### Taxing Capital versus Taxing Capital Gains

7/28/2012 07:04:00 PM
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...not exactly the same thing.

We've heard a lot about capital gains taxes in recent years, but one thing that has me a bit frustrated is how frequently people use economic analysis of taxes on capital to argue that we should tax capital gains less. I have in mind analyses like these from David Frum. Here is what Frum said:
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.
There are two big problems with this analysis. First, its sexist--why does he assume that Jane can't run the company as well as Joe? The second big problem is that we tax the net gains from selling capital, not the gross revenues. That's a big difference. Let me reproduce what appears to be Frum's (erroneous) math:
30%-50%=-20%, therefore they would have to take a 20% loss to move the capital to a more efficient use
The problem is that we do not tax the gross value of the capital to the company. Rather, we tax the net gains from capital to the company. So how much in capital gains does Joe pay? Frum doesn't provide enough information! We have no idea what price Joe purchased the company from Jane for, so it may well be that he bought the company for exactly what it is worth to Joe, so he pays no capital gains at all! And we have no idea what Jane purchased the company for--it may well be that she bought it for 30% less than what the value of the company was under her management, and in turn sold it to Joe for 30% more, in which case she is paying 50% of the 60% she earned in capital gains. Or maybe she bought it for exactly what Joe paid for it, so she owes 50% of \$0 in capital gains.

To sum up, people like Frum are thinking about capital gains taxes in exactly the wrong way. They have absolutely no intra-temporal distortionary effects--no matter the capital gains tax rate, extant capital will always be transfered to where it can be put to the best use. By contrast, the only distortionary effect of capital is inter-temporal--taxing capital gains reduces the after-tax returns from capital, which reduces the incentive of households to save.