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FALLACY 11 OF FINANCIAL FUNDAMENTALISM
William Vickrey, 1996 Nobel Award in Economics
Otober 5, 1996

It is claimed that exemption of capital gains from income tax will promote investment and growth.

Reality: Any attempt to define a special category of income entitled to differential treatment is an invitation to the sorcerer's apprentices in Congress and in the offices of the IRS to start casting spells that are bound to produce surprising consequences. Attempting to draw up administrable rules defining economically meaningful lines between interest credited to accounts but not drawn on, zero coupon bonds, stock appreciation from undistributed profits, inflationary gains, profits from insider trading, gains from speculation in land, gambles on derivatives, profits or losses on speculative ventures and so on is a sysyphean task. Taxpayers' techies can then get busy ferreting out shortcuts through the resulting labyrinth to the detriment of the revenue and also of economic efficiency. Ten special provisions of the code can be combined with one another in over a thousand ways to produce results far beyond the capacity of a Congressional committee and its staff to anticipate.

Concessions to gains must entail corresponding limitations on the deductibility of losses, lest there be intolerably large opportunities for arbitrage against the revenue. In an attempt to counter the skills of the taxpayers' techies, the rules are likely to be more severe on the deductibility of losses than liberal with respect to gains, so as to produce a number of situations where the Treasury is playing "heads I win, tails you lose" with the taxpayer. Even with effectively parallel rules, reduced effective deductibility of losses may well be more of a disincentive to speculative investment than the attractiveness of low taxes on gains in the event of success.

Most economically desirable investments take considerable time for the anticipated results to be reflected in the capital markets, and the promise of a tax concession to be effective in a remote future and subject to possible alteration by future legislatures is likely to be of little weight in the calculation of the investor. In any case the personal income tax on gains is levied after or below the market and has its primary effect on the disposable income of the investor, and relatively little effect on the capital market from which the funds for capital formation are derived.

In practice, many capital gains arise from transactions of negligible or dubious social merit. Gains derived from speculation in land add nothing to the supply of land, and much of the gains from securities trading based on advance information, whether or not characterizeable as insider trading, do no more to enhance productivity or investment than winnings from betting on basketball games. Attempts to exclude gains from speculation by limiting concessions to assets held for longer periods not only introduce new complexities in determining the holding period in cases of rollovers, reinvested dividends, and other trades, but aggravate the lock-in effect as realization is deferred to obtain the concession, an effect especially severe in the case of the total exemption from income taxation of gains on property transferred by gift or bequest.

Any increase in disposable income resulting from lower capital gains taxation is likely to accrue to individuals with a high propensity to save. If the proposal is advanced on a revenue neutral basis, the replacement revenues are likely to have a greater impact on consumption demand, so that the net overall effect of making concessions to capital gains may be to reduce demand, sales, and investment in productive facilities. The main driving force behind the proposals may well be as a pretext for providing windfalls to persons who can contribute to campaign funds as well as added commissions for brokers.

Some have argued for reductions in capital gains rates rather than full exemption, pointing to surges in revenue from the "fire sale" spate of realizations to take advantage of the new and possibly short-lived tax bargains. If this is done on a current-revenue-neutral basis, there may be some one-time stimulus to the economy and to investment, resulting from what would be an increase in the effective deficit as viewed from a longer term perspective, but this will be small, temporary, and counterproductive in the long run.

A far more effective measure would be to reduce or eliminate the corporate income tax, which is in effect a tax above the market, constituting an additional hurdle that prospective equity-financed investments must face, as contrasted to the below- or after-market impact of capital gain concessions. In addition to this double-whammy impact on the economy whereby the tax both abstracts from disposable income and also discourages investment, the tax has numerous defects in distorting investment allocation, encouraging thin equity financing with consequent increased incidence of bankruptcies, and complicating tax laws. Unfortunately any such elimination is likely to be opposed not only by those making a living from the complexities but by many who variously believe firmly that its burden falls on someone other than themselves. Actually in most plausible scenarios the chief burden will be on wage earners. If considered as a substitute for other taxes on a revenue-neutral basis, it would increase current unemployment. If current employment is assumed to be maintained by an appropriate fiscal policy, future labor productivity and wages will be depressed by labor having less capital to work with.

One excuse sometimes offered for the imposition of a corporation income tax is that undistributed profits do not bear their fair share of the individual income tax. Rather than retaining a tax on all corporate income, this consideration would call for a countervailing tax of say 2 percent per year on the accumulated undistributed profits, as a rough equivalent to an interest charge on the resulting deferral of the individual income tax on shareholders. This would be rough at best, since it allows neither for variations in the marginal rates payable by individual shareholders, nor for possible realization of the undistributed profits through sale of shares, but it would be far better than the inept and draconic taxes on undistributed profits enacted briefly during the 1930's.

A more thoroughgoing removal of the distorting effect of taxes on real investment could be accomplished by assessing the individual income tax on a cumulative basis, whereby a gross tax on the accumulated income to date (including interest credited with respect to past taxes paid on this income) is calculated by reference to tables that would take the period covered into account. The accumulated value, with interest, of taxes previously paid on this income is then credited against this gross tax. Provided that all income is eventually brought to account, the ultimate tax burden will be independent of the timing of realization of income; about two-thirds of the internal revenue code and regulations would become superfluous. The playing field would be effectively leveled; equitable treatment would be afforded both to those realizing large gains in a single year and to those having to retire after a brief career o high earnings, a group not adequately dealt with under most other averaging schemes. Bias against investments yielding fluctuating or risky returns would be largely eliminated. Decisions as to when to sell assets to realize gains or losses or when to distribute dividends could be made purely on the basis of appraisal of market conditions without having to consider tax consequences. Hordes of tax techies could turn their talents to more productive activities.

Taxpayer compliance would be greatly simplified. The actual computation of the cumulative tax and tax payable requires only six additional entries on the return, three of which are items simply copied from a preceding return. As an introductory measure, cumulative assessment could be limited to those subject to rates above the initial bracket.