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.