Consulting by RPM || Free Advice Blog

Follow-Up on Labor versus Investment Taxes

Steve Landsburg thinks he’s got Mate in One in the comments of my previous post, so before he declares victory let me write this follow-up post.

To set the context (again), I am dissatisfied when Steve (talking about Mitt Romney) uses a thought experiment to conclude, “people with investment income bear a higher tax burden, as a percentage of their income, than anyone else.” That statement is simply false, both in theory and (probably) empirically.

First, the theoretical issues: As a fan of the work of Bohm-Bawerk on capital & interest, I recoil in horror when somebody like Scott Sumner declares that “income is a meaningless concept.” It’s true, Steve Landsburg didn’t utter such profanity, but Sumner made that statement during a previous round of arguing over the proper way to calculate tax rates. I’m pretty sure Steve and Scott were tag-teaming each other back in that debate, so if nothing else, Sumner’s absurdity shows the danger of reasoning in terms of consumption and then working backwards. (To see a careful demolition of Sumner’s reasoning–and a defense of the very important concept of “income”–read my article.)

Now then, it is simply not the case that Steve has shown “people with investment income bear a higher tax burden, as a percentage of their income, than anyone else.” What Steve has shown is that people who have a large fraction of labor income, and then save and invest some of it, have a higher lifetime total income tax burden than other people who earn labor income but do not save any of it.

Yet I can just as easily come up with logically possible scenarios where someone facing our current tax code lives exclusively off of capital gains. For example, imagine some guy hundreds of years ago homesteads a big forest full of timber. Every year it goes up in price about 3% (adjusted for price inflation), and he sells 3% of it, in order to rent living quarters and buy food. (He’s not cutting down his own trees, mind you, he just sells off a certain amount of the property each year.) So he consumes the capital gain it yields every year. He passes it to his son, who does the same, and so on until today. Thus nobody in this dynasty ever worked a day in his life, and never earned a penny from selling labor. With the present tax code, comparing this dynasty to a different dynasty where the people all worked in factories, and looking at their consumption streams with and without taxes, we would conclude that the forest family pays 15% in taxes, while the factory family pays 35%.

Now I hope I’ve made my theoretical point: Steve can imagine somebody who earns investment income and pays a higher burden (under our current tax code) than somebody who earns exclusively labor income, and for my part I can imagine somebody where the opposite is true.

Great, we’re tied at this point, and I would argue that I still have a slight edge in clarity, because Steve is still having to invoke someone who gets hit with labor taxes and then wants to invest what’s left over. But let’s move on.

Empirically, which of our stories is more relevant? I don’t know. For sure, it’s ridiculous to talk as if Mitt Romney had nothing at the beginning of calendar 2010, then worked in a coal mine for twelve months, and then in the beginning of 2011 used some of his paycheck and got lucky on penny stocks.

On the contrary, there is a ton of wealth in the United States that throws off investment earnings year after year. A lot of that wealth could be traced back to “ultimate” sources that aren’t labor, for example gold and oil deposits, fish, forests, farmland, etc. I have no idea how much of today’s wealth is “congealed past natural resources” versus “congealed past labor effort,” but I’m pretty sure the answer isn’t “basically 0% / 100%,” which seems to be implicit in Steve’s position.

Now let me throw one other curveball: Even for that portion of current wealth that is due to past labor, we have to ask what the labor tax rate was when that income was earned. For example, the current heirs to the estates of Rockefeller, Carnegie, etc. are enjoying fortunes that were originally created before the federal income tax. So it’s simply not true to casually assert–as Steve does–that he can get his mechanism to kick in, by going back to earlier generations. Empirically that might be true in a lot of cases, but not all, and it’s possible that a huge chunk of today’s wealth was never taxed the way Steve’s thought experiment suggests.

Last point: I’m not doing this merely to be a stickler. I think that to a first approximation, we can understand the history of the U.S. federal tax code by realizing that there were a bunch of powerful people in the early 20th century who wanted their families to stay on top. So they put in place legislation that would kneecap any would-be entrepreneurs who wanted to follow in their footsteps. Since these titans had already made their fortunes, they wouldn’t be hit by the ridiculous marginal income tax rates on labor income that existed at various points since 1913. No, they had all sorts of tax shelters available, including setting up “100 year trusts” or “dynasty trusts” that just coincidentally expired around the time that there was a one-year window of no estate tax. (What a coincidence, those goofballs in DC must have no idea what they’re doing when they write random changes to the tax code.)

I think it’s a mistake to write as if the poor beleaguered guys like Mitt Romney are getting crushed by the federal tax code. No, it’s small business owners who get crushed. They might make hundreds of thousands per year, but when you add up the personal income tax, the employer/employee SS and Medicare contributions (and note that SS caps out, another mechanism to shield the super rich but stick it to the small-time business owner), etc. etc., it is a huge burden. Plus they have to hire accountants etc. to fill out stupid forms that are easier for big businesses to handle.

Yes yes, the average progressive who complains about the “rich getting off scot-free!” from the current tax code is misinformed, and I’m glad people like Scott Sumner and Steve Landsburg are trying to set them straight. But I’m worried that their particular styles of arguing (a) obscure the important distinctions between consumption, wages, and capital gains, and (b) ignore the fact that very rich people write the tax code to solidify their dominance.