I want to give a disclaimer that usually when I think University of Rochester economist Steve Landsburg is wrong on something, it’s not that his conclusion is mistaken, or even that the world is a worse place for him having advanced the argument. No, it’s more like, I think Steve tries to deliberately shock his readers by putting his viewpoint into a package coated with shards of broken glass. Yeah, it gets your attention all right, but it can be dangerous.
A recent example of this occurred when Steve–who was making a very important point in the “does the national debt burden our grandkids?” debate–decided to throw me off the trail by declaring, in spite of the English language, that whether U.S. Treasury securities were owned by American citizens or the Chinese government, in either case “we owe it to ourselves.”
Today we will go over another example of Steve being too cute by half. In discussing Mitt Romney’s personal taxes, Steve writes:
Mitt Romney says his tax rate is “probably around 15%”…[T]he New York Times is quick to point out that he’s a beneficiary of the “fact” that investment income is taxed at a much lower rate than wages and salaries, leaving him with a lower percentage tax burden than the working-stiffs he employs.
For at least the eighth time on this blog, I want to point out that this widely believed “fact” is not true.
To understand Mitt Romney’s tax burden, you have to compare him to his doppelganger Timm Romney, who lives on a planet with no taxes. In the year (say) 2000, Mitt and Timm both earned (say) a million dollars. Timm invested his million dollars, saw it double over the past decade or so, and cashed out his investment this year, leaving him with two million dollars. Mitt, by contrast, paid 35% tax in 2000, leaving him with $650,000. He invested it, saw it double, and cashed out last year, paying 15% tax on the $650,000 capital gain. That leaves him $1,202,500, which is about 60% of what Timm’s got. In other words, the tax system costs Mitt almost 40% of his income.
By contrast, people on our planet without investment income collect their wages, pay 35% in taxes, and spend what’s left. The tax system costs them 35%, while it costs Mitt almost 40%. In other words, people with investment income bear a higher tax burden, as a percentage of their income, than anyone else — and that’s before you even start accounting for the taxes on dividends, interest, corporate income and inheritance.
I ultimately agree with Steve’s conclusion on all this stuff–namely that it’s ridiculous that the government levies any taxes on capital gains at all–but I have to conclude that his above discussion is simply wrong. Rather than demonstrating that “people with investment income bear a higher tax burden, as a percentage of their income, than anyone else,” what Steve has really shown is that if you add two different taxes on two different types of income together, the burden is higher than if you just look at the first tax. Yes, I will agree that (a+b)>a, where a,b>0. (That’s for Steve’s mathematical sensibilities.) But I didn’t just demonstrate that b>a.
In Steve’s example, Mitt first earns $1 million in wage income, which is taxed at 35%. Then, of the post-tax $650,000, he invests it and earns $650,000 in interest, dividends, or capital gains or however you want to define it. (Steve doesn’t actually specify.) That $650,000 of investment income is then taxed at 15%. Mitt ends up with $1.2 million, compared to the full $2 million that his doppelganger Timm enjoys.
So yes, Mitt suffers about a 40% effective average tax rate, compared to his no-tax doppelganger Timm. But how in the world does Steve blame this 40% burden on the tax on dividends? No, what Steve has shown is that the wage tax and the dividend tax act together to yield an average rate of 40%. Well, right, but I don’t think anybody doubted that. By the same token, if Mitt and Timm spent all of their wealth ($1.2m and $2m respectively) on gasoline, we’d end up concluding that motorists pay more in taxes than either wage earners or hedge fund managers. Would that make any sense at all?
This isn’t a little nit, this is the whole issue. Forget taxes for a minute. Suppose an intro to accounting professor asks his kids this question on a test:
Over a certain period, Mitt earns $1 million in salary and $1 million in interest. How much of his income is due to his investment earnings?
(D) It depends on the point Steve Landsburg is trying to make with this example.
If I still haven’t convinced you–maybe you’re getting hung up on the “double taxation” thing–then I’ll go the other way: That clown Landsburg isn’t going far enough. Sure, in order for you to have any income to buy investments with in the first place, you need to have earlier earned some labor income. But Landsburg forgot that workers don’t operate on solar power–it takes food to keep them going. So in order for Mitt to have even had the ability to earn that $1 million salary in the first place, in the previous period he had to earn $50,000 in salary, out of which the government took 35%. Then Mitt had to buy groceries and pay his mortgage with it, subject to an 8% sales tax (depending on his state of residence) and property taxes. I mean, you can’t be a worker if you don’t have food or shelter! So really, when you do the math correctly, you see that compared to the no-tax Timm, Mitt the Investor is actually paying something like 60% of his income in taxes.
Does everybody see what I mean? You can play this framing games all day long. The only non-arbitrary approach is to say, “What portion of my income was actually due to my ownership of investments? Now how much on the margin was that taxed?” And the answer is 15%, which means it is perfectly correct to say, “Investment income is taxed at a lower rate than labor income.”
To conclude, I am not saying that issues of fairness or whatever dictate that investment and labor income should be taxed at the same rate. (I happen to advocate that they be so, at 0%.) All I’m saying is that it is needlessly confusing, as well as just plain wrong, to have someone earn two different types of income, add those taxes together, and declare that the total is due solely to the tax on investments.