Taxing investment income is complicated

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How should a state tax in­vest­ment in­come if it wants to max­i­mize its cit­i­zens’ welfare? This sounds like a sim­ple ques­tion but I find it sur­pris­ingly hard to think about. Here are some of the po­si­tions I’ve moved through over the last few years:

  • Tax­ing in­vest­ment has dis­tor­tionary effects, but we should have non-zero in­vest­ment taxes for the same rea­sons we want a broad tax base in gen­eral—dou­bling the size of a tax quadru­ples its so­cial cost, so it’s bet­ter to have lots of small taxes rather than a few big taxes. Whether we should have lower taxes on in­vest­ment in­come or or­di­nary in­come mostly de­pends on whether taxes have a big­ger im­pact on de­ci­sions about work­ing or about sav­ing.

  • Us­ing in­vest in­come taxes to fund re­dis­tri­bu­tion only makes sense if they are dis­pro­por­tionately paid by richer peo­ple. But if they are, then by ex­actly the same to­ken they will also re­duce the in­cen­tives to be­come rich—in fact they have just as large a dis­in­cen­tive effect as an equally-pro­gres­sive in­come tax. And that’s on top of dis­in­cen­tiviz­ing and dis­tort­ing sav­ing. So we should just raise in­come taxes in­stead.

  • We can de­com­pose in­vest­ment in­come into two parts—in­ter­ested earned by cap­i­tal at the risk-free rate, and an ex­cess re­turn from tak­ing on risk (or illiquidity, or what­ever). Tax­ing the risk-free re­turns seems bad, but tax­ing ex­cess re­turns seems like it’s al­most a free lunch: it re­duces an in­vestor’s losses as well as their gains, so they can just lever up their in­vest­ments to offset the effect of taxes. The net effect is similar to im­ple­ment­ing a large sovereign wealth fund, with the gov­ern­ment and pri­vate in­vestors split­ting both the risk and the re­turns from pro­duc­tive in­vest­ments. It’s prob­a­bly prefer­able to a sovereign wealth fund, be­cause it doesn’t re­quire the state to liter­ally own huge quan­tities of as­sets. Since risk com­pen­sa­tion is the large ma­jor­ity of in­vest­ment re­turns, it seems like cap­i­tal gains taxes are good on bal­ance.

  • All of the risk in­curred by a sovereign wealth fund or cap­i­tal gains tax is ul­ti­mately passed back on to cit­i­zens, whether in the form of taxes or re­duced pub­lic ser­vices or in­fla­tion. So a cap­i­tal gains tax or sovereign wealth fund is ac­tu­ally only a good idea if cit­i­zens are sys­tem­at­i­cally un­der-ex­posed to mar­ket risk. But most peo­ple in­vest rel­a­tively con­ser­va­tively. So in fact these poli­cies can mostly be jus­tified as ei­ther cor­rec­tions for credit mar­ket failures (to help peo­ple with­out sav­ings get an ap­pro­pri­ate level of ex­po­sure to mar­ket risk) or more re­al­is­ti­cally as pa­ter­nal­is­tic cor­rec­tions for in­vest­ment mis­takes. They may still be a good idea, but the case is way more murky and other in­ter­ven­tions may be more ap­pro­pri­ate.

My cur­rent best guess is that we should tax cap­i­tal gains at the same rate as or­di­nary in­come, but only tax re­turns above the risk-free rate. (So if I buy short-term gov­ern­ment bonds, I owe no taxes, and if I make less than that then I get a de­ductible loss.) I think this is likely to be bet­ter than ei­ther the sta­tus quo or most of the al­ter­na­tives I’ve heard se­ri­ously dis­cussed.

But given that my views have gone through this many re­vi­sions, my all-things-con­sid­ered view is more like “This is re­ally com­pli­cated, who knows.” I hope this post h helped move you in that di­rec­tion.