Burman: End Capital Gains Tax Breaks

The ongoing brouhaha over private-equity tax dodges has, in general, focused narrowly on the question of whether employees of private-equity firms such as Blackstone should be eligible for the special 15 percent top federal income tax rate on capital gains, which is less than half the 35 percent top rate for salaries and wages. Citizens for Tax Justice has argued convincingly that private-equity folks are abusing the capital gains loophole, and that their income should be taxed as regular wages at the 35 percent top rate.

But as the Urban Institute's Len Burman reminds us in today's Washington Post, there's a much bigger question lurking in the background: why should capital gains be taxed at a lower rate than salaries to begin with?

The most frequently-cited rationale for such a tax break is its impact on investment. Burman makes two points here:

1) the most obvious incentive this creates is for people to disguise their wages as capital gains. Burman argues that systematically undertaxing capital gains gives wealthy Americans "a huge incentive to make income look like capital gains rather than wages." If a cosmetic change can result in a tax break, people are likely to go for it. This point was being made long before Blackstone became a household name, but seems especially prescient now.

2) To the extent capital gains tax breaks actually are inluencing anyone's behavior, they're encouraging people to do things that the market, on its own, says are unproductive. Here's Burman:

Wealthy individuals invest enormous sums in schemes to convert ordinary income into capital gains, often making investments that would make no sense absent the tax savings. Capital is drawn away from productive investments, hurting the economy. Similarly, the highly talented people who dream up tax shelters could, in a better world, do productive work.

In short, there are plenty of reasons to think that the main investment incentives created by the lower federal capital gains rate are for wealthy people to (1) fake it and (2) do something just for the tax break.

As Burman also notes, there are other reasons to question capital gains tax breaks, not least of which is their horrendous impact on tax fairness. CTJ's most recent capital gains estimate shows that the wealthiest 1 percent of Americans enjoyed more than two-thirds of the benefits from this tax break in 2005.

Of course, eliminating capital gains tax breaks from the federal income tax aren't on anyone's political radar right now. But Burman deserves kudos for reminding us that there's an underlying tax inequity here that goes far beyond the alleged malfeasance of the private equity folks.