Sunday, November 20, 2011

Capital gains and income inequality

Capital gains, mainly from financial assets, is the biggest source of income growth for those at the top of the income ladder. Consider this from an Economix post by Laura Tyson,

According to the Congressional Budget Office, from 2002 to 2007 more than four-fifths of the increase in income inequality was the result of an increase in the share of household income from capital gains, with the remainder the result of an increase in other forms of capital income. Capital and business income are much more unevenly distributed than labor income and have become more so over time. Capital gains income is the most unevenly distributed — and volatile — source of household income. The top 0.1 percent earns about half of all capital gains, and such gains account for about 60 percent of the income of the top 400 taxpayers.

Ironically, it is also that income stream which is taxed at the lowest rate. Capital gains tax was lowered from 28% to 20% by Clinton in 1997 and then to 15% by Bush in 2003. As "carried interest", President Bush extended this rate to fees earned by hedge fund and private equity managers. In other words, while wages are subject to both federal income tax and the payroll tax, capital gains and dividends are taxed at 15% and are not subject to the payroll tax.

These trends are not unique to the US and has become the norm across the world. In fact, in India, long-term capital gains, defined by investment of more than one year, in many assets are tax exempt. Apart from the dramatic concentration of wealth and the widening inequality, the incentives created by the lower capital gains taxes is responsible for the skewed growth of the financial sector itself. Raising this tax to the level of that for other labor income streams, would curtail outsize compensation in the financial sector. Besides, in these times of fiscal crisis, it would provide a much needed boost to government finances.


Prashanth said...

By raising the rate, would not it mean that Steady income like Salary is made equivalent to risky investments (especially in stocks). Why would anyone want to risk investing in stocks when they could get a better Risk Adjusted Return via a Bond / FD.

Would not this then constrain growth since people would stay away from new business & risk.

gulzar said...

prashanth, thanks for the comment. the reality is that the risk weighted return on certain categories of financial assets, even assuming a high rate of taxation, is much higher than bonds and FD. the spectacular income gains by those at the top of the income ladder in the past few years is a testament to this trend. this has caused the skewed distribution of investments in such asset classes.

the returns on asset classes are determined by the returns on the underlying assets. if the business activity is very profitable, then the returns will be naturally very high. specific equities will always generate higher risk weighted returns than debt instruments. so there is no danger of growth being constrained.

Prashanth said...

>> if the business activity is very profitable, then the returns will be naturally very high.

Hmm. I would disagree there. First of all if a business activity is very profitable, it has to mean there exists some high degree of barrier that has meant that competetion has not reduced its returns.

Secondly, lets assume some one started this profitable business. That means he took a risk that none had taken before. If he had failed, he would be blasted for not understanding. If market rewards him for being right, well, thats a risk that has paid off.

Lets take Reliance for example. Its a business activity that is indeed profitable. Margins are pretty high and they have high barriers of entry. But the reason Ambani made money was that he took every risk that he could take & came out on top.

On the other hand, I believe it would be fair to have a Estate Tax. The risk taker should not be penalized for winning. Or how about even a Wealth Tax.

KP said...

Dear Gulzar,

I think there is a strong case for increasing taxes - there is a certain quality to the accumulation of wealth and in that regard we cannot compare salaries to investment / equity (or risk capital) - salaries mostly stagnate.

The tendency to accretion of wealth is further enhanced by productivity / technology / efficiency / market expansion. That in itself represents a significant reward.

I think elizabeth warren had some sharp remarks to make of "businessmen" and "risk" - like it all happened in isolation with nothing owed to society for their success.

[This ignoring the significant market subsidies (incentives) offered to risk takers. (more riskier than the business though is the difficulty in handling the 'environment')]