No Bain, no gains

By M.S.

AS SOON as Mitt Romney acknowledged that he paid a tax rate of about 15% because almost all of his income comes from capital gains, which feels like about a million news cycles ago, a bunch of commentators rushed to declare that while Mr Romney's personification of the 1% is an unavoidable political issue, there are good arguments for charging lower tax rates on capital gains. Strangely, though, I haven't seen anyone make any of them. The closest I've seen was this widely cited post by Republican dissident David Frum. (Here's Paul Krugman citing it.) But it seems to me that while Mr Frum makes an argument for low capital-gains rates, he fails to make a good one. Here's his take:

We want capital assets put to their highest and best use. If Joe can run the company better than Jane, if Jill can make better use of the corner of Main and Elm than Jack, then we want to see ownership of that company or that corner transferred as expeditiously as possible to the higher and better user. That's why we encourage transparent and efficient markets for capital assets.

A capital gains tax is a tax on the transfer of control of assets. If that tax is set too high, it can discourage even the most glaringly urgent transfers of control. Under Joe's management, the value of the company may rise 30%. But if the capital gains rate is set at 50%, then the transaction from Jane to Joe will not occur—and everybody will be worse off.

The first part of this parable confuses ownership with management. As John Kay recently pointed out while arguing against the current usage of the term "capitalism", few significant modern enterprises are managed by their owners. For the overwhelming majority of cases in the modern business world, if Joe can run the company better than Jane, then what we want to see is for the board of directors to fire chief executive Jane and hire Joe to replace her. This has little to do with capital gains. People who report capital gains due to ownership of a company are generally not active players in the company's activities; they're stockholders. And that, obviously, is what Mr Romney made his money from last year. He's no longer running Bain Capital, taking over companies and trying to rejigger their assets or run them better. He's a retired executive with an estimated $200m-plus in assets that are producing revenue for him in the way that assets have always produced revenues for wealthy rentiers.

In many cases, efficient deployment of capital does depend on companies acquiring assets they can put to use better than another owner could, as with a merger or acquisition. But capital-gains taxes usually play a minor role here, because expected appreciation of the shares or assets of the target company after it is acquired is not usually a major reason for the deal to go through, except in private-equity takeovers. When Daimler acquires a majority stake in Chrysler, they're mostly thinking about synergies and market share, not potential gains from selling off Chrysler stock in the future if it appreciates, though that consideration isn't entirely absent.

What low capital-gains tax rates mostly do is to encourage people to save their money by investing in assets, rather than saving it in vehicles that pay interest or dividends, or spending it on consumption goods.

Now, one may say, that's good. We want people to save and invest. True enough (though why capital gains are more virtuous than earning interest or dividends is an open question). But we also want people to work hard to earn money and create value. If we don't tax capital gains, that means we need to get the money to fund the government by taxing something else, probably income. And taxing income means there's less incentive to work hard. Mr Frum is weak on this point, too:

The underlying asset will have taxes assessed against it: corporate income taxes if it is a company, property taxes if it is a piece of land. Those taxes are paid the day before the transfer of ownership, and they continue to be paid the day after. A transfer of ownership transfers the obligation to pay the tax. But the amount of tax collection in the economy is not diminished by the transfer, and it's difficult to justify why the occasion of transfer should trigger yet more taxes.

Sure, the corporation still has to pay taxes on its income. But if lower taxes are assessed on the transfer, then something else is going to have to be taxed more highly in order for the government to be able to pay its bills. The question with taxation is never whether or not to tax; it's whether this type of tax is a better or worse way to raise revenue than some other kind of tax. Mr Frum never makes an argument that capital-gains taxes are worse for the economy than income taxes, or sales taxes. And Greg Anrig adds another point: the capital-gains tax introduces tremendous complexity into the tax code, which creates inefficiency and distortions of its own.

But here's the main point. As Mr Krugman notes, capital-gains taxes have only been 15% since 2003. From 1987-1996, they stayed around 28%. We now have capital-gains taxes that are just over half as high as in the old dystopian socialist days of Ronald Reagan's economy.

If higher capital-gains taxes led to lazy management and widespread misapplication of capital, you would have expected American businesses to have become vastly better managed and more efficient starting in 2003. If this was supposed to lead to higher growth, you would have expected GDP growth in America to be significantly greater from 2003 on than it was in the late 1980s and 90s.

Does anyone seriously think this has happened? It just doesn't sound like a good description of the history of the US economy over the past 20-odd years. What we have seen, however, were two tremendous asset bubbles, the first concentrated on the stockmarket, the second on housing, as people's money was used in ways that let them take advantage of low capital-gains taxes. As Mr Anrig writes:

Advocates of the capital gains tax break have claimed for decades that the exclusion benefits the economy and all workers by encouraging higher levels of investment and savings, which in turn promote growth and prosperity. But researchers have never been able to demonstrate that such connections actually exist. Capital gains tax rates have gone up and down over the years with little apparent relation to economic performance, aside from fleeting effects on realization of capital gains when rates change.

I think you can probably make some good arguments for taxing savings at a lower rate than income. You can argue, for example, that high capital-gains taxes don't actually produce that much more revenue, because they just lead people to hold assets for longer. Or you can point out that capital-gains taxes need to be lower than income taxes in order to compensate for inflation, which makes assets appear to have appreciated even though they really haven't. But Mr Frum doesn't make those arguments. In fact, nobody's making any arguments on that side that are very convincing. A number of people are nodding to the claim that such arguments exist, but nobody seems to be producing them.