Updated: November 22, 2012 6:33AM
To some, financiers are heroes who take enormous risks to create jobs and improve society. To others, they represent exploitation and the excesses of wealth.
That philosophical clash is especially intense this year because the Republican presidential nominee, Mitt Romney, had a successful career advising wealthy investors, and he has considerable personal wealth.
Income from capital gains — the money an individual earns from the sale of property or investment — is generally taxed at a lower rate than income from wages. Romney paid a federal income tax rate of only 14.1 percent in 2011 because much of his income was a return on investment. It may seem unfair that Romney paid a low tax rate because of the apparently arbitrary fact that much of his income was derived from investments.
In an era when the distribution of income in the U.S. has become increasingly uneven and tax revenue is insufficient to provide basic government services, it is reasonable to ask whether the wealthy are paying their fair share. Lower tax rates for investment income seem to violate the traditional value embodied in the U.S. tax system: that tax rates should increase with income, or should be progressive. But there are good reasons to tax capital gains from long-term investments differently than income from wages.
Gains from investments are taxed when an asset is sold. This procedure treats all appreciation of the asset as income, regardless of whether it resulted from inflation. An asset might have greatly increased in value, but the price of goods and services may have risen even faster.
Consider a stock purchased for $5,000 in 1960 that now sells for $30,000. It hardly seems equitable to tax someone who makes such a transaction in the same manner that we tax someone who earned an additional $25,000 from a job last year. In 1960, a family of four could live comfortably on $5,000 while today an income of $30,000 would leave the family struggling. Taxation of capital gains should account for the fact that asset appreciation reflects inflation.
The corporate income tax rate complicates the issue further. Taxing capital gains by both the corporate and personal rates could result in a higher cumulative tax rate than on wage income alone.
We could rewrite the tax code to explicitly correct for inflation and to adjust based on the corporate income tax rate. However, this might encourage individuals to play the system to reduce their tax burden. Instead, the system is designed to make an approximate adjustment for inflation, and the corporate income tax rate, by taxing capital gains at a lower rate than other income.
However, there is no reason that the capital gains tax rate has to be as low as and essentially flat as it is now. We already tax the capital gains of those in the lowest tax brackets (married couples earning less than $71,000) at a lower rate than higher-income households. If we are truly concerned with maintaining a progressive tax system and correcting the skewing of U.S. income distribution, we could adjust capital gains rates based on income, as we do with wage income.
The focus on Romney’s taxes has brought the issue of tax fairness into the public discourse. Sensible tax policy recognizing that income from investment should be treated differently than income from wages is compatible with progressive tax policy that helps remedy the skewed distribution of U.S. income.
David Merriman is associate director of the University of Illinois Institute of Government and Public Affairs and a professor of Public Administration at UIC.