Why The Low Capital Gains Tax?

Former Fed vice chairman Alan Blinder doesn't get it, and neither, frankly, do I.

Why do we have a preference for capital gains in the first place? The main argument is that lower taxes on capital gains boost investment. But the evidence on that point is iffy at best, and there are better ways to spur investment, like, say, the investment tax credit. Besides, lower taxes on capital gains reduce the tax bills of the rich relative to the rest of us — after all, they own most of the capital. But in this age of hyper-inequality, shouldn’t we be making the tax code more progressive, not less?
A far more important objection is that the tax preference for capital gains undermines capitalism — a system in which capitalists, not the state, are supposed to make the investment decisions. When I discuss this issue with my Economics 101 students, I show them an example of a proposed investment that loses money before tax (and which, therefore, should be rejected) but which actually turns a profit after tax because of the preferentially low capital gains rate. (Accountants and tax lawyers live this example every day.) The government thus induces people to make bad investments.

Justin Fox, on the other hand, says that "In economic theory it's pretty clear what a capital gain is and why you would want to give favorable treatment to capital investment." And Brad DeLong says that he's "'much more sympathetic to the capital gains tax preference than Alan Blinder is".

The way I see it, when you're rich enough, you can pretty much always structure your income so that it turns into a capital gain. (In its simplest form, you just found a company with a little bit of money, redirect your income into that company, and then sell the company.) So having a capital gains tax rate much lower than the income tax rate is tantamount to giving the rich a massive tax break – even before accounting for the fact that it's the rich who generally have capital gains in the first place, and not the poor.

But I'm not an economist, so maybe one of them can explain to me how economic theory, and/or economic practice, shows that capital gains should indeed be taxed at a lower rate than income.

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