The great capital gains tax hoax

In light of the recent Tax and Transfer Review by the Federal Government, lobbying interests are moving to reduce capital gains taxes.

The term “capital gain” contains a deliberate contradiction: real capital doesn’t gain.

Capital, as defined by the classical economists, is a product of human effort. Land is not; its supply is fixed. When the effective demand for land increases - because population grows, or because people have more money to spend, or because public investment in infrastructure makes people willing to pay more for land in the serviced locations - there can be no compensating increase in supply; therefore, in the long term, land increases in value. But if capital increases in value for any reason, the increase induces production of more capital, which competes with the existing capital, causing values to fall again.

Therefore any gain in the value of capital is temporary; in the long term, capital depreciates due to wear-and-tear and obsolescence. An exception arises when the owners of capital are given some sort of protection from competition, like that which nature gives to the owners of land - but in that case the “capital” has been stripped of its defining economic property and has become, for economic purpose, land-like.

It follows that a so-called “capital gains tax” falls preferentially on land and land-like assets, not on true capital. So why does official terminology pretend that it is a tax on capital? To make it look bad.

Taxes on capital, including taxes on income from capital, deter the production of capital and are therefore economically destructive. But taxes on values of land, including taxes on increases in land values, cannot deter production of land, because there is no such production. Neither can they deter the productive use of land; on the contrary, by increasing the attractiveness of current income relative to accrued increases in value, they encourage owners to use their land productively (or sell it to someone who will) instead of simply holding it and waiting for its value to rise.

Therefore if governments want to encourage work and productive investment rather than parasitic speculation, they should:

1. cut taxes on income from labour;
2. cut taxes on capital, including those on income from capital; and
3. raise taxes on values of land and land-like assets, including those on increases in asset values.

But of course these prescriptions are unacceptable to those who have grown rich by speculating on increases in asset values. So they obfuscate the issue by calling such increases “capital gains”, thus implying that any tax on them is a tax on capital!

Because rational policy calls for “capital gains” to be taxed more heavily than current income, the obvious response for the speculators would have been to demand that both be taxed at the same rate. Such “equal treatment” has a superficial appearance of fairness, especially to those who support income taxation in principle, and is compatible with the Haig-Simons definition of income, namely consumption plus the change in wealth.

But that wasn’t good enough for the speculators. They wanted “capital gains” to be taxed at a lower rate than current income, including labour income. Their argument had three parts. First, capital creates jobs. Never mind that all capital is produced directly or indirectly by labour, or that workers create their wages out of the marginal product of their labour (otherwise it wouldn’t be economic to employ them). And never mind that “capital gains tax” doesn’t actually target capital.

Second, because assets are purchased out of after-tax income, taxing any gain in values of those assets is double taxation. Never mind that those who complain about full taxation of “capital gains” also demand full deductibility of depreciation. And never mind that if taxation of current income and “capital gains” really were double taxation, one could solve the problem by retaining the tax on “capital gains” and abolishing the one on current income!

Third, to brush off the accurate observation that a lower rate for “capital gains” favoured speculators, it was proposed that the lower rate should be available only after the asset was held for a certain time, or that there should be a series of tax rates, with lower rates for longer holding times. Never mind that whether an asset acquisition is productive or speculative depends on the type of asset and the use to which it is put, not the time for which it is held. And never mind that the speculators who can afford to wait longer are those who were richer in the first place.

These arguments, though invalid, were plausible enough to prevail when backed by the enormous campaigning power and advertising power of those who expected to gain from them. In Australia, for example, the richest 1 per cent of taxpayers (ranked by taxable income) receive only 5.3 per cent of all wages and salaries, but receive 38.6 per cent of all “capital gains” [source: Treasury, Architecture of Australia's tax and transfer system, August 2008, p.184].

So it is that in Australia and in most developed countries, speculative gains on land and land-like assets are taxed less heavily than income from productive investment or the sweat of one’s brow. In the USA, this has been the case since 1921. So it is that the Haig-Simons formulation, which in fact unreasonably favours asset owners over workers and other producers, is portrayed as a lunar left-wing footnote to the history of economic thought.

And so it was that on the August 6 edition of Lateline Business on Australia’s ABC TV, a statement that taxing income from capital can stifle economic growth (true) together with a call to reduce the level of taxation on constructive investments (fair enough) illogically morphed into a purely opportunistic attack on “capital gains tax”.

In view of the strong correlations between speculative gains, obscene wealth, and political influence, it is perhaps unrealistic to hope that public policy will ever be determined by anyone but the speculators or can ever be changed except by pandering to the speculators. But in the course of such pandering, one should draw attention to one powerful mechanism by which the speculators have become victims of their own political success.

Because governments don’t claw back a large share of unearned uplifts in land values, they don’t have much incentive to do things that cause such uplifts - e.g. investing in infrastructure. So desirable infrastructure projects languish for want of funding, and property speculators miss out on the associated “capital gains”.

It’s easy to say “Serves the speculators right!” But they are not the only ones who suffer.