would be. Not all problems have easy answers.

On this point, I beg to differ with my colleague. Why is the answer so difficult? To my mind, the best approach would be to abolish the distinction between capital gains and ordinary income altogether and desist from using the tax system for any kind of economic or social engineering. ...

The case for granting preferential tax treatment to the real-estate transactions that Professor Mankiw describes — and to carried interest in private equity firms — strikes me as extremely shaky on grounds of both horizontal equity and plain economics. ... If the partners at Bain Capital are granted a low 15% tax rate on what basically is an earned commission for hours smartly worked, rather than a return on their own invested capital, should not the return on the neurosurgeon’s own investment in his or her human capital be granted the same preference? ...

My bottom line on the issue of tax preferences is that although Congress may wish to encourage some transactions leading directly to the formation of new capital — including human capital — that preference is best expressed with explicit subsidies that show up in government budgets and for which politicians can be held accountable, rather than through tax expenditures that spare politicians explicit accountability for their indirect spending.

Update:  Linda Beale (Wayne State), More on Greg Mankiw's Weak Arguments for the Bain Capital Gains Preference:

The ugly truth about the insistence on the capital gains preference is that it rewards people at the top of the income and wealth distribution and serves to maintain the status quo of the allocation of resources. This is what is really meant by "fiscal conservatism" these days--ensuring that resources remain inequitably distributed to the very wealthy who are the "shakers and movers" of society through the influence their money can buy. The right-leaning Supreme Court has made that even more inevitable than it was before, through the Citizens United decision upholding the right of corporations to contribute any amount to influence political campaigns, based on the laughable assertion that such "super-PAC" rights undergird free speech.

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Does the neurosurgeon forfeit the fee if the operation fails?

I don't like that criteria either. Can we just make a flat rate of 15% on all income sources and declare everyone a winner?

Posted by: John | Mar 18, 2012 9:14:13 AM

Eliminating the distinction would be a good idea, HOWEVER, we should also adjust the cost basis for inflation.

That house I bought for 20K in 1975 has NOT kept up with inflation, but I am expected to pay tax on every cent of the fictitious "gain" when I sell it.

With the multiple rounds of "quantitative easing" we will see that "cruelest tax" of inflation rearing its head before too long. In fact, we've seen a good bit of inflation already on the lower end of the marketplace, especially those "economy" items for which demand is relatively inelastic (or actually increases when people are not longer willing or able to buy "premium" items -- example: in the last four years Campbell soup is up 20%, ramen soup is up 100%). And as inflation increases, any asset held for as little as a year will create "taxable income" when sold.

Posted by: donb | Mar 18, 2012 11:52:29 PM


A house purchased for $20,000 in 1975 would have kept up with inflation if it was worth about $80,000 today. Is there a housing market in the US that is so depressed that a house is worth less than $80,000?

Assuming the house is your residence, you have enjoyed the use of the house for 35 years--which is a form of income on which you were not taxed. Further, if it is your residence, the gain is not taxed.

Posted by: Anonymous | Mar 19, 2012 11:59:29 AM

Response to DonB,
What planet are you from? You Say I quote "you have enjoyed the use of the house for 35 years--which is a form of income on which you were not taxed." R U suggesting we have a use tax. R U not happy with the unlimited taxable items we currently pay tax on and yet you think we should be taxed on the privilege of living in our own houses. I think that is called Property taxes!!!!!

Posted by: GMC | Apr 12, 2012 12:44:11 PM