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The case for raising taxes on capital gains

As Dylan wrote on Monday, most -- though not all -- economists will tell you there's a good theoretical case for taxing capital gains and investment income at a lower rate than normal income. Mitt Romney, in other words, should be paying a low tax rate.

But it's also worth understanding why more and more tax wonks are wondering if the case holds up under current conditions. For one thing, the low rate on investment income has been an important contributor to rising inequality. In fact, it's worked so well that if you want to tax the rich without ratcheting their earned income tax rate to extremely high levels, or reform the tax code without massively cutting taxes on the rich, the best option might be to raise capital gains taxes.

Joe Nocera gets at this point by taking a close look at the Forbes 400.

A large number of the Forbes 400 — “roughly 40 percent,” according to a group called United for a Fair Economy — inherited their wealth. Many others on the list — people who started companies that they’ve since left — are classified by Forbes as investors.

This investor class is doing very, very well. "In the last year alone, the cumulative net worth of the wealthiest 400 people, by Forbes’s calculation, rose by $200 billion. That compares with a 4 percent drop in median household income last year, according to the Census Bureau," writes Nocera.

It's also hard to find much evidence that cutting taxes on investment income has led to much economic growth. In the 1980s, for instance, Ronald Reagan actually raised taxes on investment income -- and the economy did very, very well. George W. Bush's capital gains cuts, however, did not lead to such a strong economy.

Tax expert Len Burman has graphed capital gains rates and economic growth and found no relationship at all:

Burman says he also "tried lags up to five years and using moving averages, but there is never a larger or statistically significant relationship."

What he is sure of is that a very low capital gains rate incentivizes very complex tax avoidance. "Since ordinary income is taxed at rates up to 35 percent while long-term capital gains are taxed at a maximum rate of 15 percent, there is a 20 percent reward for every dollar that can be transformed from high-tax compensation, say, to low tax capital gains."

The point here isn't that the economists who, all else being equal, support a lower capital gains rate are wrong. I think they're right, actually. It's that all else is very rarely equal.

If you're not willing to raise the capital gains rate, for instance, you probably can't achieve base-broadening, rate-lowering tax reform that doesn't increase taxes on the middle class. That's why the Simpson-Bowles plan eliminated the preferential rate for capital gains. That's why Romney's plan, which leaves the capital gains rate alone, is having so much trouble making its math work.

And even if you put tax reform aside, if you're not willing to raise the capital gains rate, the deficit math means you'll probably have to increase marginal tax rates on the rich by quite a lot -- and are we sure it's better to be taxing their work at 45 or 50 percent, rather than taxing their investment at 20 or 25 percent?

So all else being equal, a lower rate on capital gains is probably preferable, though the evidence in recent American history for that position is actually a bit weak. But even if it were stronger, keeping a low rate on capital gains may not be preferable to tax reform, or to the sort of tax changes we'll need to make if the rate on capital gains is held as sacrosanct.

Further reading:

- Dylan Matthews on the case for keeping the capital gains rate low.

-Len Burman's testimony on the capital gains rate.

- Joe Nocera's column on capital gains and the Forbes 400.

- What will the capital gains rate be in 2013?

Correction: This post originally said Clinton had raised the capital gains rate. In fact, the capital gains rate was not changed in the 1993 tax hike. In 1997, Clinton cut the capital gains rate from 28 percent to 20 percent, and then, of course, George W. Bush further cut it to 15 percent, where it stands now.