My Baroque Argument for Higher Capital Gains Taxes

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Matt Yglesias tweets about my post this morning on capital gains taxes:

Arguments for higher capital taxes grow more baroque, as @kdrum says private investment is economically harmful.

This is just a tweet, and there’s not much room for nuance in 140 characters. Still, I don’t think I’ve ever made my capital gains argument directly before, so maybe it’s worth doing. In a nutshell, here it is.

The usual rationale for low taxes on capital income is that it encourages capital formation and thus investment. This is self-evidently a good thing, since investment is good for economic growth, and it’s one of the reasons why most countries (including most European countries) tax capital lightly. Capital is good! The more the better!

I agree with the first sentiment: capital is good. However, I’m not so sure I agree with the second. There really might be a limit to just how much capital is a good thing. Economies are strongest when there’s a sensible balance between capital income and labor income.

The aughts are instructive here. Back in 2005 Ben Bernanke famously warned of a “savings glut,” a tsunami of money that was flooding into the United States looking for a home. The problem is that there was too much money and not enough productive uses to put it to. As a result, all that money flowed into housing and an increasingly baffling collection of Wall Street investment vehicles, and eventually it all came crashing down.

The fundamental problem was a mismatch. The flip side of a savings glut is an investment drought, and I’ve always argued that this was the real problem. If all that capital had flowed into real-world production — factory expansions, new startups, etc. — everything would have been great. But real-world production requires customers, and that in turn requires an expansion of labor income. We weren’t getting that in the aughts, though. As capital income increased, labor income necessarily decreased, which reduced the number of good investment opportunities for holders of capital. And it seems to be an iron law that when there’s not enough real-world investment for all the capital sloshing around, it piles up and eventually gets stupid. At some point the imbalance becomes too large and then the whole house of cards collapses.

So my question is this: would we have been better off in the aughts with higher capital gains taxes? I think you can make a good case. What we got with lower capital gains taxes was an extra boost to a trend that was already entering dangerous territory. Increasing capital gains taxes wouldn’t have prevented the Great Crash, but it might have lightened it a bit.

In any case, my main point about capital formation is that more is not always better. If you want a non-bubble ecoomy, you need a balance: enough capital to drive economic growth, and enough labor income to give that capital something useful to do. When that balance gets out of whack in either direction, you’re headed for trouble.

UPDATE: I should add that even if you don’t buy my argument about low tax rates on capital gains being potentially harmful, it’s still the case that the bulk of the empirical research shows no real relationship between capital gains rates and economic growth rates. The best you can say is that within reasonable limits, raising capital gains rates doesn’t seem to hurt much and lowering them doesn’t seem to help much.

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