A Good Lesson On Tax Policy

This article is about giving a tax preference to capital gains over ordinary income. This practice violates the rule of horizontal equity which holds that people at the same income level should pay the same tax rate. Congress makes changes to this rule because it wants to encourage certain kinds of behavior. In this case it wants to encourage capital investments. But the buying and selling of stocks in the secondary market does not increase productive investments in capital. It also implies that investments in human capital are not as valuable as investments in other forms of capital. Why should a surgeon be taxed at a higher rate than someone who purchases an asset and then sells it for a higher price? The surgeon has made an investment in human capital that we want to encourage as well as we want to encourage business investment.

The tax code is riddled with preferences like the capital gains preference. They are referred to as tax expenditures because they reduce tax income. They have the same impact on the federal budget as a change in government spending. If Congress wants to encourage certain kinds of behavior it would be more transparent to subsidize it by putting it in the budget as an expense. Its easier for citizens to examine the expense budget than it is to analyze the tax code. Perhaps that is why Congress rewards lobbying for tax breaks.

I would also argue that we often encourage behavior that the we don't want when we put preferences in the tax code. For example, most of the trading in the stock market today is high frequency trading. Shares are purchased and resold in fractions of second in order to capture a small capital gain that is highly leveraged. This increases volatility and it serves no public purpose. We also encourage large numbers of our brightest students to become hedge fund managers or private equity managers by taxing their income at the capital gains rate. That may not be the best way to get a return on our investment in human capital.

Democracy only works well when we have an informed public. Some decisions are so complex that few can invest the time and energy to understand them. On the other hand few things are more important than tax policy and where the government spends it money. I live in a small town that has to pass a budget annually. The citizens debate the budget every year and the attention given to it is rewarded. We get the level of services that we want and we have a relatively low tax rate. Not everyone agrees with the budget but the process works. The process is more complicated at the national level but few or our citizens have been provided the education that they need to contribute to the process. If you learned something from this article it is a good thing, but it also illustrates a gap in our education system.