Capital Income Taxation Discriminates Against Saving

July 31, 2013

Although capital income taxes penalize saving and slow long-run growth, the federal tax system imposes multiple such taxes. Seven increases in capital income taxes took effect at the beginning of 2013, and President Obama's 2014 budget plan proposes further increases. In upcoming decades, rising revenue needs fueled by entitlement growth will create pressure to further expand capital income taxation despite its negative economic effects. Opponents of capital income taxation must reframe the policy debate by explaining the economic disadvantages of capital income taxes and proposing alternative budgetary measures that maintain tax fairness, says Alan D. Viard, a resident scholar at the American Enterprise Institute.

Some commentators argue that any tax system that taxes labor income should, as a matter of fairness and economic neutrality, also tax capital income. That view misunderstands the actual consequences of capital income taxation.

  • The income tax's saving penalty distorts the timing of consumption by favoring consumption today over consumption in the future.
  • The penalty therefore artificially leads taxpayers to spend more early in life and less late in life.
  • A number of statistical studies have found that, when the after-tax rate of return on saving is lower, individuals' consumption grows at a slower rate, which confirms that their early consumption is greater and their later consumption is less.

By driving a wedge between the before-tax rate of return (which measures the benefits that the savings can offer in the economy) and the after-tax return that savers can receive, the income tax artificially discourages mutually beneficial saving. The saving penalty is also likely to slow long-run economic growth.

  • Although some business investment in the United States is financed by foreigners' savings and some Americans' savings are used to finance investment abroad, the level of business investment in the United States is still linked to the amount Americans save.
  • A reduction in the amount of Americans' saving is therefore likely to shrink the U.S. capital stock, reducing the long-run levels of output and wages.

Prominent economists' simulation models indicate eliminating capital income taxes through a move to consumption taxation would increase long-run output by 2 percent to 9 percent. A significant part of the long-run gains come at the expense of short-run consumption. The size of the gains depends on economic assumptions, which are subject to considerable uncertainty, and on the design of the consumption tax reform.

Source: Alan D. Viard, "Capital Income Taxation: Reframing the Debate," American Enterprise Institute, July 2013.

 

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