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Archive for the ‘Capital Gains Tax’ Category

I wrote last month about a new book from the Fraser Institute about demographics and entrepreneurship.

My contribution was a chapter about the impact of taxation, especially the capital gains tax.

At a panel in Washington, I had a chance to discuss my findings.

If you don’t want to watch an 11-minute video, my presentation can be boiled down to four main points.

1. Demographics is destiny – Other authors actually had the responsibility of explaining in the book about the importance of demographic change. But it never hurts to remind people that this is a profound and baked-in-the-cake ticking time bomb.

So I shared this chart with the audience and emphasized that a modest-sized welfare state may have been feasible in the past, but will be far more burdensome in the future for the simple reason that the ratio of taxpayers to tax-consumers is dramatically changing.

And it goes without saying that big-sized welfare states are doomed to collapse. Think Greece and extend it to Italy, France, Japan, and other developed nations (including, I fear, the United States).

2. Entrepreneurship drives growth – Capital and labor are the two factors of production, but entrepreneurs are akin to the chefs who figure out news ways of mixing those ingredients.

For all intents and purposes, entrepreneurs produce the creative destruction that is a prerequisite for growth.

3. The tax code discourages entrepreneurship – The bulk of my presentation was dedicated to explaining that double taxation is both pervasive and harmful.

I shared my flowchart showing how the American tax code is biased against income that is saved and invest, which discourages entrepreneurial activity.

And then showed the capital gains tax burden in developed countries.

The U.S. is probably even worse than shown in the above chart since our capital gains tax is imposed on inflationary gains.

4. The United States need to be more competitive – Last but not least, I pointed out that America’s class-warfare tax policies are the fiscal equivalent of an “own goal” (soccer reference for World Cup fans).

And this chart from my chapter shows how the United States, as of mid-2016, had the highest combined tax rate on capital gains when including the effect of the capital gains tax.

That’s the bad news. The good news is that the Trump tax cuts did produce a lower corporate rate. So in the version below, I’ve added my back-of-the-envelope calculation of where the U.S. now ranks.

But the bottom line is still uncompetitive when looking at the tax burden on investment.

And never forget that this ultimately backfires against workers since it translates into lower pay.

P.S. The Wall Street Journal produced an excellent description of why capital gains taxation is very destructive.

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I’ve written over and over again that changing demographics are a very under-appreciated economic development. I’ve also written about why entrepreneurship is a critical determinant of growth.

But I never thought of combining those topics. Fortunately, the folks at the Fraser Institute had the foresight to do just that, having just published a book entitled Demographics and Entrepreneurship: Mitigating the Effects of an Aging Population.

There are chapters on theory and evidence. There are chapters on specific issues, such as taxes, regulation, migration, financial markets, and education.

It’s basically the literary equivalent of one-stop-shopping. You’ll learn why you should be concerned about demographic change. More important, since there’s not much policy makers can do to impact birthrates, you’ll learn everything you need to know about the potential policy changes that could help nations adapt to aging populations.

This short video is an introduction to the topic.

Let’s look at just a few of the highlights of the book.

In the opening chapter, Robert Murphy offers a primer on the importance of entrepreneurship.

…there is a crucial connection between entrepreneurship and economic prosperity. …There is a growing recognition that a society’s economic prosperity depends…specifically on entrepreneurship. …Two of the top names associated with the theory of entrepreneurship are Joseph Schumpeter and Israel Kirzner… Schumpeter famously invoked the term “creative destruction” to describe the volatile development occurring in a capitalist system… Kirzner has written extensively on entrepreneurship…and how…the alert entrepreneurial class who perceive these misallocations before their more complacent peers, and in the process earn pure profits… Schumpeter’s entrepreneur is a disruptor who creates new products first in his mind and then makes them a reality, whereas Kirzner’s entrepreneur is a coordinator who simply observes the profit opportunities waiting to be grasped. …If the goal is maximum economic efficiency in the long run, to provide the highest possible standard of living to citizens within the unavoidable constraints imposed by nature, then we need bold, innovative entrepreneurs who disrupt existing modes of production by introducing entirely new goods and services, but we also need vigilant, alert entrepreneurs who spot arbitrage opportunities in the existing price structure and quickly move to whittle them away.

Murphy describes in the chapter how there was a period of time when the economics profession didn’t properly appreciate the vital role of entrepreneurs.

But that fortunately has changed and academics are now paying closer attention. He cites some of the recent research.

An extensive literature documents the connection between entrepreneurship and economic growth. The studies vary in terms of the specific measure of entrepreneurship (e.g., small firms, self-employment rate, young firms, etc.) and the size of the economic unit being studied. …Carree et al. (2002) look at 23 OECD countries from 1976 to 1996. …They “find confirmation for the hypothesized economic growth penalty on deviations from the equilibrium rate of business ownership… An important policy implication of our exercises is that low barriers to entry and exit of businesses are necessary conditions for the equilibrium seeking mechanisms that are vital for a sound economic development” …Holtz-Eakin and Kao (2003) look at the birth and death rates of firms across US states, and find that this proxy for entrepreneurship contributes to growth. Similarly, Callejón and Segarra (1999) look at manufacturing firm birth and death rates in Spain from 1980 to 1992, and conclude that this measure of “turbulence” contributes to total factor productivity growth. …Wennekers and Thurik (1999) use business ownership rates as a proxy for “entrepreneurship.” Looking at a sample of 23 OECD countries from 1984 to 1994, they, too, find that entrepreneurship was associated with higher rates of employment growth at the national level.

In a chapter on taxation, Seth Giertz highlights the negative impact of taxes on entrepreneurship, particularly what happens with tax regimes have a bias against saving and investment.

High tax rates discourage both consumption and savings. But, for a given average tax rate, taxes on an income base penalize savings more heavily than taxes on consumption. …a consumption tax base is neutral between the decision to save versus consume. By contrast, an income tax base results in the double taxation of savings. …three major features of tax policy that are important for entrepreneurship. First, capital accumulation and access to capital is essential for innovation to have a big impact. Despite this, tax systems generally tax savings more heavily than consumption….Second, the tax treatment of risk affects incentives for entrepreneurship, since entrepreneurship tends to entail high risk. …progressivity can sometimes discourage entrepreneurship. This is because tax systems do not afford full offsets for losses, making progressivity effectively a tax increase. …Third, tax policy can lead entrepreneurial activity to shift from productive toward unproductive or destructive aims. Productive entrepreneurship tends to flourish when the route to great wealth is achieved primarily through private markets… High taxes reduce the rewards from productive entrepreneurship. All too often, smart, talented, and innovative people are drawn out of socially productive endeavours and into unproductive ones because the private returns from devising an innovative tax scheme—or lobbying government for special tax preferences—are greater than those for building the proverbial better mousetrap.

In a chapter I co-authored with Brian Garst, Charles Lammam, and Taylor Jackson, we look specifically at the negative impact of capital gains taxation on entrepreneurship.

We spend a bit of time reminding readers of what drives growth.

One of the more uncontroversial propositions in economics is that output is a function of labor (the workforce) and capital (machines, technology, land, etc.). Indeed, it is almost a tautology to say that growth exists when people provide more labor or more capital to the economy, or when—thanks to vital role of entrepreneurs—labor and capital are allocated more productively. In other words, labor and capital are the two “factors of production,” and the key for policymakers is to figure out the policy recipe that will increase the quantity and quality of those two resources. …In the absence of taxation, people provide labor to the economy so long as they value the income they earn more than they value the foregone leisure. And they provide capital to the economy (i.e., they save and invest) so long as they value future consumption (presumably augmented by earnings on capital) more than they value current consumption.

And we highlight how entrepreneurs generate the best type of growth.

this discussion also helps illustrate why entrepreneurship is so important. The preceding analysis basically focused on achieving growth by increasing the quantity of capital and labor. Such growth is real, but it has significant “opportunity costs” in that people must forego leisure and/or current consumption in order to have more disposable income. Entrepreneurs, by contrast, figure out how to increase the quality of capital and labor. More specifically, entrepreneurs earn profits by satisfying consumer desires with new and previously unknown or underused combinations of labor and capital. In their pursuit of profit, they come up with ways of generating more or better output from the same amount of labor and capital. This explains why we have much higher living standards today even though we work far fewer hours than our ancestors.

And here’s what we say about the counterproductive impact of capital gains taxation, particularly when combined with other forms of double taxation.

…the effective marginal tax rate on saving and investment is considerably higher than the effective marginal tax rate on consumption. This double taxation is understandably controversial since all economic theories—even Marxism and socialism—agree that capital is critical for long-run growth and higher living standards. …capital gains taxes harm economies in ways unique to the levy. …entrepreneurs play a vital role in the economy since they figure out more efficient ways to allocate labor and capital. …The potential for a capital gain is a big reason for the risk they incur and the effort they expend. Thus, the existence of capital gains taxes discourages some entrepreneurial activity from ever happening. …the capital gains tax is more easily avoidable than other forms of taxation. Entrepreneurs who generate wealth with good ideas can avoid the levy by simply choosing not to sell. This “lock-in effect” is not good for the overall economy… Most governments do not allow taxpayers to adjust the value of property for inflation when calculating capital gains. Even in a low-inflation environment, this can produce perverse results. …taxpayers can sometimes pay tax even when assets have lost value in real terms. …Capital gains taxes contribute to the problem of “debt bias,” which occurs when there is a tax advantage for corporate investments to be financed by debt instead of equity. …Excessive debt increases the probability of bankruptcy for the firm and contributes to systemic risk.

We then cite a lot of academic studies. I strongly encourage folks to peruse that section, but to keep this column manageable, let’s close by looking at two charts that reveal how some nation – including the United States – have uncompetitive tax systems.

Here are long-run capital gains tax rates in developed nations.

By the way, even though the data comes from a 2018 OECD report, it shows tax rates as of July 1, 2016. So not all the numbers will be current. For instance, I assume Macron’s reforms have mitigated France’s horrible score.

Speaking of horrible scores, here are the numbers showing the combined burden of the corporate income tax and capital gains tax. Sadly, the United States was at the top of this list as of July 1, 2016.

The good news is that the recent tax reform means that the United States no longer has the world’s most punitive tax system for new investment.

Though keep in mind that the United States doesn’t allow investors to index capital gains for inflation, so the effective tax rate on capital gains will always be higher than the statutory tax rate.

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Ideally, there should be no capital gains tax.

After all, the levy is a self-destructive form of double taxation that reduces the quantity and quality of investment. And that’s not good for wages and jobs.

To add insult to injury (to be more accurate, to add injury to injury), the tax isn’t indexed for inflation. So investors get taxed on the full increase in the value of an asset even though a significant chunk of the increase often is due solely to inflation.

Steven Entin of the Tax Foundation has some new research on this issue.

Many elements of the income tax are adjusted for inflation, such as tax brackets, standard deductions, and income thresholds or dollar amounts of some tax credits. However, the purchase price of assets later sold for capital gains or losses is not adjusted for inflation. As a result, inflation can do a real number on savers by turning real losses into taxable nominal gains. To avoid such outcomes, it would make sense for the government to allow an inflation adjustment for the cost of assets.

Steve points out that the absence of indexing is very brutal during periods of high inflation – which may soon become a relevant issue again.

During the late 1960s and 1970s, when inflation was high and the stock market was flat, it was not uncommon for people who sold assets to report inflated nominal capital gains that were negative in terms of purchasing power. In effect, the savers were taxed on a real loss. …Suppose one had bought $100 of stock in the XYZ Corporation in 1965, and sold it in 1981, for $110. This looks like a $10 gain. But…The stock would have had to rise to $286 just to keep pace with inflation. …the investor lost $176, in 1981 dollars ($286 – $110). Any tax collected on the nominal $10 gain was, in fact, a tax on a real loss.

But even if inflation remains low, this is still an important issue.

Taxing genuine capital gains is bad enough, so it’s not a surprise to learn that taxing inflationary gains is even worse. It exacerbates the anti-capital bias in the current tax code.

Taxation of fictitious gains or other capital income reduces saving and raises the cost of capital, thereby retarding investment, productivity growth, and wage growth. …In an ideal tax system, saving would not be treated worse than consumption. …When we earn income and pay tax, and use the after-tax income for consumption, the federal government generally leaves the consumption alone, except for a few excise taxes… The earnings are taxed, but not the enjoyment of the subsequent purchases. Saving is a purchase too. It lets us “buy” a stream of future income with after-tax money. But if we buy a bond, the stream of interest is taxed. If we buy a share of stock, the dividends are taxed, and any reinvested earnings that increase the value of the company are taxed as capital gains.

Here’s Steve’s conclusion.

Inflation raises the price of many assets acquired by savers. When they sell the assets, much of their capital gains may be due only to inflation. Inflation-related gains are not a real increase in wealth. Indexing the purchase price (tax basis) for inflation would provide savers some relief for this type of tax on fictitious income.

Well said, though I have one minor quibble. A capital gain, whether real or caused by inflation, is not income. It’s a change in nominal net worth.

Though I’m sure Steve would agree with me. He’s presumably using “income” because the tax code treats that change in net worth as income.

There is a chance we’ll see some progress on this issue. Ryan Ellis, writing for Forbes, is optimistic that the newly appointed head of Trump’s National Economic Council will try to fix this problem.

There’s one project that Kudlow needs to get to work on right away: indexing the basis of capital gains to inflation. …Just last August, Kudlow wrote an op-ed…urging President Trump to do this by executive order. …This finally may be the time that this issue is ready to cross the finish line.

Executive order?

Yes, because the law specifies the rates for capital gains taxation, but it’s up to the Treasury Department to specify what counts as a gain. And there’s a very strong argument that it’s not a genuine gain if an asset rises in value solely because of inflation.

Ryan explains the mechanics of how indexing would work..

How would indexing capital gains basis to inflation work? In the tax world, reporting a capital gain is a pretty simple exercise. When you sell an asset, like a stock, you report how much you sold it for. You can subtract what you bought it for (your “basis”) from what you sold it for to arrive at your gain. …If you’ve held the asset longer than a year, you generally pay tax at…20 percent, plus the 3.8 percent Obamacare investment surtax… A problem arises in that your basis purchase may have happened many years ago. The real value of the money you used to buy a stock has been eroded by inflation. For example, $100 in 1990 is only worth $51.41 today, a little more than half the supposed basis in real terms. …Someone whose $100 initial investment has grown to $500 would see a big difference in taxes.

Here’s the table showing that difference.

And here’s what it means.

Uncle Sam still gets to tax the gain–he just doesn’t get to take the phantom gains attributable to inflation. In fact, $22.50 of the current law tax–nearly one quarter of the tax bill–is entirely due to inflation, not any real increase in wealth. …This law change would help owners of real estate, including corporate owners of real estate. It would help small businesses who pay the capital gains tax when acquired by larger firms. It would help everyone in America with a prized collection of old baseball cards or stamps sitting in an album in their den. This is truly a tax cut for everyone.

For more information, here’s a video on the topic from the Center for Freedom and Prosperity.

As was pointed out in the video, Ronald Reagan indexed much of the tax code as part of his 1981 tax cut. Now it’s time to take the next step.

But let’s not forget that indexing should only be an interim step (assuming, of course, that the White House and Treasury are willing to do the right thing and protect investors from inflation).

The real goal should be total repeal of the capital gains tax.

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Why would the economy grow faster if we got fundamental reform such as the flat tax?

In part, because there would be one low tax rate instead of the discriminatory and punitive “progressive” system that exists today. As such, the penalty on productive behavior would be reduced.

In part, because there would be no distorting tax breaks that lure people into making decisions based on tax considerations rather than economic merit.

But we’d also enjoy more growth because there would be no more double taxation. Under a flat tax, the death tax is abolished, the capital gains tax is abolished, there’s no double taxation on savings, the second layer of tax on dividends is eliminated, and depreciation is replaced by expensing.

In the wonky jargon of public finance economists, this means we would have a “consumption-based” system, which is just another way of saying that income  would be taxed only one time. No longer would the internal revenue code discourage capital formation by imposing a higher effective tax rate on income that is saved and invested (compared to the tax rate on income that is consumed).

Indeed, this is the feature of tax reform that probably generates the most growth. As I explain in this video on capital gains taxation, all economic theories – even Marxism and socialism – agree that capital formation is a key to long-run prosperity.

The good news is that reducing double taxation is a goal of most major tax plans in Washington. Trump’s campaign plan reduced double taxation, and the House Better Way Plan reduces double taxation.

But that doesn’t mean there’s an easy path for reform. The Hill reports on some of the conflicts that may sabotage legislation this year.

The fight over a border-adjustment tax isn’t the only challenge for Republicans in their push for tax reform. …Notably, some business groups have criticized the proposal to do away with the deduction for businesses’ net interest expenses. …the blueprint does not specifically discuss how the carried interest that fund managers receive would be taxed. Under current law, carried interest is taxed as capital gains, rather than at the higher rates for ordinary income. During the presidential race, Trump repeatedly said he wanted to eliminate the carried interest tax break, and Office of Management and Budget Director Mick Mulvaney told CNN on Sunday that Trump still plans to do this. Many Democrats also want carried interest to be taxed as ordinary income.

The border-adjustment tax is probably the biggest threat to tax reform, but the debate over “carried interest” also could be a problem since Trump endorsed a higher tax burden on this type of capital gain during the campaign.

Here are some excerpts from a recent news report.

Donald Trump vowed to stick up for Main Street over Wall Street — that line helped get him elected. But the new president has already hit a roadblock, with fellow Republicans who control Congress balking at Trump’s pledge to close a loophole that allows hedge fund and private equity managers to pay lower taxes on investment management fees. …The White House declined to comment on the status of negotiations between Trump and congressional Republicans over the carried-interest provision. …U.S. Rep. Jim Himes, D-Conn., a House Financial Services Committee member and former Goldman Sachs executive, said there is chaos on the tax reform front. “That’s on the list of dozens of things where there is disagreement between the president and the Republican majority in Congress,” Himes said.

Regarding the specific debate over carried interest, I’ve already explained why I prefer current law over Trump’s proposal.

Today I want to focus on the “story behind the story.” One of my main concerns is that the fight over the tax treatment of carried interest is merely a proxy for a larger campaign to increase the tax burden on all capital gains.

For instance, the ranking Democrat on the Senate Finance Committee openly uses the issue of carried interest as a wedge to advocate a huge increase in the overall tax rate on capital gains.

Of course, when you talk about the carried interest loophole, you’re talking about capital gains. And when you talk about capital gains, you’re talking about the biggest tax shelter of all – the one hiding in plain sight. Today the capital gains tax rate is 23.8 percent. …treat[ing] income from wages and wealth the same way. In my view, that’s a formula that ought to be repeated.

The statists at the Organization for Economic Cooperation and Development also advocate higher taxes on carried interest as part of a broader campaign for higher capital gains taxes.

Taxing as ordinary income all remuneration, including fringe benefits, carried interest arrangements, and stock options… Examining ways to tax capital income at the personal level at slightly progressive rates, and align top capital and labour income tax rates.

It would be an overstatement to say that everyone who wants higher taxes on carried interest wants higher taxes on all forms of capital gains. But it is accurate to assert that every advocate of higher taxes on capital gains wants higher taxes on carried interest.

If they succeed, that would be a very bad result for American workers and for American competitiveness.

For those wanting more information, here’s the Center for Freedom and Prosperity’s video on carried interest.

Last but not least, wonky readers may be interested in learning that carried interest partnerships can be traced all the way back to medieval Venice.

Start-up merchants needed investors, and investors needed some incentive to finance the merchants. For the investor, there was the risk of their investment literally sailing out of the harbor never to be seen again. The Venetian government solved this problem by creating one of the first examples of a joint stock company, the “colleganza.” The colleganza was a contract between the investor and the merchant willing to do the travel. The investor put up the money to buy the goods and hire the ship, and the merchant made the trip to sell the goods and then buy new foreign goods that could then be brought back and sold to Venetians. Profits were then split between the merchant and investor according to the agreements in the contract.

Fortunately for the merchants and investors of that era, neither income taxes nor capital gains taxes existed.

P.S. Italy didn’t have any sort of permanent income tax until 1864. Indeed, most modern nations didn’t impose these punitive levies until the late 1800s and early 1900s. The United States managed to hold out until that awful dreary day in 1913. It’s worth noting that the U.S. and other nations managed to become rich and prosperous prior to the adoption of those income taxes. And it’s also worth noting that the rapid growth of the 18th century occurred when the burden of government spending was very modest and there was almost no redistribution spending.

P.P.S. Now that we have income taxes (and the bigger governments enabled by those levies), the only silver lining is that governments have compensated for bad fiscal policy with better policy in other areas.

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Time for a boring and wonky discussion about taxes, capital formation, and growth.

We’ll start with the uncontroversial proposition that saving and investment is a key driver of long-run growth. Simply stated, employees can produce more (and therefore earn more) when they work with better machines, equipment, and technology (i.e., the stock of capital).

But if we want to enjoy the higher incomes that are made possible by a larger and more productive capital stock, somebody has to save and invest. And that means they have to sacrifice current consumption. The good news is that some people are willing to forego current consumption if they think that saving and investment will enable them to have higher levels of future consumption. In other words, if they make wise investments, it’s a win-win situation since society is better off and they are better off.

And these investment decisions help drive financial markets.

Now let’s focus specifically on long-run investments. If you have some serious money to invest, one of your main goals is to find professionals who hopefully can identify profitable opportunities. You want these people, sometimes called “fund managers,” to wisely allocate your money so that it will grow in value. And in some cases, you try to encourage good long-run investments by telling fund managers that if your investments increase in value (i.e., earn a capital gain), they get to keep a share of that added wealth.

In the world of “private equity” and “venture capital,” that share of the added wealth that goes to fund managers is known as “carried interest.” And as a Bloomberg article notes, it has played a big role in some of America’s great business success stories.

Venture capitalists…helped transform novel business ideas into some of the world’s most valuable companies, including Apple, Alphabet Inc., Amazon.com Inc., Facebook Inc., and Microsoft Corp. According to a 2015 study by Stanford University, 43 percent of public U.S. companies founded since 1979 had raised venture cash.

An article from the National Center for Policy Analysis has some additional data on the key role of investors who are willing to take long-run risks.

…up to 25 percent of pre-initial public offering (preIPO) startup funding comes from private equity or venture capital backers. Increasing the tax burden on these entities would damage a valuable access-to-capital pipeline for some startups — particularly in the energy, technology and biotech sectors where large up-front investments could be required.

The obvious conclusion is that we should be happy that there are people willing to put their money in long-run investments and that we should not be envious if they make good choices and therefore earn capital gains. And most people (other than the hard-core left) presumably will agree that people who take big risks should be able to earn big rewards.

That consensus breaks down, however, when you add taxes to the equation.

There’s the big-picture debate about whether there should be “double taxation” of income that is saved and invested. There are two schools of thought.

  • On one side, you have proponents of “consumption-base” taxation, and they favor reforms such as the flat tax that eliminate the tax code’s bias against saving and investment. These people want to eliminate double taxation because a bigger capital stock will mean a more prosperous economy. Advocates of this approach generally believe in equality of opportunity.
  • On the other side, you have advocates of the “Haig-Simons” or “comprehensive income tax” approach, which is based on the notion that extra layers of tax should be imposed on income that is saved an invested. These people want double taxation because it is consistent with their views of fairness. Advocates of this approach generally believe in equality of outcomes.

In the United States, we’ve historically dealt with that debate by cutting the baby in half. We have double taxation of capital gains and dividends, but usually at modest rates. We have double taxation of interest, but we allow some protection of savings if people put money in IRAs and 401(k)s.

But the debate never ends. And one manifestation of that ongoing fight is the battle over how to tax carried interest.

Folks on the left want to treat carried interest as “ordinary income,” which simply means that they want regular tax rates to apply so that there’s full double taxation rather than partial double taxation.

So who supports such an idea? To quote Claude Rains in Casablanca, it’s the usual suspects. Strident leftists in Congress and their ideological allies are pushing this version of a capital gains tax hike.

Rep. Sander Levin (D-Mich.), Sen. Tammy Baldwin (D-Wis.) and a group of millionaires made a push on Wednesday for consideration of legislation to close the carried-interest tax “loophole.” “We have to eliminate this loophole to make that sure everyone is paying their fair share and especially so that we can invest in an economy that creates jobs and lifts working American wages,” Baldwin said during a news conference on Capitol Hill. …The carried interest tax break is “the most egregious example of tax unfairness,” said Morris Pearl, chair of the Patriotic Millionaires — a group of 200 Americans with annual incomes of at least $1 million and/or assets of at least $5 million.

Folks on the right, by contrast, don’t think there should be any double taxation. And that means they obviously don’t favor an increase in the double taxation on certain types of capital gains. And that included carried interest, which they point out is not some sort of “loophole.” As Cliff Asness has explained, the treatment of carried interest is “consistent with the way employee-incentive stock options and professional partnerships are taxed.

But this isn’t just a left-right issue. Some so-called populists want higher capital gains taxes on carried interest, including the President-Elect of the United States. Kevin Williamson of National Review is not impressed.

Trump doesn’t understand how our economy works. …The big, ugly, stupid tax hike he’s planning is on Silicon Valley and its imitators around the country, the economic ecosystem of startup companies and the venture capitalists who put up the cash to turn their big ideas into viable products, dopey computer games, social-media annoyances, and companies that employ hundreds of thousands of people at very high wages. Which is to say, he wants to punish the part of the U.S. economy that works, for the crime of working. The so-called carried-interest loophole, which isn’t a loophole, drives progressives batty.

Kevin points out how carried interest works in the real world.

If you’re the cash-strapped startup, you go to venture capitalists; if you’re the established business, you go to a private-equity group. In both cases, the deal looks pretty similar: You get cash to do what you need to do, and the investor, rather than lending you money at a high interest rate, takes a piece of your company as recompense (for distressed companies being reorganized by private-equity firms, that’s usually 100 percent of the firm) on the theory that this will be worth more — preferably much more – than the money they put into your business. Eventually, the investor sells its stake in the company and pays the capital-gains tax on its capital gain.

And he doesn’t hold Trump in high regard.

Donald Trump does not understand this, because he isn’t a real businessman — he’s a Potemkin businessman, a New York City real-estate heir with his name on a lot of buildings he doesn’t own and didn’t build and whose real business is peddling celebrity and its by-products. He’s a lot more like Paris Hilton than he is like Henry Ford or Steve Jobs. Miss Hilton sells perfumes and the promise of glamour, Trump sells ugly neckties and the promise of glamour.

In her syndicated column, Veronique de Rugy explains why Republicans shouldn’t make common cause with the class-warfare crowd.

Trump…has seemingly swallowed a key assumption of the left. During the campaign, Trump and Hillary Clinton both pledged to raise taxes on carried interest. …sensing an opening, Senate Minority Leader Chuck Schumer recently indicated that he’d be willing to work with Trump on the issue. Of course he would. Democrats have been trying for years to raise taxes on capital. In fact, they see the reduced rate on all capital gains as a loophole. Their goal is to treat all capital gains as ordinary income because they want higher tax burdens overall. …Republicans need to remember that the left’s goal is not fairness but higher taxes. Treating carried interest as ordinary income for tax purposes would simply be the first step toward higher taxes on capital in general. That would be bad for economic growth and for our wallets.

Chuck Devore of the Texas Public Policy Foundation also has a sensible take on the economics of this issue.

…If the investment professional sees his marginal tax rate on capital gains from carried interest almost double, from 23.8 percent to 43.4 percent, he’ll change his behavior and charge more for his services. Pension funds and colleges will get less… Increasing taxes on investment success would mean less investment and consequently, fewer jobs, less innovation, and less prosperity. According to the Tax Foundation, the U.S. already levies the 6th-highest capital gains taxes among the 34 developed nations of the Organization for Economic Co-operation and Development… Generating capital gains means that money was used efficiently, benefiting not just the professional investment manager, but savers and the world. Losing money, on the other hand, is nothing to celebrate.

I agree.

The carried interest right is really a proxy for the bigger issue of whether there should be increased double taxation of capital gains. Which would be the exact opposite of what should happen if we want America to be more competitive and prosperous.

For more background on the issue of carried interest, this video from the Center for Freedom and Prosperity is very succinct and informative.

And if you want more info on the overall issue of capital gains taxation, I’m quite partial to my video on the topic.

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I’m a big fan of the flat tax because a low tax rate and no double taxation will result in faster growth and more upward mobility.

I also like the flat tax because it gets rid of all deductions, credits, exemptions, preferences, exclusions, and other distortions. And a loophole-free tax code would be a great way of reducing Washington corruption and promoting simplicity.

Moreover, keep in mind that eliminating all favors from the internal revenue code also would be good for growth because people then will make decisions on the basis of what makes economic sense rather than because of peculiar quirks of the tax system.

Sounds great, right?

Well, it’s not quite as simple as it sounds because there’s a debate about how to measure loopholes. Sensible people want a tax code that’s neutral, which means the government doesn’t tilt the playing field. And one of the main implications of this benchmark is that the tax code shouldn’t create a bias against income that is saved and invested. In the world of public finance, this means they favor a neutral “consumption-base” tax system, but that’s simply another way of saying they want income taxed only one time.

Folks on the left, however, are advocates of a “Haig-Simons” tax system, which means they believe that there should be double taxation of all income that is saved and invested. You see this approach from the Joint Committee on Taxation. You see it from the Government Accountability Office. You see it from the Congressional Budget Office. Heck, you even sometimes see Republicans mistakenly use this benchmark.

Let’s look at three examples to see what this means in practice.

Example #1: Because they don’t want a bias that encourages people to spend their income today rather than in the future, advocates of a neutral tax code want to get rid of all double taxation of savings (Canada is moving in that direction). So that means they like IRAs and 401(k)s since those vehicles at least allow some savings to be protected from double taxation.

Proponents of Haig-Simons taxation, by contrast, think that IRAs and 401(k)s are loopholes.

Example #2: Another controversy revolves around the tax treatment of business investment. Advocates of neutral taxation believe in expensing, which is simply the common-sense view that investment expenditures should be recognized when they actually occur.

Proponents of Haig-Simons, however, think that investment expenditures should be “depreciated,” which means companies are forced to pretend that most of their investment costs which are incurred today actually take place in future years.

Example #3: Supporters of neutral taxation think capital gains taxes should be abolished because there already is tax on the income generated by assets such as stocks and bonds. So the “preferential rates” in the current system aren’t a loophole, but instead should be viewed as the partial mitigation of a penalty.

Proponents of Haig-Simons, not surprisingly, have the opposite view. Not only do they want to double tax capital gains, they also want them fully taxed, which would mean an economically jarring jump in the tax rate of more than 15 percentage points.

Now, having provided all this background information, let’s finally get to today’s topic.

If you’ve been following the presidential campaign, you’ll be aware that there’s a controversy over something called “carried interest.” It’s a wonky tax issue that seems very complicated, so I’m very happy that the Center for Freedom and Prosperity has produced a video that cuts through all the jargon and explains in a very clear and concise fashion that it’s really just an effort by some people to increase the capital gains tax.

There are four points from the video that deserve special emphasis.

  1. Partnerships are voluntary agreements between consenting adults, and both parties concur that carried interest helps create a good incentive structure for productive investment.
  2. Capital formation is very important for growth, which is one of the reasons why there shouldn’t be any capital gains tax.
  3. A capital gain doesn’t magically become labor income just because an investor decides to share a portion of the gain with a fund manager.
  4. An increase in the tax on carried interest would be the camel’s nose under the tent for more broad-based increases in the tax burden on capital gains.

By the way, I liked that the video also took a gentle swipe at some of the ignorant politicians who want to boost the tax burden on carried interest. They claim they’re going after hedge funds, when the tax actually is much more targeted at private equity partnerships.

But what really matters is not the ignorance of politicians. Instead, we should be focused on whether tax policy is being needlessly destructive because of high – and duplicative – taxes on saving and investment.

Such levies would reduce investment. And that means lower levels of productivity and concomitantly lower wages.

In other words, ordinary people will suffer a lot of collateral damage if this tax-the-rich scheme for carried interest is implemented.

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The most compelling graph I’ve ever seen was put together by Andrew Coulson, one of my colleagues at the Cato Institute. It shows that there’s been a huge increase in the size and cost of the government education bureaucracy in recent decades, but that student performance has been stagnant.

But if I had to pick a graph that belongs in second place, it would be this relationship between investment and labor compensation.

The clear message is that workers earn more when there is more capital, which should be a common-sense observation. After all, workers with lots of machines, technology, and equipment obviously will be more productive (i.e., produce more per hour worked) than workers who don’t have access to capital.

And in the long run, worker compensation is tied to productivity.

This is why the President’s class-warfare proposals to increase capital gains tax rates, along with other proposals to increase the tax burden on saving and investment, are so pernicious.

The White House claims that the “rich” will bear the burden of the new taxes on capital, but the net effect will be to discourage capital investment, which means workers will be less productive and earn less income.

Diana Furchtgott-Roth of Economics 21 has some very compelling analysis on the issue.

President Obama will propose raising top tax rates on capital gains and dividends to 28 percent, up from the current rate of 24 percent. Prior to 2013, the rate was 15 percent. Mr. Obama seeks to practically double capital gains and dividend taxes during the course of his presidency, a step that would have negative effects on investment and economic growth. …the middle class would be harmed by higher capital gains tax rates, because capital would be more likely to go offshore. …[a] higher rate would have negative effects on the economy by reducing U.S. investment or driving it overseas. If firms pay more in capital gains taxes in America, they would make fewer investments — especially in the businesses or projects that most need capital — and they would hire fewer workers, many of them middle-class. Higher capital gains taxes would reduce economic activity, especially financing for private companies, innovators, and small firms getting off the ground. Taxes on U.S. investment would be higher compared with taxes abroad, so some investment capital is likely to move offshore.

At this point, I want to emphasize that the point about higher taxes in America and foregone competitiveness isn’t just boilerplate.

According to Ernst and Young, as well as the Organization for Economic Cooperation and Development, the United States has one of the highest tax rates on capital gains in the entire developed world.

The only compensating factor is that at least these destructive tax rates aren’t imposed on foreign investors. Yes, it’s irritating that our tax code treats U.S. citizens far worse than foreigners, but at least we benefit from all the overseas capital being invested in the American economy.

By the way, Diana also points out that higher capital gains tax rates may actually lose revenue for the simple reason that investors can decide to hold assets rather than sell them.

Here’s some of what she wrote, accompanied by a chart from the Tax Foundation.

…higher capital gains tax rates rarely result in more revenue, because capital gains realizations can be timed.  When rates go up, people hold on to their assets rather than selling them, expecting that rates will go down at some point. …Capital gains tax revenues rose after 1997, when the rate was reduced from 28 percent to 20 percent, and again after 2003, when rates were reduced further to 15 percent… The decline in rates resulted in higher tax receipts from owners of capitals, as they sold assets, giving funds to Uncle Sam.

Yes, the Laffer Curve is alive and well.

Not that Obama cares. If you pay close attention at the 4:20 mark of this video, you’ll see that he wants higher capital gains tax rates for reasons of spite.

But I don’t care about the revenue implications. I care about good tax policy. And in an ideal tax system, there wouldn’t be any tax on capital gains.

It’s a form of double taxation with pernicious effects, as the Wall Street Journal explained back in 2012.

…the tax on the sale of a stock or a business is a double tax on the income of that business. When you buy a stock, its valuation is the discounted present value of the earnings. …If someone buys a car or a yacht or a vacation, they don’t pay extra federal income tax. But if they save those dollars and invest them in the family business or in stock, wham, they are smacked with another round of tax. Many economists believe that the economically optimal tax on capital gains is zero. Mr. Obama’s first chief economic adviser, Larry Summers, wrote in the American Economic Review in 1981 that the elimination of capital income taxation “would have very substantial economic effects” and “might raise steady-state output by as much as 18 percent, and consumption by 16 percent.” …keeping taxes low on investment is critical to economic growth, rising wages and job creation. A study by Nobel laureate Robert Lucas estimates that if the U.S. eliminated its capital gains and dividend taxes (which Mr. Obama also wants to increase), the capital stock of American plant and equipment would be twice as large. Over time this would grow the economy by trillions of dollars.

John Goodman also has a very cogent explanation of the issue.

…why tax capital gains at all? …The companies will realize their actual income and they will pay taxes on it. If the firms return some of this income to investors (stockholders), the investors will pay a tax on their dividend income. If the firms pay interest to bondholders, they will be able to deduct the interest payments from their corporate taxable income, but the bondholders will pay taxes on their interest income. …Eventually all the income that is actually earned will be taxed when it is realized and those taxes will be paid by the people who actually earned the income. ……why not avoid all these problems by reforming the entire tax system along the lines of a flat tax? The idea behind a flat tax can be summarized in one sentence: In an ideal system, (a) all income is taxed, (b) only once, (c) when (and only when) it is realized, (d) at one low rate.

And if you want to augment all this theory with some evidence, check out the details of this comprehensive study published by Canada’s Fraser Institute.

For more information, here’s the video I narrated for the Center for Freedom and Prosperity, which explains why the capital gains tax should be abolished.

P.S. These posters were designed by folks fighting higher capital gains taxes in the United Kingdom, but they apply equally well in the United States. And since we’re referencing our cousins on the other side of the Atlantic, you’ll be interested to know that Labor Party voters share Obama’s belief in jacking up tax rates even if the economic damage is so severe that the government doesn’t collect any revenue.

P.P.S. Don’t forget that the capital gains tax isn’t indexed for inflation, so the actual tax rate almost always is higher than the statutory rate. Indeed, for folks that have held assets for a long time, the effective tax rate can be more than 100 percent. Mon Dieu!

P.P.P.S. In the past 20-plus years, I’ve seen all sorts of arguments for class-warfare taxation. These include:

I suppose leftists deserve credit for being adaptable. Just about anything is an excuse for soak-the-rich tax hikes. The sun is shining, raise taxes! The sky is cloudy, increase tax rates!

Or, in this case, Obama is giving a speech, so we know higher tax rates are on the agenda.

P.P.P.P.S. You deserve a reward if you read this far. You can enjoy some amusing cartoons on class-warfare tax policy by clicking here, here,here, here, here, here, and here.

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