Investment Tax Expenditures Have to Be Changed

I hate the tax debate.  I have 100% drunk the Kool-Aid that any tax increase will be used to increase spending even further beyond baseline, and as such needs to be resisted at all costs.

But that only means that any tax reform has to be revenue-neutral.  To actually reduce revenues when we've been dug this far into the hole is insanity.  We ought to be able to do a lot of reform with revenue-neutrality as a constraint.  Both Romney's and Ryan's plans attempt to do exactly that.

But today there's a Brookings analysis of Romney-esque tax reform.  It assumes a 20% reduction in rates across the board (I think--they've been slippery about this), then looks at how many non-investment tax expenditures (i.e., hands off capital gains and dividends) need to be phased out, starting from the top end of the income spectrum and moving down, to get back to neutrality.  Bottom line:  everybody with income under $200K has about a 1.2% decrease in after-tax earnings (i.e., their taxes go up), but incomes over $1M have a 4.1% increase.  The reason, the authors say, is that the non-investment tax expenditures heavily favor the poor and the middle class, while the investment expenditures heavily favor the rich.

Makes sense intuitively.  I'll be interested to see how--or if--this gets refuted.  In the meantime, this is a huge exposure in Romney's plan.  And frankly, this is where I have to agree with some of Obama's positioning--but only some.  Let's not raise rates on the rich, but do we really have to increase their after-tax income at the expense of the less rich?

The only way we're going to get there is to start fiddling with capital gains and dividend rates, while still reducing/flattening the tax brackets.

The argument against increasing investment taxes is that it disincents investment.  At the very least, it certainly reduces the marginal gain possible on investment, which in turn makes the investments have a less favorable risk-to-reward profile.  Even more important, in my opinion, the low capital gains rate encourages capital mobility, reducing the cost of exiting an under-performing investment and using the proceeds for a better-performing one.

Seems to me that there's a compromise to be had here:

1. Don't tax capital gains that are reinvested.  This is tricky to implement.  I'd guess that you'd have to have some sort of fed-blessed escrow account.  Note that this should also exempt capital gains distributions from taxation, which would allow for better tax planning.  It also allows for capital mobility, as long as you don't consume the profits.
2. For capital gains that aren't reinvested, tax 'em at the (reduced) ordinary income rate.
3. Get rid of the reduced qualified dividends rate entirely.  This doesn't encourage capital mobility at all (quite the contrary), and it's pure income.

I haven't crunched the numbers on this, and have no idea whether it can produce enough revenue to make a Romney-like plan revenue neutral without hurting middle- and low-income families, and to ensure that very high-income earners aren't getting a windfall.  The rich don't pull a lot of money out of their investments as consumption, which seems like a good deal both for them and for the economy in general.  But it definitely limits the revenue-generating potential from capital gains.

This is a better compromise than increasing marginal rates on high-earners.  Small-to-medium business owners take their profits as ordinary income, and will genuinely reduce expansion to manage their tax burden.  That's not to say that taxing investment income doesn't also have a negative impact on expansion and venture capital--it obviously does--but there simply isn't enough money right now.

By all means, let's simplify the system.  By all means, let's not increase revenues over where they are right now.  But burdening the middle class and the poor at the benefit of the rich just isn't going to fly.

UPDATE 9/12/12:  There's a reasonably cogent analysis from Rosen at Princeton (PDF) showing that, when you dynamically score the Romney plan to include both behavioral changes and a 3% increase in economic growth from the lower taxes, you get about $29 billion more in revenue from individuals making more than $200K per year.  Not sure I buy the 3%, but even with zero growth, the plan is slightly better than revenue neutral.  This is a pretty decent rebuttal to the Brookings/TPC study.