Soaking Rich Hurts Workers
by John Goodman
Issue 119 - November 5, 2008

Taxing Capital to Pay for Health Care Consumption? This is not just a bad idea. It is a very, very, very bad idea.

Yet the primary way Barack Obama, Hillary Clinton and many other politicians have proposed to pay for health reform is by rescinding the Bush "tax cuts for the rich." (Read: higher tax rates on dividends and capital gains.)

No matter who wins the presidential election, this bad idea is not going to go away -- even though (as previously reported here) Obama has backed away from it considerably.

Here's why: 99.9% of all the people who specialize in health policy know absolutely nothing about capital theory. They think that reversing the Bush tax cuts on dividends and capital gains for high-income taxpayers is the closest thing on God's green earth to a free lunch.

They are, of course, quite wrong.

Let's take Warren Buffett, who by his own admission has more money than he will ever need. Suppose we consider confiscating all his capital income and spending it, say, on any good cause you can think of. Is this a good idea? Put aside concerns about ethics, fairness, individual rights, justice, etc. Is it in our narrowly defined self-interest or the self-interest of others? The answer, surprisingly, is: no.

There are basically two things Buffett can do with his wealth: he can consume it or invest it. When he consumes, he is using up resources that are then not available to anyone else. By contrast, when he forgoes consumption and invests, he makes it possible for everyone else to consume more. Buffett's investment adds to the nation's capital stock. This means higher wages and more output. There will be more goods and services to be consumed and the average worker will have more income to devote to such consumption.

If you think of consumption as the end goal of economic activity, when Buffett consumes he is benefitting Buffett. When he saves and invests, he is benefitting everybody else. That's why economists on the left and the right (at least those who think about these things) prefer to tax consumption. The flat tax, the national sales tax, the value added tax are all designed to tax consumption rather than saving and investment. There are many ways to do this. Some approaches are more progressive than others. A sensible compromise is the "progressive flat tax" proposal I developed with Larry Kotlikoff.

I know what you're thinking. Even if taxing Buffett's capital is not the best idea in the world, surely the rest of us can realize some net gain from doing so. In the short run, that may be true.  But in the long run it appears not to be true. The reason: The after-tax rate of return on capital tends to be set in international markets and it tends to be independent of U.S. tax policy. That is, the long run return to capital is unaffected by how much we tax it. This implies that taxes on capital are ultimately paid by labor. In taxing capital we end up harming the very people we are trying to help.

Here is Nobel Laureate Gary Becker's very excellent treatment of this issue.

John Goodman is President of the National Center for Policy Analysis.