I am often surprised by how many commenters say something to the effect, “I don’t get how taxing capital income is double taxing wage income.” Thus, here I’ll present a simple numerical example.
Imagine an island where residents produce 100 coconuts. They have the option of consuming the coconuts today, or planting them and having 200 coconuts in 10 years. In that case, the price of future consumption is 1/2 the price of current consumption.
Now assume this society introduces a 40% wage tax to fund public goods. You must pay a tax of 40%, or 40 coconuts, on your wage “income” of 100 coconuts. In that case you can consume 60 coconuts today, or plant the 60 and consume 120 coconuts in 10 years. The ratio is still 1 to 2, and the relative price of future coconuts is still 1/2 the price of current coconuts.
That sort of tax regime does not unfairly favor either current or future consumption.
Now someone suggests that in order to be “fair” we need to also have a 40% tax on capital gains, added on to the 40% wage tax. Now the person who choses to save the 60 coconuts (after paying the wage tax, faces another tax bill in 10 years. When the coconut trees mature, they pay a tax of 24 coconuts (40% on the capital gain of 60 coconuts.) They are left with 96 coconuts to consume (120 – 24).
In this case, the tax rate on current consumption is still 40%, but the tax rate of future consumption is 54% (200 – 96)/200. The choice is no longer between 100 coconuts today and 200 in ten years, or 60 today and 120 in 10 years. Now the choice is between 60 coconuts today and 96 in 10 years. People are being encouraged to eat their capital today, not save it and boost future consumption.
The best argument for a capital gains tax is that it prevents people from disguising wage income as capital gains. This is one reason that many countries set the capital gains tax rate at a level lower than the personal income tax rate. It is assumed that when someone sells their own business, some of the rise in the value of the business doesn’t just reflect saving, rather it derives from the owner’s labor in building up the business.
But if that’s the reason, then there is no justification for limiting how much non-business owners can put into their 401k plan, nor any justification for forcing them to withdraw funds at a specified age (currently 72). And yet I frequently see people claiming that the 401k program is some sort of “tax break”. It isn’t; all consumption (present and future) is taxed at the ordinary income tax rate. You pay the income tax on all of the funds pulled out of a 401k—including the capital gain—when you need the funds for consumption. This is not double taxation, however, because the invested funds were not taxed when first earned.
PS. I know the coconut example is kind of unrealistic; choose a different kind of nut if you prefer. I assume it takes labor to find the first 100 coconuts, but after 10 years the new ones just fall from the sky.
READER COMMENTS
Mark
Apr 29 2021 at 4:25pm
I completely understand the math here, but how is it precisely an example of “double” taxation?
Aaron G
Apr 30 2021 at 9:34am
You can call it double taxation on future consumption or just call it taxing future consumption at a higher rate than current consumption. Regardless of the terminology, Scott’s example should make it clear how taxes on investment income encourage current consumption at the expense of investment.
Andrew M
May 2 2021 at 5:12pm
“You can call it double taxation on future consumption or just call it taxing future consumption at a higher rate than current consumption.”
Yes, but only the second description is correct? To the layman, these don’t seem to be equivalent descriptions. Obviously they’re not the same; but they don’t seem to entail each other either.
Ang
Apr 30 2021 at 10:45am
Your 100 coconut income was already taxed at 40% (which is why you only have 60 coconuts to invest). When you invest the 60, the profits from that 60 are taxed again (yielding 96 vs 120 coconuts).
Trying to Learn
Apr 30 2021 at 3:08pm
You’ve still failed to explain double taxation. Your assertion that “the profits from that 60 are taxed again” is incorrect. The investment income from the 60 coconut income has never been taxed. A capital gain tax would be the first and only time it’s ever taxed.
David Seltzer
Apr 29 2021 at 5:21pm
Scott wrote, “People are being encouraged to eat their capital today, not save it and boost future consumption.” Or invest less. Using your example of rule of 72, ~7.22% at 40 % tax rate it means one gets to keep 60% about 4.33% return post tax. At 54%, one gets 47% back. Those are Casino odds where the house gets 54% and the bettor is paying about a dollar for a bet that is worth $.95.
Scott Sumner
Apr 29 2021 at 6:57pm
Yes, and you don’t get to write off large capital losses.
Alan Goldhammer
Apr 29 2021 at 5:41pm
The discussion above is useful but incomplete. Tax codes are markedly inefficient as they cannot address every single case of income. Obviously were the US to move to a flat tax and eliminate all tax preferences, much of what Scott discusses becomes moot as all income is treated equally. It is when special income gets singled out for preference that things become murky. The carried interest loophole is one example yet a more nefarious example for me is the gratuitous issuance of stock options which often leads to dilution of equity holdings for the common investor. The options are taxed in two steps but the capital gains that highly compensated corporate officers ends up being significant. If you own individual equities just look at the proxy statement to see what the levels of compensation are.
One of the problems in moving to more passive investments whether it is through a 401(k) or individual investments in ETFs or index funds, is that proxy voting is controlled by the fund manager and those votes are almost always in favor of the compensation proposed by the corporate board.
Tom M
May 3 2021 at 1:24pm
I don’t see the issue with stock options?
95%+ of all stock options granted to executives are Non-Qualified Stock Options where whatever value is being “exercised” is ordinary income. It’s like being paid a bonus with shares rather than cash.
Executives can choose to come up with cash to pay the “spread” value & the associates taxes in order to retain all the exercisable shares, however I still see nothing wrong here?
In terms of share dilution, every company provides cap tables for fully diluted company share break downs. It’s safe to say the signaling effect of executives selling/exercising shares has FAR more of an impact on a given stock price than the operational increase in aggregate “undiluted” shares.
Carried interest IS an obvious attempt to lump wage income (services being rendered by a hedge fund/PE manager) into capital gain income.
Henri Hein
Apr 29 2021 at 6:36pm
I think the example works well enough. Landsburg has previously been at pains to make the same point.
I have sometimes seen a different issue with a Double Taxation claim, where a taxpayer will complain taxes from multiple jurisdictions (Federal and State, for instance) is double taxation. That doesn’t seem right to me, but I’m not familiar enough with the term to know for sure if it applies in that case.
George M
Apr 30 2021 at 12:18pm
It’s not double taxation as the term is typically used. State income taxes are additional taxes on the same income to a different jurisdiction. Double taxation refers to paying income taxes twice on the same income to the same jurisdiction. Maybe consider state income taxes as a percent surcharge based on where the activity is taking place or income earned. It could be zero (e.g. FL, TX) or it could be 8+%.
This also plays out on the state level as states are sensitive to taxes paid by residents to the jurisdiction where the income is earned and also in a taxpayer’s resident state. Picture a NY resident who invests in a business in NJ. They will have a NJ tax liability by nature of where the income is earned. The NY resident taxpayer will also have that same income taxed on their resident state income tax return. To compensate for this double taxation, NY gives a tax credit against the NY tax liability for the taxes paid to NJ on the NJ source income (the computation is more complicated as tax rate arbitrage and income ratios impact it, but that’s going further than this discussion).
BC
Apr 29 2021 at 8:27pm
What’s most disappointing about this common capital gains tax misunderstanding is how many economists either don’t understand it or are unwilling to correct it. Most professional economists, left or right, will correct someone that says something like, “Free trade costs jobs.” However, with a few exceptions like Scott, it’s very rare to hear professional economists correct someone that says that capital gains receive “favorable” treatment relative to wage income. As Scott has explained, with a non-zero capital gains tax rate, one is actually penalized, not favored, for saving instead of consuming immediately. I assume that public finance is part of economics students’ core curriculum just like trade. Why is this concept not drummed into their heads just like comparative advantage and trade?
I think of it this way. When one saves one’s wages, or coconuts, the government takes a share upfront, 40% in this case. So, when the government taxes capital gains, it’s double dipping into the saver’s 60% share. It makes no difference whether the government spent its share immediately or saves alongside the saver. Suppose an investor bought a 40% stake in your company. Later, if the company started paying dividends, it would make no sense for that investor to say that he should also get a share of your 60% of the dividends for investing in your company. That’s what his 40% share was for. It would make no difference if that investor had already sold his 40% stake and therefore was no longer receiving any dividends.
Scott Sumner
Apr 30 2021 at 1:30am
Very good analogy.
Market Fiscalist
Apr 29 2021 at 11:32pm
‘choose a different kind of nut if you prefer’
Excellent article – but is the coconut any more a nut than the grapefruit is a grape?
Scott Sumner
Apr 30 2021 at 1:29am
Well, it has a nut inside . . .
Trying to Learn
Apr 30 2021 at 12:45am
I don’t find your argument convincing Scott.
“In this case, the tax rate on current consumption is still 40%, but the tax rate of future consumption is 54% (200 – 96)/200.”
Let’s make this scenario where each party only works 1 year in their life. The spender gets 100 coconuts in their lifetime. The saver gets 160. How many coconuts should each pay in tax? With a 40% rate that’s 40 coconuts for the spender, and 64 for the saver. So total consumption is 60 for the spender and 96 for the saver. That works out to the same math as you had, and it seems pretty fair to me.
Why should the saver pay less than the 40% rate on their lifetime sum of coconuts? The spender pays 40% on lifetime resources. It seems you want no capital gains, so the saver pays 60/160 = 37.5%.
Yes, capital gains disincentivize savings, but income taxes disincentivize working. We have to tax somewhere to pay for all the government functions we seem to want. In your ideal world:
Person A inherits a $4M stock portfolio, gets a 5% annual return for $200k and does not work for 30 years
Person B works their entire life for a $200k salary. They pay 40% taxes every year and consume the rest ($120k per year)
Person A gets $10M in lifetime resources ($4M portfolio and $6M in investment earnings) and pays zero in taxes. Person B gets $3.6M in lifetime resources and pays $2.4M in taxes. How is this system better?
For any given resource amount required, eliminating capital gains in favor of more income tax increases the incentive to save, but reduces the incentive to work. It’s also deeply regressive, because most capital gains + dividends go to those who are very well off.
robc
May 1 2021 at 7:11am
You left person A’s parents out of the equation.
They paid the tax on the income that was later invested and A inherited. Why should it matter whether A paid it or his parents paid it? And depending on when they died, for him to inherit $4M, he may or may not have paid a significant estate tax.
But, for someone “trying to learn”, your posts show a lack of missing the main point. Convert everything to consumption. Taxes either tax current consumption or future consumption. Excepting some weird oddball cases, current consumption is taxed at a lower rate than future consumption. If you don’t like the coconut example, look at Jose Pablo’s post.
Andy G
Apr 30 2021 at 1:39am
I am a fan, really. But your simple coconut economy is a poor model for the economy we live in. Your model neglects the tax arbitrage opportunities arising from the differential treatment of debt vs equity, tax deferral opportunities, step-up basis, etc.. When you look at the super wealthy, a common theme is that they built a tremendously successful business and their wealth far exceeded their taxable income. When you try to explain Elon Musk’s, Warren Buffet’s or Donald Trump’s taxes with coconuts, I shake my head.
David S
Apr 30 2021 at 5:09am
It really bothers me that so many people get mad at Bill Gates for being rich (and not paying taxes) and then vote to raise MY taxes.
Scott Sumner
Apr 30 2021 at 9:58am
The point of this post was not to make a “realistic” model of the US economy, it was to show the concept of double taxation to those who don’t understand the idea. For that you need a simple model.
Thomas Lee Hutcheson
Apr 30 2021 at 6:25am
The example is backward looking. Make the tax, whatever it needs to be to finance current public goods, administer pigou taxation of negative externalities, and transfer consumption from high to lower consumption constrained people, proportional to the number of coconuts invested.
I suspect in this model if the taxing authority is going to invest some of the coconuts, it should obtain them from the coconuts that would otherwise have been invested either by taxing them or borrowing them.
Back to the real world, I suppose lower rates on capital gains are there because such gains are not indexed for inflation and can bunch, putting the payer into a higher marginal tax rate. Correct those flaws and there is no more reason not to tax consumption of capital gains than consumption out of any other kind of income.
Scott Sumner
May 1 2021 at 10:53am
I’d encourage you to read the post again, you missed the point.
Hamish M
Apr 30 2021 at 7:24am
Does this still hold when shares are included in the original compensation package? E.g. CEO has a $70k salary but receives plenty of stock in the company (not purchased with income). In that situation, there’s no trade-off between consumption and investment, it’s just investment. Please correct my understanding if wrong.
MikeP
Apr 30 2021 at 4:41pm
Yes, the same argument holds.
Those shares were not purchased with income, but they were taxed as income.
Any tax applied to those shares or their gains after that is taxing that same income again.
Dylan
Apr 30 2021 at 8:06am
This analysis assumes that taxes were paid on the initial amount used for investment, which is I guess where my confusion comes from. I’ve had a lot of capital gains over the years, but my initial investment has rarely been subject to income tax. Largely, because for a long time my wage income wasn’t high enough to pay income tax. I’ve also been granted “founder shares” in startups where I didn’t have to pay income tax on the grant, because it wasn’t considered to be worth anything, and those shares were in lieu of a wage. My bitcoin was acquired at a level where my cost basis is close to zero. Investments where my initial capital came from wages have been segregated into tax-preferred accounts.
I’ve been a big beneficiary of the existing capital gains structure, particularly in recent years where LT gains are taxed at 0%, but I’m not sure philosophically it makes sense to charge me a much lower rate just because my income comes from luck rather than labor.
Scott Sumner
Apr 30 2021 at 10:00am
This is the point of the 401k plan. If you don’t pay taxes up front, you pay them when you sell the asset. So why limit the amount that people can contribute to 401ks?
Dylan
Apr 30 2021 at 10:29am
Well, at almost $20K, the contribution limit for the median employee is effectively unlimited. According to Fidelity, only about 13% of people max out their 401K contributions each year. If you work for yourself and can set up a SEP-IRA, contribution limits are much higher than even a 401K.
Personally though, I’d much prefer they raised the anemic contribution limits on IRAs. Not sure why having a tax-preferred investment account needs to be tied to working for an employer that offers one.
Scott Sumner
May 1 2021 at 10:56am
The limits certainly affected me, as I saved about half my income each year. In any case, if the limits are not important, get rid of them. And they raised the age where you must begin withdrawing from 70.5 to 72–why not make it 100?
Dylan
May 1 2021 at 1:42pm
I wasn’t saying the limits weren’t important (I don’t have an opinion on that one way or the other), just said they don’t impact all that many people. I find it unfair that people whose employer provides them with a 401K are able to invest 3X more in tax advantaged accounts than those who don’t.
I get why there is an age when you have to start taking distributions on 401Ks and traditional IRAs, the money has never been taxed up to that point, and they don’t want you to die before they get their hands on at least some of it. Not sure why that rule applies to ROTH accounts as well though.
Scott Sumner
May 2 2021 at 8:39pm
When you die, your heirs have to pay tax on the 401k accounts.
Tom M
May 3 2021 at 2:01pm
The only rational argument for having (1) IRA contribution limits and (2) Required Minimum distributions (RMDs) are that they are both designed to increase the amount of tax revenue the federal government gets today.
Roth IRAs do not have RMDs however individual who INHIRET Roth IRAs must begin taking RMDs (another point which makes no sense at all).
Scott is also correct – individuals who inherit Traditional IRAs must ultimately pay the taxes owned when making distributions.
Therefore, the logical conclusion is that the government intentionally wants to limit future consumption/investment in order to increase revenue today.
Trying to Learn
Apr 30 2021 at 3:12pm
You don’t see how this creates a regressive tax code? Most 401k contributions are by high earners, because they get the biggest tax breaks from contributing and have the most discretionary income to contribute. I am in a high tax bracket now, but I can probably retire at ~50, spread my withdrawals over 30-40 years, and pay very low tax rates on them. A 401k can easily be gamed to mostly avoid taxes entirely on the income.
Anonymous
Apr 30 2021 at 4:28pm
What you are proposing to do is to live on a very low income for a very long time. Why should you be taxed more than a person who simply earns a low income and lives off it for the same time period?
I think it actually would be VERY rare for somewhat high earners to retire early and then live on a low income until they die, but even if they do have they “cheated the system”? They consumed as much as a low income worker would.
I suppose they had more leisure, should we tax that? Should they get no reward at all for being unusually productive and helping other people?
Scott Sumner
May 1 2021 at 10:59am
For me it will be the opposite–I’ll pay higher taxes when I retire. In any case, one should be taxed on consumption levels, not income.
Thomas Lee Hutcheson
Apr 30 2021 at 4:44pm
Right about 401K and IRA limits. Let’s talk about how to tax income according to whether it is saved or invested, not how the income originated: capital gains, dividends, wages, etc. This reminds me of those old models in which workers do not save and capitalists do not eat. 🙂
Michael Rulle
Apr 30 2021 at 10:05am
Dylan—-I am obviously interested in your point that recent LT cap gains are taxed at zero. Do you mean inside a 401K? Or something else.
Dylan
Apr 30 2021 at 10:17am
If you make under $40K as an individual or $80K as a married couple, you don’t pay any long term capital gains. Many readers of this blog are probably above those thresholds but the married income amount is still well over median household income, so seems relevant for lots of people (including me!)
Michael Rulle
Apr 30 2021 at 9:59am
I needed to work thru your 401k example, which is same as the coconut example. It was very helpful. I had already done these kinds of things before—-but forgot. Yes, the 401k style idea with single taxation does eliminate the taxation of inflation problem——which I had conflated with inflation itself. This coconut example is excellent as it relates to your future consumption point .
Michael Rulle
Apr 30 2021 at 10:25am
Side bar. Are investors triple taxed? John owns Apple. Apple Pay’s taxes, therefore John pays taxes because he is Apple. Then John pays taxes on dividends. He also pays taxes on selling shares at a profit. Let’s ignore death taxes. John also paid taxes on income to buy Apple.
Is this triple taxation? It seems like it clearly is. But I wonder if I am missing somethin here.
Rob Weir
Apr 30 2021 at 10:57am
Another approach is to look at it from the accounting perspective.
A company has sales and expenses, and the difference between the two is their income, which is taxed via the corporate income tax. That’s the first time the profit is taxed.
After that, the corporation’s leadership decides what to do with the profits, which really belong to the owners, i.e., the stockholders. They have two basic options:
Pay it to the owners in the form of dividends.
Reinvest it in the business by, e.g., opening a new factory.
In the first case, the dividend, the profits which were already taxed, is then taxed again when it are received by the stockholders. But in recognition that this is a double-taxation, the stockholders pay a special lower rate on such “qualified dividends.” (Top rate of 20% for, but for most investors only 15%.)
In the second case, the reinvestment, if it goes well, will lead to the business making even more profit down the road. When the stockholder then sells their stock, they realize a capital gain that is some combination of: a) retained earnings, b) compounded growth of retained earnings, c) inflation. Paying a tax on retained earnings is clearly double taxation. And paying a tax on inflation is absurd. The fact that the capital gain is a mishmash of inflation and already taxed earnings, with some compounding, is why it is taxed at a lower rate.
Aside from fairness, the question I think we need to ask from a tax policy perspective, is whether we want to put the thumb on the scale of corporate capital structures? Do we want to encourage payment of dividends in lieu of retaining earnings? That’s the likely outcome of raising capital gains rates much higher than qualified dividend rates. But then why would anyone invest in, say, a new tech company or a new pharmaceutical company, as opposed to an electric utility company? The former has no present earnings, and at best offers a future capital gain, while the later offers no growth prospects but a steady stream of dividends.
IMHO, the fair way to tax capital gains is to back out retained earnings, increasing the purchase basis, and then reduce the sale price by the CPI over the holding period. Of course, the recording keeping for this is non-trivial.
Stéphane Couvreur
Apr 30 2021 at 12:11pm
One way to see it is that if taxes hit equally the three kinds of income – wages, risk-free interest and pure profit – then there is no “double taxation”. Wages are taxed – and this could be seen as a tax on human capital – and other capital gains and income are taxed, too.
Where’s the double taxation if you are applying a single tax to different sources of income?
AMT
Apr 30 2021 at 3:20pm
Scott, have you, an economist, ever heard of the share of income that goes to capital vs labor? I’ll present a simple explanation, which hopefully you will be able to wrap your head around.
Someone earns 100 dollars in WAGES, and pays 40 in wage income taxes, and now has 60 dollars left. They can choose to consume or save their remaining income. If they save it, they can earn additional NON-WAGE (CAPITAL GAINS) income from investing it. Notice, these are different words, because they are different things. There is a tax on wage income, and then a separate tax on investment income. It doesn’t matter that the investment income came from savings derived from wage income, or savings from other capital income. The investment income is new income.
To be clear, I am not saying anything about what the optimal capital gains tax rate should be as it obviously disincentivizes saving, but everyone can clearly see capital gains are of a different character than wages. Many people consider investment returns to be “passive” income. You earn it without doing work, as a reward for saving and delaying your consumption (except for situations like you already described, which clearly still show a strong rationale for the capital gains tax because it actually contains labor income) and a risk premium. Have you read Capital, by Piketty? I strongly disagree with most of his opinions, but a major complaint of his is that rich people can grow their wealth without having to work, and so you can tell he basically thinks capital income is “unearned.” This is the fundamental issue in this debate. Some people think taxing this “unearned income” that disproportionately benefits the wealthy increases fairness. I’m not saying whether it is more or less fair to tax savings, but I can at least understand the argument. I wouldn’t say capital gains are unearned (because you do make sacrifices by delaying consumption and deserve compensation), but they are very different from labor income.
Is it fair to tax people for delaying their consumption? Is it fair to tax people higher rates for being more productive and earning more labor income than others? Both punish virtues that make society better off. I think it is probably less fair to have very progressive tax brackets instead of a flat tax, than it is to tax capital gains.
Jose Pablo
Apr 30 2021 at 5:53pm
If you think that capital income is “unearned” and because of that has to be penalized (or even better forbidden) then “saving and investing” makes no sense as an activity (what’s the point of doing things that are “forbidden” or heavily penalized?).
Since, on the other hand, invested capital per worker is key in fostering productivity and increasing wages (as it is), looking at capital income as “unearned” will mean reducing productivity and depressing wages.
You could also say that “labor income” is unearned since it does not require capital (which makes the same little sense that saying the opposite).
Since producing goods and services requires both capital and work, they share the benefits of this production following the voluntary agreements capital and labor reach and the relative scarcity of both.
Both are equally “agreed to be earned”. I don’t get why the earnings of one of these equally necessary inputs need to be penalized. Of course leaving apart ideological reasons (or pure envy).
Scott Sumner
May 1 2021 at 11:06am
You are mixing up two unrelated concepts. One is taxing high savers like me at higher rates than less thrifty people with the same lifetime wage income. That makes no sense. Another is taxing rich people at higher rates (an idea I support.)
And yes, I read Piketty’s book. I’m not a fan of his ideas.
AMT
May 1 2021 at 4:45pm
I’m not mixing anything up, because as you again say,
They are taxed on their INVESTMENT income, not their wage income. The person who earns identical wages, and earns ADDITIONAL income has still paid the same WAGE taxes.
Do you disagree that the high saver, who earns the same WAGE income, earns more total lifetime income? It is necessarily true if they have positive returns and YOU don’t make the mistake of conflating wage income with capital gains.
Scott Sumner
May 1 2021 at 6:53pm
Yes, the person who saves obviously has more lifetime income. And yet by assumption he is no better off than the non-saver, as they both had identical wealth, they just consumed it at different points in time. (That just shows that income is meaningless.) So why does the high saver have to pay more tax, given he is no better off than the low saver?
AMT
May 2 2021 at 10:10am
That is purely making a fairness argument, which does absolutely nothing to prove “double wage taxation.” Feel free to argue why capital gains are bad based on fairness, as well as on policy, but despite your semantic conflation, wages are not taxed twice. Capital gains and wages are different things, plain and simple.
Jose Pablo
May 2 2021 at 10:11am
a) $100 of good and services today and b) $10 of good and services per year “forever” (my lifetime and the lifetime of my children and my children’s children and ….) have, assuming a 10% discount rate, the same value.
Why you think that b (delaying consumption) should pay a higher tax rate is a mystery to me
AMT
May 2 2021 at 10:25am
You clearly need to read my posts much more carefully, because I never said I hold any such beliefs.
Jose Pablo
May 2 2021 at 10:41am
Yes, you do. a) have consume their wage income the year it was earned and b) invested that very same wage and consume it $10 a year (let us say the dividends paid by their investment) for ever (let’s assume he lives forever due to the health benefits of his ability to delay consumption).
b) does not get any “additional income” if you add “income” more carefully (as you should)
AMT
May 2 2021 at 11:08am
If NONE of the above clued you in, you are functionally illiterate.
Jose Pablo
May 2 2021 at 1:52pm
Your wrong view of capital income as “additional” income and the idea (implicit in your post if it is to mean anything) that as a “different” income should also be taxed, amounts to the same thing than saying that “capital income” (delayed consumption) should be taxed at a higher rate. That’s what the whole discussion is about.
Maybe you don’t understand the implications of what you are saying when you wrongly say that capital income is “additional income”.
If you understand “income” as “anything that gives you the right to consume”, the first year income from your wage and the perpetual dividends of your first year investment are the same (once you add them properly).
In any case, looking at how taxes affect your ability to consume (compare with a “no taxes” scenario) for any kind of income in any kind of “tax scheme”, is what will give you the actual tax rate on your “income” and will allow you to avoid this “semantic” traps.
Jose Pablo
Apr 30 2021 at 5:34pm
Leaving apart coconuts, in order to get the effective rate you are paying on each kind of income, you have to compare how much you could consume in a “no taxes whatsoever scenario” with how much you can really consume in the “real taxes scenario” you analyze.
Using this method:
a) Effective rate when you consume your wage:
• No taxes scenario: you earn $100 you get $100 of goods and services
• 40% tax on wages scenario: you earn $100 you can consume $60 after taxes. Effective tax rate 40%
b) Effective tax rate when you consume your return on invested capital
• No taxes scenario: you earn $100, invest $100 get $10 in dividends (assuming a 10% return). You can consume $10
• 40% tax on wages scenario: you earn $100, invest $60 get $6 in dividends. You can consume $6. Effective tax rate 40%
• 40% tax on wages + 25% corporate taxes: you earn $100, invest $60 get $4.5 in dividends (assuming the same pay-out and assuming that investors pay corporate taxes, so your 10% return pretax is now a 7.5% post tax). You can consume $4.5. Effective tax rate on your invested income is now 55%
• 40% tax on labor + 25% corporate taxes + 40% tax on dividends: you earn $100, invest $60, get $4.5 in dividends, and can consume $2.7 after taxes on dividends. Effective tax rate 73%
robc
May 1 2021 at 9:18am
To throw a monkey wrench into the discussion, from my deontological perspective, both a wage tax and a cap gains tax are immoral. It is why I am a Single Land Tax advocate, it is the only tax I can accept morally.
Bonus, it ends the argument over taxing wage income and capital gains income at different rates. They will be equal at 0% and still no double taxation!
Instead we can have arguments over how to value unimproved land!
Roger Sparks
May 1 2021 at 10:14am
This is really a pretty goofy example. You have confused individuals into the macro situation.
You see, planting coconuts as seed for future crop is one method of consumption. The second method of consumption is taxation which means the crop is processed through stomachs. Add the two consumption methods and we have 100% consumption.
This would go on repetitively every year.
At year 10, we have harvest = 120 coconuts.
I would say that at year 10 we can tax 120 coconuts at the wage tax of 40%. How would we apply another 40% capital gains tax?
Roger Sparks
May 1 2021 at 12:03pm
This basic model jumps from macro to micro. The closed island economy produces 100 coconuts. That’s macro.
Now we jump to taxation. That’s macro going after micro.
So then we have macro taking 40$ of the crop for public good, that’s consumption of the eating it up kind. That only leaves 60 coconuts to plant. These 60 coconuts are consumed by planting in preparation for 10 years out production. 100% of production has been consumed one way or the other.
Should we now jump to micro and allow that these 60 planted coconuts are individually owned and therefore should be subjected to a capital gains tax when they finally produce income?
I think not. In 10 years, we have a crop of 120 coconuts on the macro level. Harvest of this can be taxed at the wage level, giving us (40% of 120 equals) 48 coconuts to eat up. Capital gains are simply not a realistic part of this example.
Vivian Darkbloom
May 1 2021 at 5:14pm
I disagree with both the logic and the “simple numerical example”. I think reality is being obfuscated here so let me rephrase the example in a hopefully more coherent manner.
Let’s assume that a coconut costs $1 today and costs the same $1 in 10 years (to eliminate inflation from the equation). Let’s also assume that the tax rate on wage income and long-term capital gains is 40 percent. People don’t earn coconuts, so let’s further assume that a person earns $100 and pays a tax in the same year of $40. That person buys 60 coconuts with her after-tax wages. The effective tax rate on those wages is 40 percent 40/100).
Now, those $60 remaining after tax are re-invested and grow to $120 after 10 years. The taxpayer has a basis of $60 (representing the after-tax wages). Thus, the LTCG is $120-$60 =$60 and the tax on $60 is $24 leaving $96 ($120-$24=$96). With the $96, the person buys 96 coconuts. The effective tax rate on the LTCG is, of course, 40 percent (24/60).
At this point, we should pause and ask why, if we are given a cost basis in the after-tax wages of 60, those wages could ever by “taxed twice” as alleged here. So, let’s check the math to see what the *combined* tax rate on those wages and LTCG is. The total income is $100 in wages plus $60 in LTCG for a total income of $160. The combined tax rate is calculated as (40+24)/160 that is, 40 percent.
Stated differently, in each case each dollar of income (net of wage tax, LTCG tax and the tax on combined income after wage tax and then LTCG tax, respectively) buys one exactly .6 coconuts. Absent inflation, there is no numerical penalty for deferred consumption due to the separate taxation of wages and capital gains on re-invested wages (the intangible value of deferred enjoyment is also another matter).
The difference here is that the “income” as calculated in the last equation of the post above was $200 and not $160. The proper equation is not (200-96)/200; rather, it is (160-96)/160 which, of course, gives 40 percent. (As regards income, the equation is more logially 64/160 yielding the same result). The 200 number does not represent the proper amount of income and also conflates the initial tax on wage income with the tax on LTCG. Logically and mathematically that simply isn’t true. Commenters have every reason to doubt that “…taxing capital income is double taxing wage income.”. Wages are not taxed *twice* because of capital gains taxation. Here the faulty conclusion was due to a faulty initial assumption and the sleight of hand of simply making up an in appropriate “income” number. If you want to make a commentary about how the tax system works, then you have to give an accurate example of how it works rather than using an inaccurate example. Here, one should from the assumption (i.e. reality) that wages are actually taxed once and proceed from that and use the tax rules as they actually are. Instead of assuming a can opener, one assumed here too many coconuts.
The failure of the US system of capital gains taxation to account (directly) for inflation is, to be sure, a problem when comparing current with future consumption, as is the lack of direct reward for delayed enjoyment, but those are not the issues here and they have nothing to do with the alleged “double taxation” of wages.
Scott Sumner
May 1 2021 at 6:50pm
There’s a reason that economists almost universally look at tax incidence in terms of the impact on consumption; one avoids a confusing debate over terminology such as you have presented here. It seems to me that you’ve simply assumed your answer is correct; you’ve demonstrated nothing.
Again, in my example current consumption is taxed at 40% and future consumption at 54%. That’s what matters. The concept of “income” is almost meaningless for evaluating tax incidence. Your $160 figure adds current and future income, which is like adding apples and oranges.
Vivian Darkbloom
May 2 2021 at 5:29am
There is no confusing issue over terminology in my post. And, no, I’m not “adding apples and oranges”. Of course, I’ve added current and future income. What you’ve done, on the other hand, is not only add current and future income but *imaginary* income to boot to get a faulty result!
There is no question that capital gains tax (as well as income tax on wages and all other taxes) reduces consumption. But, there is also no question that here there is no “double taxation of wage income”. As regards “confusing terminology”, if you believe that the term “income” has no meaning, then by all means stop using it as if you think it does, but only to suit your means when it is convenient, such as here in your very first introductory topic sentence:
“I am often surprised by how many commenters say something to the effect, “I don’t get how taxing capital income is double taxing wage income.”
Jose Pablo
May 2 2021 at 10:29am
Yes, you do. When you add dollars today and dollars in the future you are, in fact, adding apples and oranges.
Do you prefer $3,500 today or my promise of paying you $3,500 in 20 years’ time? (or even better my promise of paying you, in 20 years’ time, whatever the number I get throwing a dice time 1,000)
If you have a preference for one of these two incomes (and I bet you do) you cannot add them as if they were the same. They are not.
Scott Sumner
May 2 2021 at 8:45pm
You seem to be saying that wage income and capital income can be added together to get a meaningful concept called total income, which is just wrong. Just because the IRS does things that way, doesn’t make it right.
Henri Hein
May 3 2021 at 2:11pm
That is not the combined total tax rate. You discounted the initial wage tax from the capital gains calculations. Absent taxation, the tax-payer would have had 200 at the end. The total effective tax rate in your example is 96/200=48%.
I don’t understand how Scott’s example is imaginary in ways yours is not. They are examples. They are imaginary by nature.
Henri Hein
May 3 2021 at 2:14pm
Correction: it should be (200-96)/200 = 52%.
John Hawkins
May 1 2021 at 9:28pm
I’ve seen analysis that changes like this should get cancelled out by changes in the interest rate (I.e. the incidence falls in a way that doesn’t pervert anything because interests rates rise with higher capital gains and vice versa) – what do you think of those arguments?
Interestingly, even if those arguments are right, it would seem that there might be macro consequences of higher cap gains taxes as you get closer to the lower bound…
Phil H
May 2 2021 at 3:27am
My worry about this is composition effects. I get the idea that for an individual, taxing capital gains can be seen as double taxation. But for the economy as a whole, under a fractional banking system, that saved money is still available. It’s not buried in the ground like the coconuts. So it’s not obvious to me that a capital gains tax harms the economy as a whole. I can see how it might have the effect of pushing people to consume more and save less. But it would take furhter logical steps for me to arrive at the conclusion that this is a bad thing.
Per Kurowski
May 2 2021 at 8:15am
“People are being encouraged to eat their capital today, not save it and boost future consumption”
Is that not what the Fed is currently encouraging?
Roger Sparks
May 2 2021 at 8:19am
Let’s try this for a capital gains example:
Imagine an island where grows a coconut crop. Here, if you plant one coconut, you can get two coconuts 10 years later.
A worker helps harvest coconuts and is given 100 coconuts as a wage. Government levies a wage tax of 40% and takes 40 coconuts. This worker has 60 coconuts left to do with as he chooses. He can eat them or he can plant them. If he plants them all, he would harvest 120 coconuts in 10 years.
NOW someone suggests a capital gains tax of 40%. How should we apply this?
If our worker eats his coconuts, there would be no future coconuts to tax.
If our worker plants all 60 of his coconuts, he will have 120 coconuts in 10 years. Should he (in the future) pay capital gains tax on 120 coconuts? Or just pay capital gains tax on the gain of 60 coconuts? (He already paid a wage tax on 60 coconuts.)
[Under today’s tax rules, I think our worker would (in 10 years) harvest 120 coconuts, then sell and pay income tax on 60. That would leave 60 in his ownership that could be planted to keep the pattern repeating. This worker would have operating capital of 60 coconuts invested so long as the pattern continues.
Someday, if our worker grows weary of growing coconuts, he might eat his invested capital.]
Finally, if coconuts are converted to fiat money equivalent, we could easily have a change in coconut value over a 10 year period. Should we charge a capital gains tax on our workers invested capital if it increases value in terms of fiat? I think that would be a “double taxation” and very unfair.
Dale Doback
May 2 2021 at 11:18am
Warren Buffett has been saying for years that he pays a lower tax rate than his secretary. I would like that fact explained with coconuts.
robc
May 3 2021 at 10:30am
He recently said that 99.97% of his wealth is in BRK stock. Since it doesn’t pay dividends and he doesn’t sell, it would depend on how he is calculating his denominator.
Or, he has a really good coconut accountant.
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