Capital Gains

Income from capital gains - e.g. the increase in the value of assets like stocks - is taxed at a lower rate than wages. In theory, lower taxes on capital income should lead to higher investment, which benefits the entire economy. The idea is to increase the incentive to save - if the taxes on the gains are lower, people will respond by buying more shares (an act of saving, because they forego consuming goods and services to buy shares). If people are more eager to buy shares, it will be easier for firms to raise money in the stock market for investment projects, like new factories and equipment (i.e. capital). A larger capital stock means that workers can produce more, and therefore wages should rise. So, even though the direct benefit of a capital gains tax cut goes mainly to a relatively small group of wealthy people, it may actually have economy-wide benefits.

I'm rehashing the argument for special treatment for capital income because the case against was made last weekend in the Washington Post by Leonard Burman of the Tax Policy Center, and in the Times by Princeton economist Alan Blinder. Writes Burman:

...In fact, the tax break on capital gains does more harm than good. The overall level of saving responds little to tax rates. And enough investment is financed from sources unaffected by individual income taxes -- such as pension funds, insurance companies and foreigners -- that the direct taxation of capital gains of U.S. stakeholders doesn't matter much....
What the low tax rate on capital gains does is spur a huge amount of unproductive tax sheltering. Wealthy individuals invest enormous sums in schemes to convert ordinary income into capital gains, often making investments that would make no sense absent the tax savings. Capital is drawn away from productive investments, hurting the economy. Similarly, the highly talented people who dream up tax shelters could, in a better world, do productive work....

Here's a graph of the effective capital gains tax rate (blue line, from the Tax Policy Center) and nonresidential fixed investment as a share of GDP (red line, from the BEA):
In the data, the relationship is far from clear; the correlation coefficient is actually slightly positive at 0.16! There is a bit of a dip in investment after the Tax Reform Act of 1986, which (temporarily) ended the differential treatment of capital gains income. However, investment is down again lately, despite the cut in the top capital gains rate as part of President Bush's package. Though this is short of a rigorous analysis for sure, it suggests that, although the logic is sound in the first paragraph above, the magnitude of the effect is so small it doesn't matter.