The inflation hypothesis has some legs in the Wall Street Journal today, with a front page story on rising global inflation and accompanying unrest in emerging markets, plus an op-ed by Michael Darda of MKM Partners on "The Inflation Threat to Capital Formation."
Darda’s work is especially important in our opinion. When inflation meets high tax rates on capital, the result is a falling return on investment. And to the extent that allocators of capital perceive this, real investment falls. In the 1970s, the combination of inflation and cap gains rates was so toxic that it resulted in a "tax" on investment of well over 100%! More relevant to today’s situation, Darda argues that productivity growth falls commensurately with every rise in the effective (inflation plus nominal cap gains rate) tax on capital. When Sens. Clinton and Obama promise to raise the capital gains tax rate, and say nothing about indexing capital gains for inflation, they are essentially promising to lower productivity growth, which leads to slower growth in real wages. Granted, if you are someone whose real wages are falling anyways, this rhetoric essentially promises to spread the pain, and is thus very rational for certain voters. However, for the U.S. economy as a whole, it is patently irrational.
As valuable as Darda’s observations are, they are, as is too often the case in these discussions, examined in isolation from other taxes. That’s a mistake, and it serves to increase the risk of policy error. At a minimum, any discussion of capital gains taxes should be expanded to corporate and income taxes as well.
Corporations in the U.S. face high tax rates relative to other countries, and high cap gains tax rates relative to other investors. And of course, neither of these rates are indexed for inflation either (although corporations have traditionally used LIFO accounting and other measures to counteract inflationary pressures on their tax burdens). Those groups of voters who are pushing to share their own pain with the rest of the domestic economy through higher tax rates, and with overseas economies through higher trade barriers, would be better served by pushing their candidates to lower the overall burden on corporate capital investment.
As for income taxes, we like to argue (thanks to our contrarian bent) that at a certain level, there is no meaningful distinction between human capital ("labor") and other forms of physical capital (factories, tools, machinery, etc). Both require ongoing upkeep and maintenance. Both can be made to operate more productively (or less). And both eventually wear down and must be replaced. On any day, an owner of physical capital must decide whether to employ that capital, which is a matter of estimating whether the return will exceed the cost. We all make a similar decision when we decide whether to exchange our labor for compensation, e.g.:
"Is it worthwhile for me to perform task x in exchange for $y? Or would I be better served to (a) take my personal capital offline and go fishing or (b) earn a higher return on my personal capital in the underground economy (e.g., tax evasion, criminal activity, etc)?"
It’s also important to note that personal capital is the primary source of future financial capital (i.e., savings) for most people, excluding those who inherit it or otherwise chance into it (e.g., through the lottery). Most individuals do not have options available to them like LIFO accounting or complex tax arrangements; for the most part, their choices consist of tax evasion or other criminal activities when taxes and inflation make it difficult to earn a living, and/or various welfare programs when they are available.
It should be quite clear that there is absolutely no valid argument for levelling different tax rates on labor or corporate income versus capital gains and dividends. This means that when Democrats say that financial capital gets a sweeter tax deal than income earners under the current tax code, they’re right (they conveniently leave out that the same is true of corporate income). Add it all up along with payroll taxes, and the U.S. tax system is not nearly as steep and progressive as many conservatives argue (such arguments usually rely solely on income tax data, which is very progressive). The current problem is that in policy debates, Republicans tend to overlook these facts, while Democrats want to level the field by raising the overall tax burden. Neither course is optimal for the long term health of the domestic economy or for the long-term well-being of U.S. citizens.