THE economics of capital taxation are poorly understood by the general public, because they are in fact subtle.
A common tendency is to advocate capital taxation on the grounds of some distate for capital, perhaps because capitalists are supposedly rich (and therefore disliked), or because they do not derive their income from their labour, which means they do not suffer for it, which is supposedly immoral. In fact, capitalists are not necessarily rich, they may for example be pensioners who have invested their savings in corporate bonds or equity in order to provide for their old age. If one wants to tax the rich, say for redistributive purposes, so be it, but then one should tax wealth or income irrespective of their source.
I THINK, in today's world, there should be two objectives in redesigning taxes on capital. The first should be to encourage corporate investment and therefore stimulate growth and employment. And the second should be to enhance a sense of fairness among the general public.
I'D LIKE to see the tax system move in the direction of a progressive consumption tax. I don’t have a detailed plan in mind, and I recognise the many difficulties in devising such a plan. This would require lighter taxes on capital income and higher rates on the remaining tax base, all in the context of unsustainable future deficits. Thus, this approach flies against prevailing political winds.
But if I could I’d take the answer in a different direction. In many ways it’s unfortunate that tax reform is rising to be a first-tier issue. By the time tax reform ripens politically, possibly by 2014, the US may be far enough along in the deleveraging process that Washington should turn to addressing longer-term deficits, and I worry that tax reform could distract from or complicate that effort.
WE WANT to tax luck—heavily. We don't want to tax enterprise and ingenuity. We do not want to create armies of accountants gaming our system. In a world that is as a whole still relatively poor we do not want to tax thrift. And we want to use our tax system to provide a substantial amount of social insurance: if you could ask us all as neonates whether we wanted a lump-sum, a flat, or a progressive tax, we would (if we could think and talk) nearly all call for a strongly progressive tax—and if you could ask us even earlier, before we had drunk from the Lethe when we all still faced the risk that we might not choose the right parents, that conclusion would be squared.
I FAVOUR a consumption tax. Though this seems radical to some, it turns out that most Americans already face a consumption tax due to the many tax-deferred savings plans available. Such plans allow you to defer taxes on money saved in IRAs, 401(k)s, Keough plans and the like until the money is withdrawn and spent.
ONE of the most basic principles in economics is that the taxation of capital income is inefficient. Taxes on interest, dividends, and capital gains represent a sort of “double taxation”, of wage income. For some reason many people have difficulty grasping this concept, and one often sees even Nobel Prize-winning economists talking about “income inequality” using data that includes both wage and capital income. This makes about as much sense as adding up blueberries and watermelons and calling it the “number of units of fruit”.
JUST as the Christmas-cracker poser “When is a door not a door?”* can liven up any yuletide party, Christmas spirits can also be lifted by the question “When is a trade deficit benign, when is it malign?”. Except the answer is more difficult to fathom. In reality, in fact, depending on the guest list, the ensuing debate could see the party end in tears. As with most economic issues there are two ardent camps at opposite ends of the scale, with an army of opinions in between.
While the raw merchandise trade deficit betrays much about the competitiveness of the manufacturing sector of an economy, the current account deficit (the broadest measure of a country’s net exports to the rest of the world) sheds more light on its underlying state of health and serves better as an early warning of potentially dangerous imbalances. It is not that long ago that acolytes of the “current account deficits don’t matter” thesis seemed to be winning the argument. The so-called Pitchford thesis states that a current account deficit does not matter if it is driven by capital flows in the private sector. But when the financial crisis struck in 2007/8, countries with sizeable deficits suffered disproportionately as international capital flows shuddered to a halt.
Focusing on the euro zone, the Allianz Euro Monitor, which evaluates EMU countries’ ability to achieve balanced macroeconomic growth, has long been flagging dangerous imbalances on the competitiveness and domestic demand front, one of four key categories in the overall scoreboard.
INTERNATIONAL trade theory has almost nothing to say about whether current account (or “trade”) deficits are good or bad. Yet in press discussion of trade balances, it’s almost a given that surpluses are good and deficits are bad. This is a mistake; not all trade deficits are bad, and even those that are generally reflect some deeper problem in the economy.
It makes sense for a fast growing economy to borrow against the future, as when Korea ran deficits during the 1970s and 1980s. Or take a developed country like Australia. It absorbs a large flow of immigrants, who may borrow to buy a house against their future income within Australia. Indeed some current account deficits don’t even represent borrowing, at least in the ordinary sense of the term. Consider the case where Australians buy cars from East Asia, and pay for the cars by selling vacation condos on the Gold Coast to wealthy Asians. In many respects this is ordinary trade, except that the products that are built with Australian labour (the condos) never leave the country.
A COUNTRY that runs a current account deficit is borrowing money from the rest of the world. As with any loan, that money will need to be paid back at some point in the future.
The cost of these loans is the interest that must be paid, and any vulnerabilities to speculative attacks that come with them. But so long the benefits from the investment of the borrowed money exceed the costs, then there is no reason to be concerned about running a deficit. The profits from the loans will be more than sufficient to pay back the interest and principle.
TRADE deficits, or more concretely current account deficits, have to be financed by net capital inflows, and it is really the cause of the deficit and the nature of the financing that determines whether or not persistent trade deficits are harmful. If a country is running a trade deficit mainly because domestic investment levels are very high, the high investment levels should generate enough growth in the economy that the costs of servicing the foreign capital inflow can easily be covered. In that case many years of trade deficits are unlikely to be a problem.
Featured guest
Laurence J. Kotlikoff is a William Fairfield Warren Professor at Boston University, a Professor of Economics at Boston University, a Fellow of the American Academy of Arts and Sciences, a Fellow of the Econometric Society, a Research Associate of the National Bureau of Economic Research, and President of Economic Security Planning, Inc., a company specializing in financial planning software. Professor Kotlikoff publishes extensively in newspapers, and magazines on issues of financial reform, personal finance, taxes, Social Security, healthcare, deficits, generational accounting, pensions, saving, and insurance. His most recent book is Jimmy Stewart Is Dead.
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