Economists rethink the view that capital should not be taxed

The Economist magazine has a most useful article questioning the old orthodoxy, prevalent since at least the 1970s, which says that the lower tax rates on capital, the better. The article's subtitle, Economists are rethinking the view that capital should not be taxed, represents quite a turnaround from its previously rather strenously anti-tax view when it comes to financial capital.

You would not have read paragraphs like this in The Economist a few years ago:

"Some economists are questioning the prevailing view, not least because reductions in capital-tax rates appear to have delivered more inequality than growth. In a 2008 paper, Juan Carlos Conesa of Universitat Autònoma de Barcelona, Sagiri Kitao of the University of Southern California and Dirk Krueger of the University of Pennsylvania argued that taxing capital was “not a bad idea after all”. Capital markets are imperfect, they observe, and households are unable to insure themselves against all of life’s ups and downs. Taxing away some of the return to capital to provide social insurance against risks is appropriate."

One might have thought that that was blindingly obvious. Not to economists, it seems. Their models were elegant, to be sure. But as we all know now since 2007/8, many their models - on tax, but on many other things too, were fantasies. Just take a look at the FT's two devastating recent critiques of Mervyn King, governor of the Bank of England, for an illustration of just how hard it has been for economists to speak out against the prevailing consensus. More:

"The old models contend that capital supply is highly sensitive to changes in tax policy, and that a zero tax rate is needed to prevent capital from drying up over the long run."

Duh. This kind of thinking rests on the assumption that taxation essentially involves pouring money down a rat hole. It merely transfers it from one productive sector (the private sector, with all its imperfections) to another productive sector (the government sector, for all its imperfections, provides eduction, infrastructure and so on, all of which is highly productive, if long-term.) Why transferring capital from one productive sector to another would lead to capital drying up in the long term is a mystery.

The world is awash in capital - and the economics in today's world, awash with capital, points squarely to higher taxation on corporations and capital. Take a look at this - nobody has knocked down these arguments, or even come close, and there are signs in fact that people are beginning to catch on to it.

Thomas Piketty of the Paris School of Economics and Emmanuel Saez of the University of California at Berkeley poke different holes in the models in another paper.

"The old models, they point out, ignore inheritances. In the real world inheritances strongly influence income levels, particularly among the very rich. Mr Romney recently reinforced this very point by exhorting students to borrow from parents if necessary. Taxes on wages and salaries are inadequate to the task of limiting inequality because they punish those who owe high incomes to greater ability and effort, rather than to inheritances. Messrs Piketty and Saez also question the scale of the threat to growth. They point to ratios of capital to output, which are surprisingly stable over time despite tax swings. Their model finds that the optimal tax rate on inheritance could be 50-60% or more."

And then there is the question of all those inefficiencies and distortions that stem from rich people finding loopholes and ways to recategorise income so that is no longer classed as labour income (which is taxed highly) and is classed instead as capital income, which (partly as a result of international competition to attract highly mobile capital) is generally taxed at much lower rates.

"All told, capital-tax rates as high or higher than those on labour may make sense, they [Piketty and Saez] think."

A recent paper by Emmanuel Farhi of Harvard University, Christopher Sleet and Sevin Yeltekin of Carnegie Mellon University, and Ivan Werning of the Massachusetts Institute of Technology makes another argument. Rising inequality is potentially destabilising, and a progressive tax on capital in the present may lead to more investment by keeping inequality in check and by convincing firms that their wealth is (mostly) safe over the long term.

We have been critical of many things written by The Economist in the past. But we salute them for admitting that they may have been getting it wrong for a very long time. They were far from alone. We don't see too many others rushing out to admit the scale of their errors. Let's hope this article will flush out a few more of them.

More on this theme from Citizens for Tax Justice, here.

Hat tip: Richard Brooks.