Sunday, February 3, 2008

On Incentives and Cap Gains

In response to yesterday's post on tax credits, a loyal reader asked via email:

I enjoyed your entry on tax credits and have a question.

You said, "If a choice is bad without a tax credit, commonsense suggests its likely also the wrong preference with a tax credit." Why isn't this true for the capital gains tax, which I imagine you don't like?

Good question. It is a subtle difference. My statement does apply to the capital gains tax—the situation is just inverted.

A tax credit—such as, say, the mortgage interest credit—is a subsidy in favor of mortgages. The credit makes mortgages cheaper, thus encouraging homeownership beyond where it would be in an unperturbed equilibrium.

The tax on capital gains is a burden on investing. The tax lowers the returns on investment, thus discouraging investment below where it would be in equilibrium (how much depends on certain elasticities and is an open research question).

In both cases, we have deadweight loss, where the optimal quantity supplied or demanded is not met. In and of itself, we want to avoid deadweight loss, but the capital gains tax is particularly bad as we want to encourage, not discourage, personal savings and investment.

For exactly this reason, I support lowering or even eliminating the capital gains tax.