Well… That was unexpected. I open a blog and I get a link and an approving comment from Greg Mankiw! (Thanks Greg!) This is what I would call a win. Give me a second to bask in that glory… OK, let’s get back to business.
A lot of very interesting points were brought up and I can’t respond to all of them, but I want to respond to what I felt was a theme in the comments. It goes something like this: “Greg Mankiw and you don’t get it. We want to know whether Warren Buffett should be paying higher taxes or not.”
The problem with that argument is that tax policy is hard. It’s very hard. There are plenty of complicated questions, some of which have no clear objective answers. In other words, it’s complicated enough as it is and getting tax incidence mixed up with tax collection will just confuse the issues further. So let’s get the basics right first. If the President is proposing policy based upon a flawed understanding of the current tax system, his policy is also going to be flawed. Garbage in, garbage out.
So how should we tax Warren Buffett? I’m going to argue that raising taxes on capital gains is a bad idea. There are many ways to reach that conclusion (and ways to reach the opposite conclusion too) and I’m only going to bring up one here and I will bring up more in future posts.
Taxing capital gains discourages capital formation. Let’s imagine a very simple economy. Every day, people have 8 hours of time during which they may work. During that 8 hours of work, they have two activities available to them. They can spend 1 hour making a loaf of bread or they can spend 4 hours creating a machine. That machine every day creates 2 loaves of bread forever.
So how do you split your day? Well, you could make 8 loaves of bread, 2 machines or 4 loaves of bread and a machine. Which you choose depends upon how impatient you are. (Your time discount rate in econ-speak) If you are a very impatient person, you might choose to make 8 loaves of bread every day because having the bread right now is important to you. If you are very forward-looking, you might make 2 machines every day because you are willing to wait. If you are somewhere in between, you might make 4 loaves of bread and a machine every day.
Now obviously, we want there to be as many loaves of bread to go around as possible. That’s what growth is all about right? In the very short run, that means making 8 loaves of bread per day. But over the long-run, we’re better off the more machines there are because then we have many loaves of bread produced automatically every day.
Now the government imposes a tax on the output of the machine. Every day, when the machine creates 2 loaves, one is sent to the government and never seen again. Of course, this will shift the incentives. If you were on the edge whether to make a machine or just an extra 4 loaves, you now will decide to make the 4 loaves. In the long run, we are poorer.
I don’t want to curb anyone’s well-deserved enthusiasm for my post, but I want to clarify something. What I am referring to here is the taxation of capital, not necessarily the income-progressivity of the tax system. Now of course, accumulating more capital does tend to lead to one being “rich”. But that’s a second-order consideration here.