Keeping It Real

KEEPING IT REAL….Matt Yglesias endorses Ron Wyden’s tax plan today, and I might join in if I had the slightest idea what Wyden was proposing here. Unfortunately, “All Americans should be able to complete their taxes in an hour or less” isn’t a proposal, it’s populist nonsense. The modern world has lots of complex ways of making money, and if you choose to earn your money in one of those complex ways there’s really no alternative to having a complex tax code to handle it.

Furthermore, although I hate to do it, I have to take issue with Matt’s suggestion that “all income should be taxed according to a single rate schedule. Right now, capital income is taxed much more lightly than labor income, which is great if you’re rich, but otherwise not such a hot idea.” I agree, but I think this requires a caveat.

The problem with investment income is that it gets eroded by inflation. Suppose, for example, that you have $100, the inflation rate is 5%, your return is 8% (3 points higher than inflation), and the tax rate is 30%. Here’s what happens.

At the end of the year you have $108, which makes your total income $8. At a 30% tax rate you have to pay $2.40. However, your inflation-adjusted income was only $3, which means that your effective tax rate is 80%. That’s a bit steep, no?

Taxing capital income at the same rate as labor income seems like basic fairness to me. But that needs to be a real rate, which means including an inflation adjustment of some kind. Of course, that also means adding some complexity to the tax code. Sorry, Ron. Alternatively, you can do a quick and dirty adjustment by taxing capital gains at a lower rate and figuring that that’s close enough. But you really have to do something.

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