I highly recommend a recent Matt Yglesias post on taxes. This caught my eye:
My preferred framework for a progressive consumption tax is the one that Cornell University economist Robert Frank has outlined. It would work more or less exactly the same as today’s income tax, but with two major changes:
There would be no differentiation based on the source of income — whether it’s wages, capital gains, dividends, interest, rent, whatever — it all goes into the “income” bucket.
Instead of a little form where you list your 401(k) contributions and deduct them from your income, you’d deduct all contributions to any kind of savings vehicle (bank account, brokerage, whatever).
This is separate from optimal tax theory, but the way it ought to work is the IRS sends you a pre-filled form saying what they think you owe based on what’s been reported to them by employers and financial institutions. In 80-90 percent of cases, you could just check “yes, okay, that’s right” rather than needing to do your taxes.
This is similar to an idea that I often advocate—an unlimited 401k system. People can put as much of their income as they like into a 401k account, and then take the money out for consumption whenever they wish. That essentially converts an income tax into a consumption tax. I especially like the last part, which would save me from having to spend lots of time doing my taxes. But for many of us, that would require simplifying the tax system.
So how does Yglesias come down in the debate over capital gains taxes? Should they be taxed at the same rate as ordinary income, or at a lower rate (as in the current system)?
The phrase “no differentiation based on source of income” might suggest that Yglesias sides with the progressives that favor a higher capital gains tax rate. But things are not quite that simple, as when you reframe taxes as a function of consumption, everything looks very different.
In theory, a flat tax on wage income is identical to a flat tax on consumption. Yglesias prefers to tax consumption directly with the 401k approach, because he fears that wealthy business owners would evade a wage tax by claiming that income they earn working in their own company is actually capital income. This is a general problem with our tax system—the problem of tax avoidance.
Oddly, most people don’t see a wage income tax as being identical to a consumption tax. In a 401k type consumption tax setup, it looks like capital gains are taxed at exactly the same rate as is wage income, although the tax isn’t paid until the income is consumed. But this tax system is identical to a simple wage tax with no capital gains tax at all. How is that possible?
With a wage tax, you prepay taxes on your future investment income before the money is even invested. With a 401k approach, you pay the tax in the future when the money is withdrawn and spent on consumption. Consider a person determined to save 40% of their wage income, which is $100,000 before taxes. Also assume the invested money increases 5-fold over 40 years, before being spent.
A 50% wage tax: After-tax wage income is $50,000, of which $30,000 is spent on consumption and $20,000 is saved. After 40 years, the saving grows 5-fold to $100,000, when it is spent on consumption.
A 50% income tax with 401k privileges: The person saves $40,000 and pays a 50% tax on the other $60,000. That leaves $30,000 for current consumption. After 40 years the $40,000 grows to $200,000. When that $200,000 is withdrawn and spent, half is paid in tax. Future consumption is $100,000.
In both cases, current and future consumption is identical. The two tax systems are essentially the same. But one system looks like it taxes capital gains at the same rate as ordinary income, while the other looks like it doesn’t tax capital gains at all.
This confusion occurs because “income” is such an ambiguous concept. In economics, consumption has a clear meaning, while income does not. We can say that both systems apply the same 50% tax rate to current and future consumption, but as for the “income tax rate”, that’s a pretty meaningless concept. What do you mean by “income”? Thus one person might claim that Yglesias favors taxing capital gains at the same rate as ordinary income, while another might claim he favors abolishing the capital gains tax. Neither person is lying—those are two valid ways of looking at the same reality. He favors no taxation at the moment the gain is realized, but full taxation at the point it’s spent on consumption.
Readers might have noticed that the wage tax example is sort of like the Roth IRA approach to saving. You pay the full tax on the money before it is put into saving, but then don’t have to pay a further tax when the money (plus investment income) is withdrawn at a later date. Nonetheless, the two plans might differ in terms of ability to avoid taxes. Consider the following example from Bloomberg:
If Peter Thiel could use a special retirement account to accumulate $5 billion tax free, why can’t you? . . .
According to ProPublica, Thiel was able to put 1.7 million shares of then-private Paypal into a self-directed Roth IRA in 1999. There are contribution limits for Roth IRAs, but the total value of the Paypal shares was below the $2,000 threshold at the time. Those shares have since exploded in value, along with other investments Thiel has made, but since they’re in the Roth, they aren’t subject to tax.
For simplicity, assume the 1.7 million shares were worth exactly $2000. Also assume that Theil paid a 50% wage tax on his income. In that case, he needed to earn $4000 in wage income to accumulate the $2000 in after-tax income he put into the Roth IRA. If it were a 401k system, he could have put the entire $4,000 into a 401k, which would have grown to twice the level of his Roth balance. In other words, today he would have $10 billion in the 401k, instead of $5 billion in the Roth. So while it seems like he’s getting by without having to pay tax on this huge capital gain, he’s implicitly given up the extra $5 billion that he would have accumulated if he’d spent $4000 on 3.4 million shares of Paypal stock, instead of $2000 on 1.7 million shares of Paypal stock.
You might wonder if the $4000 option was ever actually on the table. After all, if $2000 could turn into $5 billion, then why not invest $200,000, which would later become worth $500 billion—making Theil the world’s richest man. Our intuition tells us that this investment was not scalable. And that intuition is probably linked in some way to our intuition that this investment option wasn’t available to average people. That is, in some sense Theil’s investment success reflected his skill as an entrepreneur. This would imply that the $5 billion gain was partly wage income being treated as capital income. While I don’t know anything about this particular case, I suspect that this is the general problem that Yglesias had in mind when he suggested that the 401k approach was superior to the Roth IRA approach.
Bloomberg points out that there is no evidence that Theil did anything illegal:
Don’t assume that because the IRS didn’t challenge Thiel, they won’t go after you. First, it’s unclear whether Thiel engaged in any prohibited transactions — and he has ample resources to hire lawyers to argue the point with the IRS. For almost everyone else, the resources spent are likely to outweigh any benefit.
Consider almost any highly successful entrepreneur that works hard and builds a very successful business. When they sell that business, some of the capital gain will be a return on the initial investment, and some will reflect the increase in the business value from the entrepreneur’s hard work. This is especially common in the high tech industry, where in some cases a clever idea combined with a relatively small capital investment can produce extraordinarily large returns. It makes an ongoing issue with our tax system much more noticeable. No one cares if a blue color worker purchases and fixes up a run down duplex, and then sells it for a profit that shows up as capital gains, not wage income. In contrast, the Theil case received major news coverage.
PS. I still favor supplementing a 401k-style consumption tax with a wage tax (and a VAT), as I believe that multiple approaches to taxation make tax evasion more difficult. But the focus should always be on taxing consumption. Income should not be taxed at all.
PPS. Yglesias also favors taxing land and negative externalities. I agree.
PPPS. Have you noticed how many people suddenly have an opinion on whether the IRS should get more money? I’d like to ask these people two questions:
1. What is the optimal IRS budget?
2. What is the current IRS budget?
Unless they can answer both questions, their opinion isn’t very valuable. I suspect that most people (on both sides of the debate) cannot answer both questions.