With the differential tax treatment of investment income and labor income in the news, I thought it would be interesting to highlight some of the academic research on the subject. The standard “classic” result in this field is, in fact, that an optimal system would have no taxation of investment income. But there are several strands of research that question some of the premises underlying that analysis. One popular line of inquiry makes what amounts to a political economy argument that if you have hugely differentially taxation of different kinds of income you end up generating more and more shenanigans like the “carried interest” loophole where smartypants rich guys find ways to reclassify labor income as capital income. But Thomas Piketty and Emannuel Saez take a different approach in “A Theory of Optimal Capital Taxation” (PDF) arguing that we should see capital income taxation as a kind of distributed inheretance tax:
This paper develops a realistic, tractable normative theory of socially-optimal capital taxation. We present a dynamic model of savings and bequests with heterogeneous tastes for bequests to children and for wealth accumulation per se. We derive formulas for optimal inheritance tax rates expressed in terms of estimable parameters and social preferences. The long-run optimal inheritance tax rate increases with the aggregate steady-state flow of inheritances to output, decreases with the elasticity of bequests to the net-of-tax rate, and decreases with the strength of preferences for leaving bequests. For realistic parameters, the optimal inheritance tax rate should be as high as 50%-60% -or even higher for top bequests- if the government has meritocratic preferences (i.e., puts higher welfare weights on those receiving little inheritance). In contrast to the Atkinson-Stiglitz result, bequest taxation remains desirable in our model even with optimal labor taxation because inequality is two-dimensional: with inheritances, labor income is no longer the unique determinant of lifetime resources. In contrast to Chamley-Judd, optimal inheritance taxation is desirable because our preferences allow for finite long run elasticities of inheritance to tax rates. Finally, we discuss how capital market imperfections and uninsurable idiosyncratic shocks to rates of return can justify shifting one-off inheritance taxation toward lifetime capital taxation, and can account for the actual structure and mix of inheritance and capital taxation.
That’s a bit of an exotic argument, but if you want to undermine the standard approach there you have it. In practical terms, I think it suffices to say that opponents of low rates of capital income taxation are primarily concerned with (a) the distribution of wealth, income, and opportunity and (b) the impact on the federal budget. The challenge then to people who feel strongly that reduced capital income taxation will boost economic growth is to devise a tax reform that (a) preserves progressivity and (b) does not increase deficits. It’s quite possible to achieve those goals, as a matter of theory, but in practice the proposals influential policy entrepreneurs have put on the table over the past 20 years don’t even attempt to meet them even as the more scholarly quarters of right-of-center thought tend to agree on them in principle.