For most of the past six decades, the U.S. government has taken a lenient approach toward taxingfinancial wealth. Dividends from stocks and gains on long-term investments are currently taxed at 15 percent, compared with rates on ordinary income as high as 35 percent. The differential treatment has resulted in such attention-grabbing distortions as Warren Buffett paying a smaller share of his income in taxes than his secretary, and Mitt Romney paying an effective federal rate of only 14.1 percent on $13.7 million in income last year.
In a certain kind of world, such a system makes sense. In
the 1970s and 1980s, researchers built models of the economy
showing that, if everyone started out with nothing, made money
by working and didn’t pass anything on to their children, the
optimal rate on investment income would be zero. The logic was
that if you tax people once on their labor income, it’s not
right to tax them again on the part that they set aside for the
future. Doing so would inhibit saving, starving the economy of
the investment it needs to grow. Fewer jobs would be created.
Everyone would be worse off.
Now consider a different world. Here, some people are born
well-off, with inheritances so large that they can live
comfortably without working. Most, however, are born relatively
poor, with little or no capital at all. In this world, taxing
labor income alone would amplify the inequality by putting an
outsized burden on people who work. Taxing capital, by contrast,
would take some of the pressure off labor, increasing the
incentive to work and providing a net benefit to the majority of
The second world closely resembles the present-day U.S. As
of 2010, the wealthiest 10 percent of families commanded about
75 percent of all households’ total net worth, while the poorest
50 percent held only 1 percent, according to Federal Reserve
data. The distribution of inheritances is similar.
To get a sense of what tax rates should be in such a world,
two researchers -- Thomas Piketty of the Paris School of
Economics and Emmanuel Saez of the University of California,
Berkeley -- built a model of the economy that took into account
the vastly divergent financial endowments.
They found that the distribution of wealth makes a big
difference: The more it’s concentrated in the hands of a few,
the more the benefit of shifting the tax burden off labor income
outweighs any potential negative impact on saving. They estimate
that in the extremely concentrated case of the U.S., if the aim
is to make humanity as a whole better off, the optimal tax rate
on capital -- including bequests, corporate profits and
investment income -- would be as much as 60 percent.
What does all this mean for the current U.S. tax system? It
suggests that if you think the government needs more revenue to
reduce its budget deficit, raising taxes on investment income is
a good solution.